Optimal Monetary Policy for Minimizing Loss Resulting From Inflation Deviation

Abstract

This study aimed to investigate the optimal monetary policy instrument in Kenya to minimize loss resulting from inflation deviation, specifically between interest rates and money reserve. Using time series data between 1980 and 2016 and applying Ordinary Least Squares (OLS) and Vector Error Correction Model (VECM), the study established that interest rates as a monetary policy tool is optimal in minimizing losses arising from inflation deviation in Kenya. A positive correlation is found between the money markets and economic output and interest rate while a negative relationship exists between the level of economic output and exchange rates. There is greater flexibility in using interest rates as a monetary tool since it would influence monetary aggregates and the money markets easily and drive the economy to the desired output level and minimizing losses that may be caused by deviation of inflation rate from the target