The Relationship between Inflation and Financial Sector Development: Evidence from Uganda

This paper sets to empirically investigate the relationship between inflation and financial sector development in Uganda using annual time series data over the period 1980-2014. The variables used are; Inflation rate (CPI), Government Expenditure, Trade Openness and Investment, all as a percentage of GDP while Domestic Credit to Private Sector (DCPS) was used to proxy financial sector development. The econometric technique used is the Autoregressive Distributing Lags (ARDL) model bound testing approach developed by Pesaran, Shin and Smith (2001). The finding established a statistically negative long run relationship between inflation and financial sector development in Uganda. The coefficients of the Error Correction Terms (ECM) tells us that the rate of adjustment of the variables from short run to long run occurs at 58 percent. It has also been established that, financial sector development will drop by 0.013 for a one point increase in inflation rate and is statistically significant at 1 percent level. Investment and trade openness were found to have statistical significant positive relationship with financial sector development. However Government expenditure reveals a negative relationship with financial sector development. The study therefore concludes that high inflation rates is detrimental to the development of financial sector in Uganda. The main policy recommendation is therefore that, the central bank should concentrate on those policies that keep inflation rates as low as possible.