Memoire Online - Analysis of factors affecting inflation rate in Rwanda (1990-2009)

A research project submitted to the faculty of social sciences and business studies, Kigali Institute of education

In partial fulfillment of the requirements for the degree of bachelor of social sciences (hons), Economics with Education and QTS (Secondary).

ABSTRACT

This study was carried out in the context of global financial crisis characterized by a worst inflationary shock in Rwanda during recent years, it uses chronological data (1990-2009) to analyze the extent to which changes in Money Supply (M2); in Output (Real GDP); in Exchange rate and interest rate (Lending rate) influence the inflation. The data consist of the aggregated data set of 20 years compiled by NBR and NISR. Using a non- linear and multivariate model, this study estimates the dynamic influence of changes in M2, in real GDP, in exchange rate and interest rate on Inflation. It is found that an increase in M2 has a positive and significant influence on Inflation. Contrary to Real GDP have a negative and significant influence on Inflation. The study reveals that Money Supply (M2), in Output (Real GDP), in Exchange rate and interest rate (Lending rate) count for 97.2% variations in the general prices level (Inflation). Some recommendations are suggested as emanating from the findings of the study like to pursue a control of monetary and fiscal policy by government as well as substantial growth in agriculture sector and other economic activities that contributed in increase of output are also suggested to moderate the rate of inflation in Rwanda.

DECLARATION

I hereby declare that this submission is my own work and to the best of my knowledge it contains no materials previously published or written by another person, nor material which to a substantial extent has been accepted for award of any other degree or diploma at KIE or any other educational institution, except where due acknowledgement is made in the project. Any contribution made to the research by others, with whom I have worked at KIE or elsewhere is explicitly acknowledged in the Report.

I also declare that the intellectual content of this report is the product of my own work, except to the extent that assistance from others in the project's design and conceptions or in style, presentation and linguistic expression is acknowledged.

(Signed) ....................................... Date .....................................

APPROVAL

This is to certify that UFITINEMA Richard has carried out research entitled «Analysis of factors affecting inflation rate in Rwanda (1990-2009)» under my supervision and guidance.

DEDICATION

To my mother, brothers and sisters and my late father who never lived to see this dissertation,

The success of a dissertation is a big endeavor that one never claims to own alone and when it comes to expressing gratitude, it is always hard to find who to thank and who to leave. This is because various people played different roles under different circumstances in their particular capacities through out the period of writing my dissertation. However let me attempt to this great task:

I owe special thanks to my Mum who managed to forego all and made their son an opportunity cost, without forgetting my brothers and my sisters who were always there for me during my academic struggle. May God bless them abundantly.

I extend my sincere gratitude to my supervisor Mr. Alain Claude KARASIRA, I am grateful for their advice, instructions and time sacrificed towards the success of this work.

Lastly I wish to thank the entire staff of the Kigali Institute of Education; mostly the Faculty of Social Sciences and Business studies, Department of Economics and Business studies may the almighty God award you abundantly.

Appendix 2: Regression analysis of consumer price index and Gross domestic product 38

Appendix 3: Regression analysis of consumer price index and Exchange Rate 39

LIST OF ABBREVIATIONS

EICV : « Enquêtes Intégrale sur les Conditions de Vie des Ménages au Rwanda »

LIST OF TABLES & GRAPHS

Table 2 : Evolution of CPI, M2, Real GDP, Exchange rate and Lending rate (1990-2009)

CHAPTER ONE: INTRODUCTION

1.1 Background

Inflation constitutes one of the major economic problems in emerging market economies that requires monetary authorities to elaborate tools and policies to prevent high volatility in prices and long periods of inflation.

Based on the statistics released by International Monetary Fund (IMF), in industrialized countries, inflation has generally been controlled. Inflation, measured by the change in the Consumer Prices Index (CPI), declined steadily, reaching 1.5% in 1998, the lowest rate recorded since 1990, after 2.1% in 1997, 2.7% in 1996 and 2.6% in 1995 (IMF, 1999:180).

Regarding developing countries, the same statistics mentioned above shows that inflation has fallen sharply since 1995, recording rates of 22.1% and 14.6% respectively in 1995 and 1996 against 47.5% in 1993 and 51.8% in 1994. During 1997, inflation has fallen sharply again to 9.2% and then increased to 10.3% in 1998. In Asia the rate of inflation fell to 4.8% in 1997 against 8.2% in 1996 while in Africa, he settled in less than half of the new 1996 (11.1% in 1997 against 25.9% in 1996) due to reforms and macroeconomic stabilization policies implemented in the country market. In 1998, inflation was reduced to 8.7% in Africa, while in Asia it rose again to 8.0% on the trace of the crisis that rocked the continent.

In sub-Saharan Africa, the inflation rate was 13.7% and 10.3% respectively in 1997 and 1998 against 32.3% in 1996.

After the years of double-digit inflation in 1990-95 and predominantly high inflation in 1996-2000, global rates fell to less than 5% in 2000-05. The most marked decreases were recorded in the transition countries, and the most stable, continuously low and decreasing inflation was recorded in the developed countries (ILO 2005:32).

