Abstract

The aim of this study was to extend the P-Star methodology by applying an alternative approach to the derivation of the foreign price gap; to estimate the P-Star model using Kenyan data over the period from 1960 to 2011 and finally, to compare the forecasting performance of the P-Star model with alternative inflation models. The results from the estimated P-Star model show that the domestic price gap has highly significant positive effects on inflation in Kenya with the implied result that a 1 per cent increase in domestic price gap leads in the subsequent period to an increase in inflation by 0.5 per cent. On the other hand, the foreign price gap was found to have insignificant effects on inflation. When forecasts from the P-Star model are compared with forecasts from alternative inflation models, the P-Star model outperforms these models. Policy wise, the results in this study underscore the usefulness of the P-Star model in providing forecasts of inflation for Kenya.

 

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