Academic journal article Research in Applied Economics

Monetary Conditions Index for Kenya

Academic journal article Research in Applied Economics

Monetary Conditions Index for Kenya

Article excerpt

Abstract

The purpose of this paper is to construct and test the feasibility of a monetary conditions index (MCI) for Kenya using 2000 - 2011 time series quarterly data. Empirical results confirm the existence of cointegration between aggregate demand (GDP), the real exchange rate, the short-term interest rate and the claims on private sector. The last three variables are key in the monetary transmission mechanism for Kenya. Their relative strengths proceeds from the exchange rate, credit to private sector and the interest rates respectively. On the use of the monetary conditions index as an indicator, results show that it closely mirrors the movements of the interest rates while also closely tracking changes in the exchange rates. This makes its use in Kenya quite realistic since it would not be a radical departure from the use of the Central Bank of Kenya (CBK) rate.

Keywords: monetary policy; MCI; transmission mechanisms; Central Bank of Kenya

(ProQuest: ... denotes formulae omitted.)

1. Introduction

In pursuit of price stability, the Central Bank of Kenya (CBK) has over the years used either legislation or monetary policy instruments in the form of interest rates and monetary aggregates. However, in the face of increased financial transactions brought about by improved technology and the speed at which money moves across borders, the central bank's role in terms of monitoring and intervention are more challenging now than it was before. These changes weaken the link between monetary aggregates and inflation through an unpredictable demand function resulting from increased velocity of money. Despite the daily behavior of interest rates and exchange rates being more overt in most economies today, the Central Bank of Kenya still lacks an effective indicator of its intentions (both internally and externally) to financial markets. Furthermore, the CBK's occasional interventions are not pegged on optimum levels of exchange rates but on intuition (Oduor and Khainga, 2010). According to Ho (2010), economists are traditionally wary of discretionary monetary policy because it is uncertain if central bankers can read and interpret the signs correctly and respond accordingly.

In view of the foregoing, this paper constructs the monetary conditions index (MCI) and tests the feasibility of the index for Kenya to supplement the existing monetary framework. The MCI is a weighted measure of internal and external conditions through the interest rates and the exchange rates. A number of central banks such as those in Sweden, Canada and New Zealand as well as international financial institutions such as the IMF construct such an index and report on it. Its use in a small open economy like Kenya would help signal the inflationary pressures through aggregate demand but also assist financial markets to gauge the current stance of monetary policy.

2. Central Bank of Kenya and the Conduct of Monetary Policy

2.1 Towards a Monetary Conditions Index

The main objective of the Central Bank of Kenya is to formulate and implement monetary policy in order to achieve and maintain stability in the general level of prices (CBK, 2010). The CBK targets a 5% level of inflation, which would ensure the growth of savings, investment and the economy while maintaining public confidence in the currency. Currently, the CBK has to carry out its role in an environment of increased financial transactions arising from improved technology, increased speed of movement of money across the boarders and a weakened relationship between the monetary aggregates and inflation. This calls for a tool that can be used by policy makers to signal any changes in the monetary conditions both internally and externally so that they can judge the extent by which adjustments are needed on the instruments of monetary policy.

Monetary conditions index is a simplified numerical indicator of the relative tightness or looseness of monetary policy. …

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