The financial crisis which occurred in the United States in the second half of 2006 and became acute in 2008 continues to affect seriously the world economic outlook. In USA, inflation was 3.8% on average at the end of the year 2008 against 2.9% recorded in 2007 then declined by 0.3% in 2009. In the Euro Zone, harmonized inflation was 3.3% while it was 2.1% in 2007. The last estimates of the International Monetary Fund (IMF) highlight a world economic growth rate of 3.2% at the end of 2008 against 5.2% recorded in 2007 and stood at 0.3% in 2009. (NBR, 2009:15)

The following table shows annual percentage change of inflation by region of the recent years from 2005 to 2009

1.2 The research Problem

Thanks to the direct control of credit and prices, inflation was kept at a low level during the 1980s, an average rate of 4.7%. In the context of the 1990-1994 war, inflation was bound to increase and it indeed reached 64% in 1994. During the 1996-2000 period, the progressive restoration of institutions and security in the entire country, the control of public expenditure and monetary policy allowed the country to contain inflation at an average level of 5.4%. During the 2001-2005 periods, inflation was kept at an average rate of 6.7%. (Musoni 2009:5)

Rwanda's economy in 2008 developed in an unfavorable international economic environment characterized by a worst inflationary shock and the current global financial crisis. The world economy experienced important inflationary shocks during the first half of 2008 due essentially to the increase in world oil and food prices. On annual average, inflation in advanced economies was 3.4% in 2008 against 2.2% in 2007.

Despite the unfavorable international environment, Rwandan economy continued to perform well with the real GDP growth rate of 11.2% in 2008 following 7.9% recorded in 2007. This growth was mainly due to a strong recovery in the agriculture sector which registered a growth rate of 15% compared to 0.7% in 2007 and a noticeable improvement both in industry and service sectors which increased by 10.7% and 7.9% respectively. The secondary sector growth was driven mainly by good performance in the construction and public works sub-sector (26%) and production of electricity (16.9%) despite a decline in manufacturing of 4.1%. (NBR 2008:3)

According to the NBR (2009:4), the overall inflation accelerated from 6.6% in December 2007 to 22.3% in December 2008, despite the improvement in agriculture production and the low growth of broad money. In terms of annual average, the inflation in 2008 reached 15.4%, against 9.1% in 2007 due to decline in import prices, good performance of agricultural production, annual average inflation dropped to 10.3% from 15.4% in 2009.

The inflationary pressures resulted particularly from the international fuel and food prices. Compared to the year 2007, terms of trade deteriorated by 16.5% in 2008, their index falling from 150.5 in 2007 to 125.7 in 2008. Contrary to the year 2007 when the export average value had increased more than the import average value (18.2% compared to 2.2%), trends were reversed in 2008.

The questions that come to mind after considering these issues concerns factors that explain inflation in Rwanda. Relatedly, is there an economically interpretable relationship among Consumer prices Index, output, interest rate, money supply and the exchange rate? And lastly, how can we use these variables to forecast future inflation rate in Rwanda?

1.3 Research objectives

In view of the above research problem, the broad objective of this study analyzes statistically factors affecting inflation rate in Rwanda. This involved specifying and estimating an inflation regression model with the consumer prices index as the dependent and, gross domestic product, interest rate, money supply and exchange rate as the explanatory variables.

ii. To determine the effect of the gross domestic product (output) on the inflation rate in Rwanda;

1.4 Research Hypotheses

In consistent with specific objectives above, this study tests the following null hypotheses:

H1 : Money supply has a significant positive effect on inflation rate in Rwanda.

H1 : Exchange rate has a significant positive effect on inflation rate in Rwanda.

H1 : Interest rate has a significant positive effect on inflation rate in Rwanda.

The student's t-test was used to test the above hypotheses at the 5% significance level.

1.5 Significance of Study

In an inductive perspective, this study increases our understanding about the effect of studied variables on inflation rate in Rwanda hence, it can be used by decision markers to control or carry out the problem of inflation based on correlation coefficient of each variable to the inflation. In a deductive perspective, this study helps the researcher to increase deep knowledge about the frequent fluctuations of the prices on the market; it will also help my community to ascertain further studies about the inflation based on our achievement.

1.6 Scope of the study

Our research as any other scientific work is limited in time, space and in the domain. In time, we focused our analysis on the period from 1990 to 2009 because the period allowed us to search recent data related to our subject.

Regarding the delimitation of space, our study focuses on Rwandan territory. In the field, our study focuses on aggregate macroeconomic variables between inflation and its possible effects on the economy.

1.7 Organization of the study

This study have five chapters which will be organized as follows: Chapter one is an introduction giving the background of the study, research problem, research objectives, research hypotheses, significance of the study, hypothesis, and scope of the study. Chapter two is the literature review. Chapter three presents a discussion of the methodology adopted for the empirical analysis, followed by the results and discussion of the empirical analysis in chapter four. The last chapter considers the conclusion and recommendations.

CHAPTER TWO: LITERATURE REVIEW

2.1 DEFINITION OF KEY CONCEPTS

The concept is a prerequisite for any research. To avoid using vague terms and to fight against any kind of ambiguity, it is important to begin by defining the details of the key concepts of the study. The concepts defined in this study are: Inflation, Consumer Price Index, Gross Domestic Product, Interest Rate, Money Supply, Exchange rate.

2.1.1 Inflation

In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. Moreover different economists have defined inflation as follows: According to the Kumar (1993:258) «inflation refers to the persistent, steady and continuous rise in the general prices of all outputs as well as inputs».

G. Crowther defines inflation as «a stage in which value of money is falling i.e. prices are rising.» Thus, inflation does not refer to the rise of price of one or two commodities, but the general rise in prices of all goods.

Prof. Coulburn has defined inflation as «too much money chasing too few goods» (Kumar and Mittal 2002:168).

According to Peterson (1977: 294) popularly inflation refers to the «sustained rise in the general price level and is generally measured by changes in the consumer price index».

A. Different types of inflation

According to the Kurman (1993: 260) Inflation has been divided into many kinds on the basis of different criteria like (1) Speed of inflation, (2) cause of inflation, (3) Control etc.

a. Creeping, Walking, Running and Galloping inflation: on the basis of rapidity of the rise in the prices inflation has divided into 4 types: creeping, walking, running and galloping inflation. However the different between these types of inflation is rather matter of degree only. Different names are given to different speed of price-rise.

