Effectiveness of Monetary Policy on Inflation Control and Economic Growth in Kenya: An Application of Factor Augmented Vector Autoregressive Model

Abstract

The question of the effectiveness of monetary policy (MP) on inflation control and economic growth is a long-standing issue in the literature of monetary policy. Despite immense research, most researchers and policy makers still remain divided on effectiveness of monetary policy and the appropriate choice of monetary policy instruments, targets and framework. This follows enormous divide in empirical findings on the subject in both developed as well as developing countries. This problem is more pronounced in developing countries which not only have underdeveloped financial markets but also lack appropriate tool to model their economies. This study seeks to complement existing literature by further examining effectiveness of monetary policy in Kenya using a Factor Augmented Vector Autoregressive Model (FAVAR) 1997 to 2015. The study examines the role of money supply, exchange rate and the repo rate in the inflation and real sector dynamics. The specific objectives were to determine the impact of repo rate innovations on price stability and Gross Domestic Product (GDP), the relationship between Money Supply, price stability and GDP and the effect of exchange rate fluctuations on price stability and GDP. A FAVAR model has several advantages; first it can handle poor quality data and is able to control for little information problem. The study found that repo rate has a negative effect on inflation. The response of inflation is instantaneous and the decrease in inflation only recover at seventh quarter. The study also found that money supply, price stability and GDP have a long run relationship. However, the study found that exchange rate fluctuations had insignificant effect on price stability and that the effect of exchange rate fluctuations on GDP was unstable, oscillating form negative to positive. The study concludes that repo rate is effective in controlling inflation but ineffective in stimulating economic growth. Therefore, the finding implies that Central Bank of Kenya (CBK) should use repo rate to control inflation. The study also shows that there exists a long run relationship between GDP, money supply and inflation implying that the Central Bank of Kenya should take into consideration the long run impact on GDP when designing tools to control inflation. The study findings also imply that exchange rate is not an effective monetary policy tools to control inflation and stimulate GDP growth. Hence, the CBK should not target exchange rate in the management of the economy.