3.1 Introduction

section illustrates the conceptual framework, the model specification, and
evaluation of factors that influence the sources of data and the type of data
collected. It discusses the research methodology that was employed in this

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3.2 Conceptual Framework

can be defined as a ‘visual’ presentation of key variables, factors or concepts
and their relationship among each other which have been or have to be studied
in the research either graphically or in some other narrative form (Miles and
Huberman, 1994).

variables in this study are as follows; the dependent variable is the ratio of
private investment to GDP and the independent variables are real GDP growth,
inflation rate, public investments, real exchange rate, lending rates, and
deposit rates openness of the economy, broad money supply, private sector
credit, foreign exchange reserves, domestic savings, and public debt along with
others. It majorly aims to assess relationship and the impact of credit to the private
sector on inflation, interest rates and economic growth.

define investments as the accumulation of newly produced physical entities,
such as factories, machinery, houses, and goods inventories. Investments can
also be defined as putting money into an asset with the expectation of capital
appreciation, dividends, and/or interest earnings. Investment has also been
defined as the contribution of local or foreign capital by an investor, including
the creation of, or the acquisition of business assets by or for business
enterprises, and includes expansion, restructuring, improving or rehabilitating
of a business enterprise.

3.3 Model Specification

The neoclassical
flexible accelerator model formulated by Jorgensen (1967) was the model used in
this research. This is because this model ranks the most popular amongst all
investment theories. The flexible accelerator model has been used in actual
research due to data limitations and other structural rigidities and
constraints in developing countries.

GDP growth rate plummeted in the mid 1970s to 1.5% in 1975 only for it to
stabilize again in the late 1970s up to 7.9% in 1978. This could be attributed
to the coffee boom that year. The economy shrank, however, in 1983 and 1984 to
1.6% in the two years, and stabilized again to stay between 4% and 6% up to 1990. In 1991, it dipped to 1.4%, only
for it to hit an all time low of -1.08% in 1992 and -0.09% in 1993 following the introduction of multi party
politics. A similar dismal performance of 0.29% was also
recorded in 1997 following another general election. The economy managed to
revive in the next two years, only to dip
again in 2000 and 2002 at 0.59% and 0.29% respectively. The year 2002 was
alsoanother election year. It started picking up again from the year 2003 at
2.78% and rose steadily to 6.99% in
2007 when the country was gearing up for another general election. In 2008,
however, it shrank again to 1.53%, the major
reason being the post election violence. (GOK, 2009). Things started looking
up,though, in 2009 when the economy grew by at least 3% .The economy has more
or less been static at a growth rate of
between 4% and 5% up to 2012, now expected to grow at over 5% in 2014 (World
Bank,Economic Survey, 2014).

Kenyan economy remains small compared with the rest of the world. The sluggish
economic growth in mid 1970s, mid 1980s and early 1990s can be attributed to
such factors as an influx of imports with little exports, thereby raising
prices; and credit crunch when it became increasingly difficult to borrow from
the outside. Structural adjustment programs of 1980s introduced by the Bretton
Woods institutions did not help matters.

chapter  provides the model specification for
determinants of domestic private investments identified in the literature review. There is no general consensus on the
specific influence on private investments. We therefore have to estimate the
first estimate the standard accelerator investment model and then incorporate other variables that would
enable formulation of investment equation. According to the accelerator theory, investment is a function of
economic growth. In the long-run, the desired capital stock
(K) is assumed to be directly related to levels of income (Y).

Kt ? Yt

K = ?Yt……………….(1)

where ? is a constant.
Differentiating the equation with respect to time, t;

?Kt = ??Yt ………………(2)

where the ? is the difference

To obtain an equation
for the relationship between investment and desired capital stock, the

capital accumulation
identity is used to identify investment, I;

Kt = (I – ?) Kt – 1 + It……………………………………………(3)

where ? refers to depreciation
of capital. From equation (3) we can obtain the following equation;

Kt – Kt – 1 = It – ?Kt –
1 …………………………(4)

Rearranging the
expression and assuming ? = 0, we can solve for It to yield the following

?Kt = It…………………………………………(5)

Equation (5) can be
substituted in equation (2) to obtain;

II t= ? + ?Y 1

This equation represents
the basic investment function. But we need to account for the slow adjustment
of the actual capital stock to the desired capital stock, lagged values of the
dependent variable can be introduced into the expression to yield the

It = ?1t – 1 + ?1?Yt+
?2?Yt – 1 + ?t…………….(7)

where the first two
terms on the right hand side are lagged investment and income growth rates respectively.
?1 represents coefficients while ?Yt – 1 represents lagged growth rate of
output. ?t is the disturbance (error) term which captures the effects of
omitted variables.

