MOI UNIVERISTY

RELATIONSHIP BETWEEN INFLATION AND MONETARY POLICY ON

KENYAN ECONOMY

HENRY BIWOTT

A Research Project submitted to the Department of Economic studies in the School of

Business and Economics in partial fulfillment of the Degree of Bachelor of Economics
(Art), Moi University

JULY,2021
 DECLARATION

This project is my own original work and has not been presented for the award of a Degree or
Diploma in any other university or institution.

Signature______________________ Date________________________

Henry Kibiwott

ECO/1002/18

This project has been submitted for examination with my approval as the university Supervisor.

Signature_______________________ Date_________________________

Mr. OBiro

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 DEDICATION

I dedicate this project to my family and friends who made it possible for me to achieve all that I
have achieved through continuous encouragement and material support and bringing a new table
into my life and endless prayers to see me through.

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 ACKNOWLEDGEMENT

I would personally like to acknowledge the efforts of my parents for the support they gave me
through the time as I prepared to undertake this study.

I also would like to extend my gratitude and appreciation to my project Supervisor,, Mr Obiro for
the guidance she offered me all through the writing of this proposal.

Lastly I would like to appreciate the university at large for giving me the opportunity to use its
facilities in facilitating my study which includes the library in which part of the study was
researched.

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 ABSTRACT

Inflation is a critical aspect of every economy and presents a balancing act to most government
through regulatory framework. Inflation can break or break the economy of a nation. Hence
policy makers in the government regulating bodies spend considerable time in developing
policies aimed at achieving set targets of inflation which are geared to supporting the broader
economic objectives of an economy. The Central Bank of Kenya (CBK), like most other central
banks around the world, is entrusted with the responsibility of formulating and implementing
monetary policy directed at achieving and maintaining low inflation as one of its two principal
objectives; the other being to maintain a sound market-based financial system. This study set to
establish the relationship of monetary policy tools and inflation in Kenya. The study employed
correlation research design. The study used time series empirical data on the variables to
describe and examine the relationships between monetary policy tools and inflation. The study
used secondary data on the Consumer Price Index, the measure for inflation, 91-day Treasury bill
rate, exchange rate, money supply (M3) and repo rate. The analyses entailed the computation of
the various coefficients of correlation denoted as „β‟ in the model to determine the relationship
of monetary policy tools in and inflation in Kenya. The study established that inflation and the
money supply were positively correlate with each other. The study established that the general
level of prices increase with the increase of money supply. The study established the 91 Treasury
bill rates have an impact on the level of inflation. This is because the treasury bills rate forms the
base of commercial banks interest rates. Therefore an increase in treasury bills leads to an
increase in commercial banks base lending rate leading to reduction in liquidity therefore
reducing the aggregate demand. Fluctuations of foreign exchange rates were seen to have an
effect on the prices. The study recommends that the policy makers need critically evaluate and
monitor the levels of money supply in Kenya so as to ensure a stable retail price levels. The
study also recommends that the CBK to use 91-day Treasury bills rate in monitoring the level of
prices because it has a significant effect on the level of Inflation in Kenya

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 TABLE OF CONTENTS

CHAPTER ONE

INTRODUCTION ...................................................................................................................... 1

1.1 Background of the Study ....................................................................................................... 1

Monetary Policy Tools ............................................................................................................... 2

1.1.2 Inflation .............................................................................................................................. 3

1.1.3 Effects of Monetary Policy on Inflation ............................................................................ 4

1.1.4 Monetary Policy Tools and Inflation in Kenya .................................................................. 5

1.1 Research Problem................................................................................................................... 6

1.3 Research Objective ................................................................................................................ 8

1.3.1 Main Objective .................................................................................................................... 8

1.3.1Specific Objectives ............................................................................................................... 8

1.4 Value of the Study .................................................................................................................. 9

CHAPTER TWO

LITERATURE REVIEW

2.1 Introduction .......................................................................................................................... 10

2.2 Theoretical review ................................................................................................................ 10

2.2.1 Keynesian Theory .............................................................................................................. 10

2.2.2 The Quantity Theory of Money ......................................................................................... 11

2.2.3 Monetarism Theory ........................................................................................................... 13

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2.3 Monetary Policy Tools .......................................................................................................... 14

2.3.1 Interest Rates ....................................................................................................................... 14

