Empirical Analysis of Real Money Demand Function in Kenya: 2000 – 2016

Abstract

Demand for money is one of the fundamental considerations in effective formulation and performance of monetary policy. Central Bank of Kenya highly dependent upon the stability of the demand for money function to achieve efficient policy formulation. In the past decade, Kenya has experienced rapid financial innovations in payment systems which provide alternatives to cash money. Certainly, these innovations affect monetary policy transmission channels and financial sector players and hence the effectiveness of monetary policy. The main objective of this study is to empirically establish the real money demand function in Kenya and analyse its stability. Empirical analysis has been carried out using quarterly time series data from 2000q1 to 2016q4 based on Engle-Granger Two-Step approach to cointegration analysis. The empirical analysis establishes cointegration and shows that there are structural breaks in Kenya’s real money demand function while CUSUM and CUSUMSQ stability tests, show that real money demand function is not stable. The impulse response analysis shows significant changes in real money demand as a result of shocks in the explanatory variables. We find that interest rate are not significant in the short-run. We conclude that the instabilities in money demand function in Kenya, and lack of significance in interest rates could be attributed to financial developments and innovations in Kenya. We recommend use of alternative monetary policy frameworks that are not based on money supply aggregates to achieve monetary policy goals. Specifically, we recommend the use of the nominal GDP targeting, alone or in combination with others, to offer effective conduct of monetary policy in Kenya.