Achieving a high and stable economic growth is one of the main objectives of any state but oil price fluctuations and its impact on inflation, exchange rate and on other macroeconomic variables may cause difficulties in attaining this goal. This study investigated empirically the channels through which oil price shocks affect economic activity in Kenya. Following existing literature, the study focused on five macroeconomic variables: real exchange rate, inflation, money supply, real GDP growth and international price of crude oil. Existing quarterly data from the first quarter of 1991 to the last quarter of 2014 were used in the analysis on the basis of the Structural VAR approach. Granger causality tests found no causality between crude oil prices and any of the four macroeconomic variables. The study found that there exist a bi-directional causality between real exchange rate and inflation in Kenya. There also exists a unidirectional causality from inflation to real GDP and from real GDP to real exchange rate. The study found that crude oil price shocks have a significant effect on Kenya’s macroeconomic performance. Following an oil price shock, the Kenyan shilling depreciates with the shock contributing 2.16 percent of real exchange rate volatility in the first four quarters. This contribution however rises gradually to 2.34 percent over a three-year horizon. Oil price shocks explain a relatively small portion of less than one percent of forecast error variance in the domestic price level both in the short run and long run. Money supply exhibits an immediate and sustained negative reaction to the shock which peaks in the sixth quarter after the shock but does not die out even in the longer horizon. Finally, the study found that oil price shocks have a negative and significant effect on real GDP growth with the impact being persistent over the longer horizon. Results suggest a moderate, negative response of real GDP growth in the first three quarters. The contribution of oil shocks to variations on GDP growth gradually rises from zero in the first quarter with the largest impact of the shock being felt in the 8th quarter after the shock after which domestic output growth starts to recover. Over the 12-quarter period, an oil price shock contributes 3.46 percent of variations in Kenya’s real GDP. Finally, the study identified real exchange rate and money supply as the most important sources of disturbances in Kenya following an oil price shock. Given the findings of the study, the government’s main focus should be to stabilize the exchange rate and implementation of policies that encourage development and use of alternative sources of energy.