When the price rises very slowly by about 3%, we call it creeping inflation, it is very mild and does not cause any harm to the economy. During walking inflation the rise in prices becomes more marked and it gives the danger signal of the occurrence of running inflation. When the prices increase by more than (say 10%) per annum, there is running inflation, which causes great harm to the economy. Running inflation gives rise to the galloping inflation, which is also known as jumping or hyper-inflation. During this situation, there is acute shortage of goods and extra ordinary expansion of currency and credit and it is very alarming and has disastrous consequences.

b. Demand-pull and Cost-push inflation: On the basis of cause of inflation, it has been divided into two types: Demand-pull inflation and Cost-push inflation. Demand-pull inflation is one kind of inflation which is caused by the excess demand for goods and services. This inflation takes place when the general prices rise as a result of growing demand for goods and services in relation to their supply.

On the other hand cost-push inflation refers to the situation of steady rise in prices which are mainly caused by the continuous rise in the cost of production of goods and services. It is the most important and popular type of inflation in developing countries. The cost of production of the producers rises continuously. Higher cost leads to higher prices always.

If the prices rise only due to higher wages then we call it «wage-induced» inflation. In other words the wage induced inflation occurs when the money wage rises faster than the labour productivity. Sometimes cost-push inflation becomes «profit-push» inflation, when the monopoly producers charge higher prices and enjoy higher profit margins.

c. Open inflation and suppressed inflation: open inflation refers to the unrestricted price-rise. When prices rise continuously and substantially, without any regulation, the phenomenon is called `open' inflation. During this inflation, the increase in demand directly leads to the ever increasing prices.

However, open inflation does not occur nowadays. No government allows such situation to take place. There are always some regulatory methods adopted by the governments to control the rise in price.

On the other hand, Suppressed inflation is regulatory inflation, known as latent inflation. The control measures sometimes may succeed for a short period. But in the long run the suppressed inflation may become uncontrollable and become open or hyper.

d. Imported inflation: Inflation due to increases in the prices of imports, increases in the prices of imported final products directly affect any expenditure-based measure of inflation. Increases in the prices of imported fuels, materials, and components increase domestic costs of production, and lead to increases in the prices of domestically produced goods. Imported inflation may be set off by foreign price increases, or by depreciation of a country's exchange rate.

B. Causes of inflation

There are many different reasons that can account for the inflation in goods and services, depending on a number of factors:

Cost-push inflation occurs when businesses respond to rising production costs, by raising prices in order to maintain their profit margins. There are many reasons why costs might rise:

b) Rising labour costs: caused by wage increases which exceed any improvement in productivity.

c) Higher indirect taxes imposed by the government: for example a rise in the rate of excise duty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate of Value Added Tax or an extension to the range of products to which VAT is applied.

Demand-pull inflation is likely when there is full employment of resources. In these circumstances an increase in aggregate demand will lead to an increase in prices. Aggregate demand might rise for a number of reasons:

a) A depreciation of the exchange rate, which has the effect of increasing the price of imports and reduces the foreign price. If consumers buy fewer imports, while foreigners buy more exports, Aggregate Demand will rise. If the economy is already at full employment, prices are pulled upwards.

b) A reduction in direct or indirect taxation. If direct taxes are reduced consumers have more real disposable income causing demand to rise. A reduction in indirect taxes will mean that a given amount of income will now buy a greater real volume of goods and services.

c) The rapid growth of the money supply when the monetary authorities permit an excessive growth of the supply of money in circulation beyond that needed to finance the volume of transactions produced in the economy.

d) Rising consumer confidence and an increase in the rate of growth of house prices: both of which would lead to an increase in total household demand for goods and services

e) Faster economic growth in other countries: providing a boost to exports overseas.

Rising expectations of inflation can often be self-fulfilling. If people expect prices to continue rising, they are unlikely to accept pay rises less than their expected inflation rate because they want to protect the real purchasing power of their incomes.

C. Measuring Inflation

According to Report of European Central Bank (Jan 2009:25) Most countries have a simple common-sense approach to measuring inflation, using the so called «Consumer Price Index» (CPI).

For this purpose, the purchasing patterns of consumers are analyzed to determine the goods and services which consumers typically buy and which can therefore be considered as some how representative of the average consumer in an economy. As such they do not only include those items which consumers buy on a day-to-day basis (for example bread and fruit), but also purchases of durable goods (for example cars, Computer, washing machines, and so on.) and frequent transactions (for example rents). Putting together this «shopping list» of items and weighting them according to their importance in consumer budgets leads to the creation of what is referred to as a «market basket».

Each month, a host of «price surveyors» checks on the prices of these items in various outlets. Subsequently, the costs of this basket are then compared over time, determining a series for the price index. The annual rate of inflation can then be calculated by expressing the change in the costs of the market basket today as a percentage of the costs of the identical basket the previous year.

However, the developments of the price level as identified by such a basket only reflect the situation of an average» or representative consumer. If a person's buying habits differ substantially from the average consumption pattern and thus from the market basket on which the index is based, that person may experience a change in the cost of living that is different to the one shown in the index. There will therefore always be some people who experience a higher «inflation rate» for their «individual basket» and some who face a lower «individual rate of inflation». In other words, the inflation measured by the index is only an approximate measure of the average situation in the economy; it is not identical to the overall price changes faced by each individual consumer.

2.1.2 Consumer Price Index

International Labour Office (ILO) defined consumer prices index (CPI) as index numbers that measure changes in the prices of goods and services purchased or otherwise acquired by households, which households use directly, or indirectly, to satisfy their own needs and wants.