The final equation can
thus be estimated;

It = ?1t – 1 + ?1?Yt +
?2?Yt – 1 + Xt+ ?t…………(8)

where Xt represents some
of the variables that are applicable in the developing countries such as
financial factors, policy-related factors, neoclassical factors, open economy
factors and general macroeconomic factors.

Our model for domestic private
investments can now take the following form;



Therefore, to estimate
the parameters ?, the equation can take the following form;

PRINV/GDP = ?0 + ?1
RGDPG + ?2 INFL + ?3 RER + ?4 PUBINV/GDP + ?5 RLIR + ?6 RDIR + ?7

OPEN + ?8 FRES + ?9
PCREDT + ?10 M2/GDP + ?11 DSAV + ?12 FAID+ ?13 PUBDEBT + ?14 DBTSER

+ ?

where PRINV/GDP is the
dependent (endogenous) variable being the ratio of domestic private investments
to GDP. Exogenous (independent) variables include:

RGDPG which is the real
GDP growth rate

INFL which is inflation

RER which is the real
exchange rate

PUBINV/GDP which is the
ratio of public investment to GDP

RLIR which is real
lending interest rate

RDIR which is real
deposit rate

OPEN which is openness
of the economy i.e. exports plus imports as a ratio of GDP

FRES which is foreign
exchange reserves

PCREDT which is private
sector credit

M2/GDP which is broad money
supply as a ratio of GDP

DSAV which is domestic

FAID which is foreign

PUBDEBT which is public
debt (both domestic and foreign debt)

DBTSER which debt
service  is the error term.

Dummy variables are
included to represent financial liberalization which takes on the value of zero
before multi partyism in 1992, and one from 1992 onwards, hence DUM92.

Another dummy variable,
DUMGOV, represents governance. For instance, during

Kenyatta’s time, most
macroeconomic variables were increasing. They started falling during Moi’s time,
and started increasing again during Kibaki’s regime.

Moreover, dummy
variable, DUMMKT, represents market demand. The higher the market demand, the
higher the rate of private investment in the economy.

3.4 Description of Variables and the Expected Signs


. Macroeconomic
instability adversely affects private investments. Serven (1998) used inflation
as the epitome of macroeconomic instability. The results show that inflation is
negatively related to domestic private investments. A 1% increase in inflation
reduces private investment by 0.38% but it is not significant. Therefore,
inflation causes low levels of private investment since domestic investors
foresee a low return on capital (Heranandez-Cata, 2000).

investment has a positive but insignificant impact on private investments. This
suggests evidence of crowding in. A 1% increase in public investments leads to
a 0.05% increase in private investments.

investment in Kenya stimulates growth in the long-run. The government of Kenya
has been investing heavily in major infrastructure projects over the past few
years. This increases the supply capacity and promotes new investments.

lending rates have a negative but insignificant impact on private investments.
A 1% increase in real lending rates leads to approximately 0.97% decrease in
investments. This supports the neoclassical theory that interest rates are
negatively related to investments.

the long-run real deposit rates are negatively related to domestic private
investment. A 1% change in real deposit rate results to 0.36% decrease in
investments. This implies that private investment in Kenya does not support the
McKinnon-Shaw (1973) hypothesis in the long-run. McKinnon and Shaw argued that
a rise in interest rates increases the volume of financial savings thus raising
funds for investments.

events before multi party politics in 1992 could have adversely affected
private investment. But after financial liberalization in 1993, financial
repressions were reduced hence high deposit rates were meant to induce savings
and investments. This shows that deposit rates in Kenya do not encourage savings
or possibly few Kenyans can afford to save.

policy proxied by the sum of imports and exports has a positive impact on
private investment. A

change in trade policy of the economy leads to a small increase of 0.01% in
private investments. This shows free trade has opened up the economy which
attracts private investment.

results of this study support the existence of a short-run dynamic adjustment
and the long run equilibrium relationship between these macroeconomic variables
and domestic private investments.

study shows that  in the long-run,
political regimes and credit to the private sector negatively affect private
investment, while real GDP growth, real exchange rate and broad money supply
positively affect private investment.

Policy Prescriptions

an aggregate level, our study shows that domestic private investment is
determined by majorly macroeconomic variables such as GDP growth rate, real
exchange rates, domestic savings, foreign aid and public investment. Taken
together, the variables explain a significant amount of fluctuations in levels of
domestic private investment. These results hence encompass information on the
possible future policyformulation in Kenya.

Public Investment on Infrastructure, Security and Human Capital Formation.
Major policy prescriptions from the results include allocation of public funds
to capital accumulation. This boosts the private sector. In order to increase
new levels of domestic private investments, the government should increase
investment on infrastructure development and human capital formation through
education. More funds need to be channeled to development expenditure as
opposed to recurrent expenditure. There is also need to increase efficiency of
public investment. Tough action should be taken against public institutions
which do not spend their allocations optimally. This way, funds will be
absorbed in the economy for accelerated growth.