2.3.4 Central Bank Rate ............................................................................................................... 17

2.3.5 The Cash Reserve Ratio ...................................................................................................... 18

2.3.6 Foreign Exchange Market Operations ................................................................................ 18

2.3.7 Money Supply .................................................................................................................... 19

2.4 Empirical Studies .................................................................................................................. 20

2.5 Summary of Literature Review .............................................................................................23

CHAPTER THREE

RESEARCH METHODOLOGY

3.1 Introduction ......................................................................................................................... 25

3.2 Research Design .................................................................................................................. 25

3.3 Data Collection .................................................................................................................... 25

3.4 Data Analysis ....................................................................................................................... 26

3.5 Model Specification ............................................................................................................. 26

CHAPTER FOUR

4.1 Introduction .......................................................................................................................... 28

Table 4.1 Descriptive Statistics ................................................................................................. 28

4.2 Consumer Price Index .......................................................................................................... 29

4.3 Money Supply .................................................................................................................... 30

4.5 Exchange Rate (US dollar rate) .......................................................................................... 32

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Figure 4.6 Exchange rates (USD rate) ...................................................................................... 33

4.6 Central Bank Rate .............................................................................................................. 34

Table 4.4 CBR 2016-2021........................................................................................................ 34

4.9 Summary and Interpretation of the Findings ...................................................................... 40

CHAPTER FIVE

SUMMARY, CONCLUSION AND RECOMMENDATIONS

5.1 Introduction ........................................................................................................................ 41

5.2 Summary............................................................................................................................. 41

5.3 Conclusion .......................................................................................................................... 42

5.4 Policy Recommendations ................................................................................................... 42

5.5 Limitations of the Study ..................................................................................................... 43

5.6 Suggestions for Further Research ....................................................................................... 43

REFERENCES .......................................................................................................................... 45

APPENNDIXES ........................................................................................................................49

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ABBREVIATIONS

CBK Central Bank of Kenya

CBR Central Bank Rate

CPI Consumer Price Index

CRR Reserve Requirement

GDP Gross Domestic product

IT Inflation Targeting

KNBS Kenya national Bureau of statistics

MPC Monetary Policy Committee

NBFIs Non- bank Financial Institutions

OMO Open Market Operations

QTM Quantity Theory of Money

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 CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

The major goals of economic policies include high employment, stable prices and increased

growth. According to Friedman (1968) although there is no common concession that all the

goals are compatible, there is agreement on the roles various instruments can and should play

in aiding the realization of these goals. Monetary policy is one of the instruments that policy

makers use to achieve these desired economic goals.

Monetary policies are formulation and execution policies aimed at guiding bank lending rates to
those consistent with supply elasticity with a goal of ensuring there is stable prices and fostering
of economic growth. Monetary policy is a major policy adopted in many countries to help
counter different economic imbalances. In practice, monetary policies work in coordination with
other instruments, in achieving the stable price levels.

The effectiveness of monetary policy tools and instruments as a economic stabilization varies
across different economies and countries. The difference in effectiveness is caused by variability
of economic structures, financial markets, and level of development of capital markets among
others .Inflation as a progressive rise in price level, usually over a period of time. Inflation is
caused by continuous increase in the supply of money, a progressive decrease for money or both.

Governments sometimes increase the quantity of money supply. If the demand for money was
relatively fixed, the increase in price level would grow at the same rate as money supply.
Increase in level of incomes usually causes the demand for money to increase over time. This
tempers the inflationary effect of the money growth and the price levels grows slowly than the
money supply. Therefore a higher rate of money supply growth is expected to cause a higher rate
of inflation.

Nation”s central bank is responsible for formulating and implementing monetary policy. The

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formulation of monetary policy centre around developing a plan geared towards at pursuing

the goals of stable prices, full employment and, more generally, a stable financial environment

for the economy. In implementing those plans. the central bank uses the tools of monetary policy
to induce changes in interest rates, and the amount of money and credit in the economy. Through
these financial variables, monetary policy actions influence, with considerable time lags, the
levels of spending, output, employment and prices

1.1.1 Monetary Policy Tools

The set of monetary instruments employment will always differ from state to state. This is due

to dynamics existing in different economies in respect to economic structures, statutory and

institutional procedures, political systems and ideals, the level of developments of capital

markets among others. The more advanced the economy, the more instruments the policy

makers will have at disposal to bring inflation to the desired levels.

