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Monetary Conditions Index for Kenya: Introduction

Monetary Conditions Index for Kenya: IntroductionIn 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. According to Ho, 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. Payday Loans Online

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.
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. 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. It captures the degree of pressure that monetary policy exerts on an economy’s aggregate demand through changes in the interest rate and exchange rate, and hence on inflation. A weighted average of the interest rate and exchange rate, it is used by several central banks and international financial institutions. When properly used in a small open economy, it is serves to increase the transparency and credibility of monetary policy. However, if the central bank uses it poorly, it may increase confusion and distort the management of expectations incase the central bank reacts to every twist in the index.

This post was written by , posted on January 19, 2014 Sunday at 4:45 pm