Determinants of Inflation in Kuwait

This paper is an attempt to study the factors affecting the behaviour of domestic inflation in Kuwait for the period from 1972 to 2004. To achieve this goal the study used three variables believed to influence inflation in a small open economy, namley, foreign inflation, domestic money supply and domestic real GDP. The variables were subjected to a stationarity test which indicates that domestic inflation and money supply are first difference stationary, while foreign inflation and domestic income are stationary in their level. Accordingly, it may be argued that there is no evidence of a long run relationship between domestic inflation and its foreign counterpart. Based on these results the study tested the cointegration between domestic inflation and domestic money supply. The results indicate the exisence of long run relationship between inflation and the broad measure of money supply. The study then moved to examine the possibelity of short run relationships between domestic inflation and the rest of the variables using Granger causality test which indicates the lack of such relationships. Therefore, the study reveals that domestic inflation is influenced mainly by the development of domestic lequidity which overwhelmed the theoritcally expected effect of imported inflation. These results might be caused by two main factors; the first is the economic and political developments during the period of study, and the second is the difference in constructing each measure of inflation. These factors might be responsible for destorting the expected relationship between domestic and imported inflation.