According to the National Institute of Statistic of Rwanda, The CPI is a measure of the average change over time in the prices of consumer items goods and services that people buy for day-to-day living. The CPI is a complex construct that combines economic theory with sampling and other statistical techniques and uses data collected each month to produce a timely measure of average price change for the consumption sector of the Rwandan economy (NISR: March 2010)

The CPI can be intended to measure either the rate of price inflation as perceived by households, or changes in their cost of living (that is, change in the amounts that the households need to spend in order to maintain their standard of living).

In practice, most CPI are calculated as weighted averages of the percentage price changes for specified set, or «basket», of consumer products, the weights reflecting their relative importance in household consumption in some period. Much depend on how appropriate and timely the weights are. (ILO 2004:4).

However there is some criticism in calculation of this CPI whereby the prices collected were not a fair sample of the prices that actually existed for goods of equal quality. According to the Morgan (1947:29) CPI neglect to consider the following:

1. Underreporting of prices by stores and large rise in prices of important goods not included in the index.

2. Disappearance of low grades of goods and deterioration in the quality of goods priced.

According to the National Institute of Statistics of Rwanda (CPI October 2009), The CPI is a Modified Laspeyres index that covers household consumption as it is used by national accounts. The reference population for the CPI consists of all households living in urban areas in Rwanda.

The household basket includes 1,136 products observed in many places spread all over the administrative centers of all provinces in Rwanda. All kinds of places of observation are selected: shops, markets, services, etc. More than 29,200 prices are collected every month by enumerators of the National Institute of Statistics of Rwanda and of the National Bank of Rwanda.

The weights used for the new index (CPI of the Base year of February 2009) are the result of the Household Living Conditions Survey (EICV II) conducted in 2005-2006 with a sample of 6,900 households.

The basket used in measuring CPI by NISR is composed by the following division of commodities:

1. Food and non-alcoholic beverages (Bread and Cereals, Meat, Fish, Vegetables, Non-alcoholic beverages) 2.Alcoholic beverages and tobacco 3.Clothing and footwear 4.Housing, water, electricity, gas and other fuels 5.Furnishing, household equipment and routine household maintenance 6.Health 7.Transport 8.Communication 9.Recreation and culture 10.Education 11.Restaurants and hotels 12.Miscellaneous goods and services.

2.1.3 Gross Domestic Product

Gross domestic product (GDP) is the sum of the market values of all final goods and services produced in a country (that is, domestically) during a specific period using that country's resources, regardless of the ownership of the resources (Richard 2004:11).

In other words, GDP refers to the market value of the flow of final goods and services within the domestic territory of the country during the period of one year, inclusive of the consumption of fixed capital. Using the product approach, it is estimated as the sum total value added by all the producing units within the domestic territory of the country. In terms of income approach, it is estimated as the sum total of compensation of employees, operating surplus, mixed incomes of the self employed, net indirect taxes and consumption of fixed capital. And, in terms of expenditure approach, it is the sum total of private consumption, government consumption, gross domestic capital formation and net exports. (Jain and Khanna 2007: 95).

Gross domestic product comprises Gross domestic product at factor cost and at market price. In the words of Hanson, «The Gross domestic product at factor cost is the sum of net value added by all the producers in the domestic territory of the country and the consumption of fixed capital in an accounting year». In contrary, according to the Dernburg «Gross domestic product at market price is defined as the market value of the output of final goods and services produces in the domestic territory of a county during an accounting year».

2.1.4 Interest rate

According to the encyclopedia dictionary, an interest rate is the price a borrower pays for the use of money they borrow from another borrowee, for instance a small company might borrow capital from a bank to buy new assets for their business, and the return a lender receives for deferring the use of funds, by lending it to the borrower. Interest rates are fundamental to a Capitalist society. Interest rates are normally expressed as a percentage rate over the period of one Gregorian year.

The interest rate changes when money is loaned the lender delays spending the money on consumption goods. Since according to time preference theory people prefer goods now to goods later, in a free market there will be a positive interest rate.

The interest rate comprises the nominal and the real interest rate, the nominal interest rate refers to the amount, in money terms, of interest payable as opposed to the real interest rate which measures the purchasing power of interest receipts, is calculated by adjusting the nominal rate charged to take inflation into account.

2.1.5 Money Supply

Money supply or money stock is the total amount of money available in an economy at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circulation and demand deposits.

Moreover, Economists define money as anything that is generally accepted in payment for goods and services or in repayment of debts. Currency, consisting with notes and coins is one of type of money. Define money as currency is to narrow because checks are also accepted as payment for purchases, checking account deposits are considered as money. Other deposits such as savings deposits can in effect function as money if they can be quick and easily converted into currency or checking account deposits.

1. The narrowest measure of money (M1) in Rwanda includes the currency in circulation out the banking sector (CC) and checking account deposit (CD) in other words, narrow money measures cover highly liquid forms of money (Money as means of exchange).

2. The broad monetary aggregate (M2) in Rwanda adds to M1 savings deposits in Rwf and in foreign currency. It includes the less liquid forms (Money as a store of value).

2.1.5 Exchange rate

The exchange rate is the price at which one the national money can be exchanged for another (When transactions are permitted). For example, a common exchange rate is the Rwandan franc/US dollar exchange rate. If the RWF/USD exchange is 5.80, this means that 580 Rwandan franc will buy one US dollar.

The changes in the value of the exchange rate over time are referred to as appreciations or depreciations. A currency appreciates when its value rises, relative to another currency, and depreciates when its value falls, relative to another currency.

2.2 THEORETICAL FRAMEWORK

A great deal of economic literature concerns the determinants and causes of inflation, in which inflation's role in the economy has been at the center of economic studies and has been debated for a long time.

