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Monetary Conditions Index for Kenya: Theoretical Studies

In the conduct of monetary policy, central banks the world over use different variables to play different roles. Central Banks usually have an ultimate goal to achieve such as price stability. To achieve this, the Central Bank starts with policy tools such as open market operations, the discount rate, the reserve requirement among others. Because of the long lags and indirect connection between the tool and the ultimate target, Central Banks use intervening variables to stand in between the ultimate target and the tools. An intermediate target is a variable closely linked to the ultimate goal but can be influenced by policy instruments. It helps to adjust the instrument more quickly and more accurately in response to a shock to the system than it could if the Central Bank relied solely on the values of the ultimate target. Intermediate targets include broad money or high powered money, credit, exchange rate and inflation forecasts.

Targeting one of these variables (e.g. broad money which is known to influence inflation) helps the central bank to respond more quickly than waiting to affect the ultimate goal. The operating target is usually treated as the instrument variable as in Poole and McCallum where short term interest rates and monetary aggregates were used. However, in the case of a country with a floating exchange rate, it is preferable to use a monetary conditions index as the operational target for policy rather than the short-term interest rate. For many years, Central Banks have used interest rates and monetary aggregates as operational targets. However, since its formulation, the monetary conditions index which is a combination of the short term interest rate and the exchange rate has become an operational instrument of policy and an indicator of the direction monetary policy. This has been occasioned by the need to identify alternative variables to function as intermediate operating targets and information variables in the conduct of monetary policy. The rationale for using the MCI has been propelled by two issues in the policy making process. First, financial market liberalization and deregulation in Kenya during the early 1990s has weakened the relationship between monetary aggregates as intermediate targets to inflation. The second issue is the need to measure the influence of exchange rate changes on inflation. However, the need for an instrument that indicates by how much policy should change has been long overdue as indicated by Friedman when he argued that policy rules are desirable when the authorities don‘t have the information or capability to know when or by how much to stimulate or dampen the economy without which, activist stabilization policies can end up exacerbating the very economic volatility they seek to reduce. Bank


Figure 2: Monetary Transmission Mechanism

This post was written by , posted on January 25, 2014 Saturday at 4:49 pm