 Improving the Investment Climate.
Macroeconomic stability is an integral part of any investment activity in a
country. It provides a more reliable economic environment which enables
investors take advantage of profitable opportunities,(Serven and Solimano,
1993). Macroeconomic stability indicators include inflation, public debt and
exchange rates. High inflation rates negatively affect profits. High national
debt reduces a country’s credibility to borrow. Huge debts could possibly be a
prelude to more heavy future taxes. Proper utilization of borrowed funds is
necessary to spur new investments. Volatile exchange rates render international
trade unpredictable. All these need to be checked to enhance investor

Reform Programs. Structural reforms are important in determining the actual and
future profitability of private investments. Structural reform index
incorporates an indicator of trade policy. Openness of the economy positively
affects private investments even though insignificantly. In this regard, policy
makers should formulate policies that promote exports and reduce imports.
Export-led growth is key with agricultural protection and subsidization to
enable local industries compete internationally. Another structural reform
index incorporates private sector credit. From the results, private sector
credit has a negative impact on domestic private investments. This could be due
to the fact that loans are used.

Donor Funds and Encouraging Economic Partnerships. Private investments can
alleviate economic hardships and create jobs as envisaged in Vision 2030
(GOK,2007). Donor funds are needed, so are economic partnerships, in major
infrastructure areas like transport and communication, energy etc. Foreign aid
and loans supplement domestic taxes. Care should be exercised, however, to
ensure these aid flows are not misappropriated and that they are used
efficiently and effectively.

Productivity Real GDP has a significant positive effect on domestic private
investments. There is a general consensus that growth is necessary but not
sufficient for poverty reduction. The World Bank (2000) came up with results
showing that it is the quality of human capital that is more important than the
quantity. Therefore, policy makers should direct their attention to improving
welfare of the masses in terms of increased per capita incomes, proper
healthcare, education and proper nutrition if output is to increase.

3.5 Data Sources and Type

this study, secondary data was used. The time series of study was covered
within the year 1970 – 2010. Data was
derived from the following sources,

– Private investment as
a percentage of GDP: IFC (2000) and GOK, Economic Surveys

– Real GDP growth annual
percentage: GOK, Economic Surveys, various issues

– Inflation annual
percentage: GOK, Economic Surveys, various issues

– Real exchange rate:
Ryan 2002 and GOK, Economic Surveys, various issues

– Public investment as a
share of GDP: IFC (2000) and GOK, Economic Surveys, various issues

– Real lending interest
rate: Ryan 2002 and GOK, Economic Surveys, various issues.

– Real deposit interest
rate: Ryan 2002 and GOK, Economic surveys, various issues

– Private sector credit:
Ryan 2002 and GOK, Economic Surveys, various issues.


– Broad money supply as
a share of GDP: Ryan 2002 and GOK, Economic Surveys, various issues

– Domestic savings: GOK,
Economic Surveys, various issues.

– Foreign Aid: GOK,
Economic Surveys, various issues

– Public Debt: Ryan 2002
and GOK, Economic Surveys, various issues.

– Openness of the
economy: GOK, Economic Surveys, various issues.

– Public debt service:
Ryan 2002, and GOK, Economic Surveys, various issues.

3.6 Estimation Technique

The relationship between
the variables had been regressed on the equation for private investments using
the ordinary least squares (OLS) estimation technique. Economic analysis posits
that there is long-run equilibrium relationship between the dependent variable
and the independent variables, the variables of domestic private investments
under consideration.

Applied econometrics,
when trying to estimate the long-run relationship, implies the variables are
constant in terms of means and variances but not dependent on time (Gujarati et
al 2007).

The empirical
relationship can be established as;

Yt = ? + Xt?t+ ?t

Where Yt is private
investment as a ratio of GDP, and ? and ? are the parameters to be estimated.
Xt represents determinants affecting private investment in year t, and ?t is the error term with mean
zero,measuring the effects of omitted variables (Ghura and Goodwin,2000).
Nonetheless, most time series data have unit roots (are non-stationary).
Regression of time series data yields spurious results. With this in mind, the
t-statistic and F-test based on this estimation procedure become misleading.

3.7 Data validity and

Validity refers to the best estimate of the truth of any
proposition or conclusion or inference described in the research. Reliability
refers to the measurement of the quality of the data collected in any research;
it’s a measurement of the consistency of the data with the research background

The sources for the
research was collected
from the official websites in order to ensure that only data that are credible
and that data collected covered all the variables of interest to the study.

importance of sourcing data from official websites also ensures validity and
reliability of the results.

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