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Monetary Conditions Index for Kenya: Conclusion and Policy Implications

The purpose of this study was to examine the feasibility of an MCI in the conduct of monetary policy in Kenya using 2000 to 2011 quarterly data. The results indicated the presence of cointegration between real GDP and the exogenous variables namely the interest rates, exchange rates and claims on private sector. This implies that the three variables are the main channels of monetary policy transmission in Kenya.
The relative strength of the transmission mechanism on aggregate demand among the three variables proceeded from exchange rate, the credit channel and interest rates. Overall, the results indicated that the MCI responded to the interest rates reasonably well and leads to the following policy deductions.
As a guide to monetary policy stance, MCI is an indicator that can be used to monitor the interest rate and exchange rate movements and their effect on the aggregate demand and eventually, on inflation. This study has established that MCI movements are more responsive to interest rates. This means that interest rates can be used as a reliable indicator of monetary policy stance. This also implies that rather than use the interest rates, the MCI would still serve to lessen overreliance on the interest rates to stabilize output and by extension inflation.
A percentage point change in the exchange rate has more impact on aggregate demand than interest rates. This means that the exchange rate channel has a faster impact than the interest rate on aggregate demand pressures. This intuitively means that a strong shilling would be a good way to keep inflation at bay while providing some still waters for an overheating economy. The caution, however, in the use of the exchange rates would be the fact that the policy maker has to identify the source of the exchange rate movement then decide on the size and direction of the interest rate movement to offset the change.

This post was written by , posted on February 2, 2014 Sunday at 4:54 pm