There are three main schools of thought which attempt to explain the main determinants of inflation. First, The classical which revolved around the quantity theory of money,

Blinder (2002), a representative of the second school of thought, the Keynesian economists, states that the main determinants of inflation are aggregate demand in the economy rather than the money supply.

Thirdly, the monetary approach led by Milton Friedman, Friedman and Schwartz (1970), who wrote an influential book on the monetary history of the United States, argue that "inflation is always and everywhere a monetary phenomenon". Whereas Neo-Keynesians and other critics of monetarism argue that the demand for money is directly linked to supply and that the demand for money cannot be predicted. Stiglitz and Greenwald (2003) have proposed that the relationship between inflation and money supply growth cannot be separated for ordinary inflation, in contrast to hyperinflation, which is mostly considered an effect of monetary policy.

The classical economists' view of inflation revolved around the quantity theory of money, and this theory was in turn derived form the Fisher Equation of Exchange.

According to Fisher's Formula, we how MV = PQ. Here M represents that the average number of currency in circulation during a certain period; V represents the velocity of money circulation; P represents the price index of goods and services and Q represents transaction volume of goods and services. Fisher recognized that V and Q are invariable because V is decided by social system and custom and Q is stable under the condition of sufficient employment. Therefore, to some extent, the formula means the Quantity Theory of Money (IBR, 2009:42).

In other words, increases in the money supply would lead to inflation. The message was simple: Control the money supply to control inflation.

Keynes didn't agree with the classical economists. In fact the easiest way to look at Keynesian theory is to see the argument he gave for Classical theory being wrong. The key to the classical view of inflation was the Quantity Theory of Money. This theory revolved around the Fisher Equation of Exchange as we have seen above.

Keynes once again rejected this theory. He argued that increases in money supply would not inevitably lead to increases in inflation. Increasing M may instead lead to a decrease in V. in other words the average speed of circulation of money would fall because there was more of it about.

Alternatively, the increase in M may lead to an increased in T (Number of transactions), because Keynes disputes the assumption that the economy will find its own equilibrium. It may be in a position where there is insufficient demand for full employment and in that case increasing the money supply will fund extra demand and move the economy closer to full employment. Keynesians tend to argue that inflation is more likely to be cost-push inflation or from excess levels of demand. This is usually termed demand-pull inflation (Robert J. Gordon 1988: )

According to the Keynesians, the natural level of gross domestic product is a level of GDP where the economy is at its optimal level of production. If GDP increases beyond its natural level, inflation will accelerate as suppliers increase their prices. If GDP decreases below its natural level, inflation will decelerate as suppliers attempt to fill excess capacity by lowering prices.

Keynes argued that money has no significant relationship with inflation, but inflation is an outcome of the goods market. He proposed the "inflationary gap" model to explain the change in price level, (Keynes 1936). But Pigou (1949) rejected the inflationary gap theory. He placed attributed inflation to the increase in money income. According to Pigou, inflation exists when money income increases more than the income earning capacity.

The most popular neo-classical economic critique of Keynesian economic theory is by Lucas (1976), who argues that rational expectations will defeat any monetary or fiscal policy. The new Keynesian argument is that this critique only applies if the economy has a unique equilibrium at full employment, and that rational expectations models do not produce any simple result. They claim that because of price stickiness, there are a variety of possible equilibriums in the short run.

Much of the Monetarists' theory is a development of earlier Classical theoretical work. Their main contribution is in updating many of these ideas to fit them into a more modern context.

Classical economists suggested that V would be relatively stable and T would (as we have seen above) always tend to full employment. Friedman developed this and tested it further, coming to the conclusion that V and T were both independently determined in the long-run. The conclusion from this was that:

If the money supply grew faster than the underlying growth rate of output there would be inflation. Inflation would be bad for the economy because of the uncertainty it created. This uncertainty could limit spending and also limit the level of investment.

Apart from the above schools of thought which was undertaken to explain the main determinants of inflation, other theories have been illustrated

Balance of payments and forcing a depreciation of the exchange rate, The interactions between fiscal policy and inflation are particularly highlighted in Razin and Sadka (1978:239) and Bruno and Fisher (1990: 353). This category indicates the change in money supply and real exchange rate as sources of the inflation

Henry Hazlitt (1978:111) believes that one of the reasons why inflation is persistently advocated by Keynesians and others is that it is thought to increase the profitability of business. This is, in fact, an essential part of the argument of those who believe that inflation tends to bring full employment. By improving the outlook for profits, it leads enterprises to start new businesses or to expand old businesses, and therefore to take on more workers.

2.3 EMPIRICAL FRAMEWORK

Currently, the quantity theory of money is widely accepted as an accurate model of inflation in the long run. Consequently, there is now broad agreement among economists that in the long run, the inflation rate is essentially dependent on the growth rate of money supply. However, in the short and medium term inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices and interest rates (Federal Reserve Board, July 2004)

Sargent and Wallace believe that budget deficit could increase inflation because of their preponderance in the growth of money supply, point out that this deficit will become ever larger, because of cumulative of effect of interest payments (David 1992: 204). This idea is supported by Liviatan and Piterman (1986: 324) «The most commonly cause of inflation is the government budgets deficit» according to this explanation, the government prints money to finance the deficit, and as long as the demand for money is less that unit elastic, a larger real deficit will result a higher inflation rate.

The more sophisticated view was expounded by Irving Fisher (1926:785-792): When the dollar is losing value, or in other words when the price level is rising, a businessman finds his receipts rising as fast, on the average, as this general rise of prices, but not his expenses, because his expenses consist, to a large extent, of things which are contractually fixed. . . . Employment is then stimulated for a time at least.

