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Monetary Conditions Index for Kenya: Towards a Monetary Conditions Index

Since the liberalization of the exchange rate in Kenya in December 1993, there has been a debate on the appropriate level of exchange rate in Kenya as exporters complain when the currency appreciates and the importers take their turn when the shilling depreciates. This dilemma justifies the need for a monetary index. In 2011, the depreciation of Kenya’s exchange rate caused uproar as the exchange rate reached an all time high of Kenya shillings (Ksh.) 101.27 to the dollar far above its 20 year average of 70.43 Ksh. to the dollar. According to Oduor and Khainga, the Central Bank of Kenya’s occasional interventions are not pegged on optimum levels of exchange rates but on intuition. This underscores the need for a yardstick or signal to help the central bank to determine the direction and extent of monetary policy interventions necessary to steer the exchange rate and economy back to equilibrium. Lack of an indicator in instances where there are misalignments and whether the misalignments are an over-appreciation or over-depreciation denies the policy maker an opportunity to optimally steer the exchange rate to the long-run equilibrium especially in response to external pressure. The MCI will also help in monitoring interest rate movements hence supplementing the use of the CBR which is currently the indicator of internal conditions. Credit card

The prominence of the exchange rate and interest rates in dealing with inflation and monetary policy in general cannot be refuted. In an open economy both the real interest rate and the real exchange rate are important factors in the determination of aggregate demand. Exchange rate movements indirectly affect aggregate demand and the spending behaviors of economic agents. For instance, in case the local currency depreciates, products in the local market will become cheaper to foreign buyers who increase local demand thus raising the domestic price levels. On the import side, this depreciation will increase the unit price of imported inputs thus increasing the cost of production and increasing inflation further. Buying and selling foreign exchange to and from the market helps CBK to influence inflation. Here, when CBK sells foreign exchange to banks, it withdraws the local currency from the market. Similarly, when CBK buys foreign exchange, it injects liquidity into the market.
The most important influence on demand is through interest rates since it affects portfolio choices in the market. If the interest rates (as reflected by the central bank rate (CBR)) are rising, representing a tight monetary stance, then the shilling appreciates. This causes market participants to sell dollars in order to obtain the shilling. As a result, there will be more dollars available in the market, causing the value of the dollar to decline, and vice versa. This shows that the interest rate and the exchange rate can work together to manage inflation and would come in handy in indicating the magnitude and direction of inflation. This would lay to rest the question of how much and when to alter monetary policy in response to inflation.
This paper seeks to construct and test the feasibility an MCI for Kenya to supplement the existing monetary framework while seeking to bridge the above mentioned policy gap. The theoretical argument to support the search for an alternative information variable is validated by various studies describing the inflationary process while maintaining a stable exchange rate in Kenya. Gichuki et al found that a composite index minimized losses from equilibrium output better than either the interest rate or the reserve money instruments taken independently. This study recommended the use of the monetary conditions index. Ndung’u in a study on the role of the exchange rates on inflation and monetary policy found that the exchange rate policy has not been supported by the appropriate monetary policy. Furthermore, it is currently the desire of CBK to focus “monetary policy on anchoring inflation expectations to low levels within the target and sustaining the stability of the exchange rate”. The monetary conditions index combining the interest rate and the exchange rate will therefore complement this effort.

This post was written by , posted on January 21, 2014 Tuesday at 4:46 pm