Coe and McDermott (1977) in a study of 13 Asian economies, highlights the fact that: just as in industrialized countries, inflation in developing countries indicates an overheated economy and is influenced by a variable of activity. The output gap and a measure of activity level in the world are the sources that are suggested by this category.

According to Henry Hazlitt (1978:92) for many years it has been popularly assumed that inflation increases employment. This belief has rested on both naive and sophisticated grounds. The naive belief goes like this: When more money is printed, people have more "purchasing power"; they buy more goods, and employers take on more workers to make more goods.

Another reason of the persistent causes of inflation revealed by Henry Hazlitt (1978:118) is the perennial demand for cheap money. The chronic complaint of businessmen, and still more of politicians, is that interest rates are too high. The popular complaint is directed especially against the rate for home mortgages.

Chopra (1985:693) expresses the idea that inflation must have a strong autoregressive component from adjustments in relation to expected inflation. This category indicates a source of inflation, its own past achievements.

Empirical results regarding the inflationary effect of official exchange rate depreciation in cross-country and individual country studies are also conflicting. For example, Canetti and Greene (1992:37), studying a number of African countries, report a failure in their attempt to identify which between exchange rate depreciation and monetary growth is a more important cause of inflation.

Chhibber and Shaffik (1992:107) do not find a direct relationship between official exchange rate changes and inflation in Ghana. According to them, official devaluations had a positive effect on the budget and were therefore anti inflationary. Their study found that the parallel market exchange rate had a stronger influence on inflation compared with the official exchange rate. However, Sowa and Kwakye (1993:50) claim that Chhibber and Shafik (1992) emphasize monetary factors at the expense of supply factors in Ghana and conclude that the supply constraint (output) was the main force behind inflation.

Hyuha (1992:73) found that the devaluations of the official exchange rate had a push on domestic prices in Uganda. The parallel rate was also a significant determinant of inflation. Kasekende and Ssemogerere (1994: 62) reached a similar conclusion for the period 1987-1992, using monthly data.

Ball and Mankiw (1995: 161) examines another source of inflation, focusing on the supply of goods and services and the «cost shock» that is to say, the movement of prices specific price level. To capture the cost shocks, this category indicates changes in the prices index for petroleum and petroleum product not as source of inflation.

Tsalinski and Kyle (2000: 39) analyzed the determinants of Bulgarian inflation in the period from 1991 to 2000 using monthly data. Bulgarian inflation has been shown to have experienced two radically different regimes over the past decade. The dividing point between the two regimes is the spring of 1997 when the hyperinflationary trend of the prior period was ended by the institution of a currency board. They found that inflation during the previous period had been determined in large part by monetary growth and to some extent by past inflation. Inflation after the currency board was established was no longer dependent upon monetary growth.

Ghavam Masoodi and Tashkini (2005:42), to investigate the long term relationship between the inflation rate and its effective factors in Iran, they used the ARDL method. The results obtained via this research showed that GDP, the imported goods price index, liquidity and the exchange rate are the most significant factors contributing to inflation in Iran.

According to Ferdinand GAKUBA (2009: 30) Inflation is thought to be an outcome of various economic factors. In Rwanda context he choice the factors from supply side that come from cost-push or mark up relationships characterized by unit labor cost , import prices and oil prices index in the long-run; the demand side factors that may cause the demand pull inflation; monetary factors; and foreign factors. In order to capture the various determinants of inflation he has combine the methodology developed in Brouwer and Neil R. Ericsson (1998) and Juselius (1992) for Australia inflation.

CHAPTER THREE: RESEARCH METHODOLOGY

The research intends to follow quantitative patterns. For it to be systematic and intensive process of carrying out data collection, it will involve some sort of procedures in collecting and analyzing data.

The methodology will follow procedures of quantitative research because it is based on measurements of quantitative indicators. It is applicable to the phenomena that can be expressed in terms of quantity that is easily empirically measured.

3.1 DATA COLLECTION

3.1.1 Techniques

A technique is defined as all resources and processes that enable researchers to gather data and information on the research topic (WELMAN J. C and KRUGER S.J., 2001:34)

Thus, we preferred the documentary techniques which is a systematic search of all that is written related with the research area such as books, pamphlets, monographs, unpublished documents, reports, budgets, public records etc. the documentary technical allows us to choice among the books available what are useful for our research and help to use the best resources.

3.1.2 Types and sources of data

The success of any econometric analysis ultimately depends on the availability of the appropriate data. It is therefore essential that we spend some time discussing the nature, sources, and limitations of the data that one may encounter in empirical analysis.

Time Series Data will be used in our research. A time series is a set of observations on the values that a variable takes at different times. Such data may be collected at regular time intervals, such as daily (example stock prices, weather reports), weekly (money supply figures), monthly [the unemployment rate, the Consumer Price Index (CPI)], quarterly (GDP), annually (government budgets), every 5 years (the census of manufactures), or decennially (the census of population).

Time series data are used heavily in econometric studies but they present special problems for econometricians; most empirical work based on time series data assumes that the underlying time series is stationary. Although it is too early to introduce the precise technical meaning of stationarity at this juncture, loosely speaking a time series is stationary if its mean and variance do not vary systematically over time GUJARATI (2006:26).

Different visits to libraries, internet exploration, and use of documents provided by National Bank of Rwanda, National Institute of Statistic of Rwanda, Ministry of finance has been considered useful.

3.2 DATA ANALYSIS

3.2.1 Methods

Method is defined as an ordered set of rules and principles of intellectual operations to do the analysis to achieve a result (WELMAN J. C and KRUGER S.J., 2001:36).

At the completion of our work, we have chosen the analytical method, this method allows to systematically analyzing all information and data collected. It allowed us to systematically analyze the inflation's relationship with others macroeconomic variables, to interpret and draw the conclusion.

Data will be entered in the tables where they will be clearly viewed and checked for errors. After these, they will be entered in the computer (SPSS software) for analysis.

Once data will have been entered and checked for errors, analysis will take place .The exploratory data analysis approach for this study will emphasize the use of diagrams to explore and understand the sense of the data. During this process, research questions and objectives will be kept in mind. It will help to formalize the practice of looking for other relationships in data which have not been thought of initially .So, at this stage, they will be a request to structure and label clearly each diagram and table to avoid possible misinterpretation.

This will involve choosing the appropriate statistics to describe the data and the choice of the adequate statistics to examine relationships among data.

At this step, the researcher will be concerned with answering the question»how do some variables relate to others?» During the statistical analysis, this question will be answered by testing the likelihood of the relationship between specific variables. Here, relationships between Gross domestic product, Money Supply (M₂), Interest rate, Exchange rate and Inflation will be discussed. Testing whether the variables are significantly associated, the help of a simple regression model does it.

Whereby â, ã, ë and ä are parameters of the model and log ì is the error terms

According to GUJARATI (2006:126) there are two mutually complementary approaches of hypothesis testing which is concerned with developing rules or procedures for deciding whether to reject or not reject the null hypothesis, namely confidence interval and test of significance. Both these approaches predicate that the variable (statistic or estimator) under consideration has some probability distribution and that hypothesis testing involves making statements or assertions about the value(s) of the parameter(s) of such distribution.

At this step the, T-test (the Student test) will be used to test the significance of the variables and F-test (Fischer' test) will be used to test the significance of the model.

The t-test is probably the most commonly used Statistical Data Analysis procedure for hypothesis testing. Actually, there are several kinds of t-tests, but the most common is the "two-sample t-test" also known as the "Student's t-test" or the "independent samples t-test".

The statistics t-test allows us to answer this question by using the t-test statistic to determine a p-value that indicates how likely we could have gotten these results by chance. By convention, if there is a less than 5% chance of getting the observed differences by chance, we reject the null hypothesis and say we found a statistically significant difference between the two groups.

The p-value is a numerical measure of the statistical significance of a hypothesis test. It tells us how likely it is that we could have gotten our sample data even if the null hypothesis is true. By convention, if the p-value is less than 0.05 (p < 0.05), we conclude that the null hypothesis can be rejected. In other words, when p < 0.05 we say that the results are statistically significant.

CHAPTER FOUR: DATA PRESENTATION, ANALYSIS AND INTERPRETATION

The purpose of this chapter is to present and analyse the results of the studies conducted on the field. We will first give data presentation. Then, we will direct the study towards interpretation of result of SPSS regression analysis.

4.1 DATA PRESENTATION

4.1.1 Table2: EVOLUTION OF CPI, M2, Real GDP, ER and LR (1990-2009)

SN	Years	Consumer Price Index (CPI)	Money Supply (M2) (In millions Rwf)	Real GDP (Base Year: 2000) (In millions of Rwf)	Exchange rate (ER) In US Dollars	Lending rate (LR) in %
01	1990	19.00	31,893.70	213,533.0	83.70	9.96
02	1991	22.70	33,730.30	239,310.0	125.16	13.65
03	1992	24.90	37,900.50	276,488.0	133.94	15.00
04	1993	28.00	37,966.30	284,368.0	144.24	13.61
05	1994	55.70	32,221.70	165,800.0	140.70	12.88
06	1995	55.70	62,645.00	339,143.0	262.18	16.07
07	1996	59.80	69,856.90	424,130.0	306.82	16.17
08	1997	67.00	90,163.60	558,281.0	301.53	16.22
09	1998	71.20	91,984.50	621,388.0	312.31	17.13
10	1999	69.40	98,056.30	606,991.0	333.94	16.84
11	2000	72.20	111,254.70	676,099.0	389.70	16.99
12	2001	74.60	121,418.20	741,872.0	442.99	17.29
13	2002	76.10	144,567.90	781,468.0	475.37	16.37
14	2003	81.70	167,523.50	955,164.0	537.66	17.05
15	2004	91.70	187,225.00	1,138,470.0	557.45	16.48
16	2005	100.00	218,372.30	1,332,910.0	557.82	16.07
17	2006	108.90	285,646.30	1,563,830.0	551.71	16.07
18	2007	118.80	375,273.50	1,866,120.0	546.96	16.19
19	2008	137.10	395,808.80	2,063,505.5	546.85	16.51
20	2009	146.60	404,365.40	2,187,000.0	568.00	16.49

Source: ECONSTATS, NBR, NISR (Annual reports: 2009; 2006; 2003; 2000; 1997; 1995)

4.2 DATA ANALYSIS AND INTERPRETATION

4.2.1 Correlation between variables

The correlation coefficient is a number between -1 and +1 that measures both the strength and direction of the linear relationship between two variables.

The magnitude of the number represents the strength of the correlation. A correlation coefficient of zero represents no linear relationship (the scatter plot does not resemble a straight line at all), while a correlation coefficient of -1 or +1 means that the relationship is perfectly linear (all of the dots fall exactly on a straight line).

The sign (+/-) of the correlation coefficient indicates the direction of the correlation. A positive (+) correlation coefficient means that as values on one variable increase, values on the other variable tend to also increase; a negative (-) correlation coefficient means that as values on one variable increase, values on the other tend to decrease, that is, they tend to go in opposite directions.

A Scatter plot here was used to determine if there is correlation between two variables. Moreover they are things to consider when using scatter plots like that a direct or strong correlation does not necessarily imply a cause-and-effect relationship. If a scatter plot shows signs of correlation, investigate further for confirmation.

A. Correlation between Consumer Price Index and Money Supply (M2)

This scatter plot describes a positive trend; there is a weak positive correlation between CPI and M2. In other words, the value of CPI increases slightly as the value of M2 increases.

Thus, our regression analysis shows that the volume of money supply is positively related to the consumer price index; coefficient has a positive sign and also is statistically significant at 0.001 Since observed t-value (9.930) lies in the critical region we reject the null hypothesis. Therefore, we confirm the alternative hypothesis says that Money supply has a significant positive effect on inflation rate in Rwanda.

It also shows results from an increase of one unit of Money supply would result to an increase in Consumer price index by 62.9 %.

B. Correlation between Consumer Price Index and Real Gross Domestic Product

This shows that there is a correlation between GDP and CPI. This is known as a weak positive correlation as the line goes up meaning that if the GDP increases, CPI also increases which differs from the output of regression analysis of the general model as well as the monetarist theory whereby an increase in GDP should affect a decrease in CPI.

Consider the observed t-value of Real GDP (8.206) shows that it lies in the critical region or region of rejection of null hypothesis. Therefore we accept the alternative hypothesis says that Output has a significant effect on inflation rate in Rwanda. Since an increase of one unit in output (Real GDP) affect a decrease of 66.1% in Consumer price index

C. Correlation between Consumer Price Index and Exchange rate

This scatter plot describes weak positive trend between Exchange rate and CPI, The value of CPI increases slightly as the value of exchange rate increases. P-value (0.000) is statistical significant, the t-values of exchange rate (11.541) lies in the critical region. Therefore, we reject the null hypothesis and confirm the alternative hypothesis says that exchange rate has a positive effect on inflation rate in Rwanda. In addition one unitary change in exchange rate affects an increase in consumer price index by 32.55%

D. Correlation between Consumer Price Index and Lending rate

In this graph the plots are not on a completely straight line but some are near each other and a line tends upward therefore there is a positive correlation though but not strong. The value of CPI seems to be related to the value of lending rate, but the relationship is not easily determined.

Considering the result of the regression analysis, t-values of lending rate (4.586) lies in the rejection area of null hypothesis and is also statistical significance as shown by P-value (0.000). As conclusion we accept the alternative hypothesis says that Lending rate has effect on inflation rate in Rwanda. Since the change in one unit of lending rate affect an increase by 325.5% in consumer price index.

4.2.2 Regression equation of the model

1. Summary of output from SPSS regression analysis of multivariate

Examining the output from this regression analysis; we look to the p-value of the F-test to see if the overall model is significant. With a p-value of zero to three decimal places, the model is statistically significant. The R-squared is 0.945, meaning that approximately 94.5% of the variability of CPI is accounted for by the variables in the model. In this case, the adjusted R-squared indicates that about 94.5% of the variability of CPI is accounted for by the model; even after taking into account the number of predictor variables in the model. As explained below, the coefficients for each of the variables indicates the amount of change one could expect in CPI given a one-unit change in the value of that variable, given that all other variables in the model are held constant.

In order to arrive at a more efficient model, variables with low t-values or incorrect signs in the over-parameterized regression were excluded.

2. Specification of general model

3. Predictive accuracy of the general model

One way to measure the overall predictive accuracy of a multiple regression model is the R-square value. The interpretation of R-square is: "The amount of variance in the dependent variable that can be explained by the model." For our model the R-square value is 0.945, this means the model explains 94.5% of the variance and so the model will produce perfect predictive accuracy. The point is, the closer to 1.0 the R-square value is, the better the model. The closer the R-square value is to 0, the worse the model.

CHAPTER FIVE: CONCLUSION AND RECOMMENDATIONS

Historically, a great deal of economic literature was concerned with the question of what causes inflation and what effect it has, forecasting inflation is key for a central bank to adjust its monetary policy to control inflation. Regardless of its monetary policy framework broad money growth target, exchange rate target, or inflation target, stabilizing inflation is a primary objective of monetary policy.

The main goal of this work was to determine the factors influencing inflation rate in Rwanda. To have this goal reached analytical method was used, this method allows to systematically analyzing all information and data collected. As far as data analysis is concerned, specific software designed for data analysis have been used based on the times series data collected from different government institutions.

From the findings, Money supply and Real GDP (Output) were found to be important in determining the level of inflation. The effects of the two variables conformed to our priori assumptions. Other alternative two hypotheses were also rejected exchange rate and Lending rate that have not significant effects on inflation rate in Rwanda. There was no evidence suggesting the influences of exchange rate and lending rate on inflation, as both t-tests are not statistical significance. This was tested based on SPSS software attributes in accordance with the theory given in chapters 2 and 3. These results collaborate studies on inflation in other African economies like Chhibber and Shafik (1992: 107 - 133) obtain similar results for Ghana and Samuel A and Ussif (2001:14) for Tanzania.

Based on the research findings, skills of the researcher and other constraints accounted, we can conclude this study by giving the following recommendations for further research.

The outcome of this study does not establish the superiority of one hypothesis over the other; rather it provides a much boarder perspective of the complexities of the inflationary process in Rwanda. It also points towards some of drawbacks of the domestic economic policies as well as the effects of the external factors influencing the economy which were beyond the control of the government.

The monetarist assert that inflation everywhere is a monetary phenomenon and can be controlled by controlling the money supply, thus to control inflation the government will have to pursue a contractionary monetary and fiscal policy.

The results indicated that output has a significant effect on inflation rate in Rwanda. Hence emphasizing in substantial growth in agriculture sector as well as other economic activities that contribute in increase of Gross domestic product can help to moderate the rate of inflation.

Further studies in the areas of domestic supply of agriculture commodities, imports and exports of agricultural output were suggested in Rwanda to determine the actual inflationary movements and pertinent policy implications.

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