In capitalist countries, monetary authorities use among others following instruments: changes in
reserve ratio, open market operations, discount rates, exchange rates regulations. We found out
that developing countries because of their different economic growth and outlook, different
patterns of production structures usually result to qualitative supervision. Whereas the success of
monetary policy does not necessarily depend on no of wide range of instruments used, it‟s
beneficial to use several coordinated instruments.

Among most frequently used monetary policy tools include: Money supply, repo rate, Open
Market operations, Interest rates and Exchange rates The last few years have been an
extraordinary period for many central banks. There has been a great expansion in breadth and
scale of operations in many economies. In amidst these developments the financial crisis of
2016– 2021 brought into questions the stability of markets and the preparedness of unpredicted

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events in the financial markets in periods of down turns and instability. Events in the last few
years of financial crisis have raised questions about how central banks manage trade off between
price stability, output stability and financial stability in order to meet the macro economics
objectives.

Through the period of inflation, and inflation targeting by various governments, the

importance of the trade off between output and inflation stabilisation in the short term has

been well comprehended. Monetary policy is usually regarded as aiming at target inflation in

the long run. This is usually achieved by ensuring that inflation is brought back to the target

within a suitable time horizon in order to avoid excessive fluctuations in real variables such as

output and employment. Optimal monetary policy is seen as best ways of navigating the short
run tradeoffs while still ensuring the long term financial objectives are met at the same time.

1.1.2 Inflation

Inflation is a subject that is most often discussed today. Politicians to economist usually

engage in endless debates and discussions with promises to fight inflation. However the

inflation is brought about by the same people through money policies and fiscal policies

Inflation is a condition of rising prices . Inflation, always and everywhere is caused by an

increase in the amount of money in supply. Credit poses critical economic problems of our time
inflation management is one of the underlying fact of in any economy setups. Its one aspect that
every country and governments have to contend with in the modern economy. This makes in not
only the dreaded but also misunderstood economic phenomena.

Inflation has been affecting mankind since the days of barter trade to the developments of
medium of exchange, like precious metal .Whereas it cannot be disputed that there is no full

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comprehension of inflation, it remains a threat to all economies in the world form the developing
nations to the super powers. This has led to development of ways and policies to control
inflation.

In periods of inflation there is a general increase in the amount f money in supply. People

have more money to offer for goods in the event that the quantity of goods

supplied does increase as much as the increase of money the price of goods are will generally

go up. This is because each individual unit currency becomes less valuable as there more unit

currencies. The price of goods will rise not because there is a scarce of good but because there

is surplus money available.

1.1.3 Effects of Monetary Policy on Inflation

Although price stability is a useful tool in helping achieve maximum sustainable output,

growth and employment over the long run, it may result to some tension in the short run

between the two goals. When employment levels are reduced, there is a tendency for the

pressure on prices to lessen, this is mainly due to the weakening of the labour market by

easing policy does not have adverse inflationary effects. There are instances where upward

pressure on pressure on price develops as output and employment are softening. This occurs
mainly when an adverse supply shock, such as a spike in energy prices has occurred. In this
scenario, any attempts to lower the inflation pressure only compound the weakness in the
economy or attempt to reverse employment losses aggravates inflation. This poses great dilemma

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those tasked with monetary policies because they need to decide either to reduce the rising
pressure on prices or cushioning the loss of employment and output.

Before late 2007, there had been advances in both theoretical and empirical studies of

monetary economics had led to the academicians and policymakers to agree that there exist a

well defined and established art and science of effective monetary policies. It was generally

agreed that central banks central banks had proven to be effectively successful through their

monetary elements. This success at least in OECD countries had not only kept inflation

relatively but also cushioned against unusual variations. The period since 1980 was referred to

as ``Great Moderation‟‟. This stability made economist, bankers and policy makers to

appreciate their success because it was felt that they could control inflation

However as from August 2007 the world was hit by what Alan green span,

former Chairman of the Fed, called in congress testimony as a ``once-in-a century credit

tsunami‟‟. The financial crisis from 2007-2009 depleted economic activity in most countries,

led to severe worldwide economic contraction since the great depression. The financial crisis

eroded the confidence of economist, bankers and policy makers of ability to successfully

manage the economy.

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1.1.4 Monetary Policy Tools and Inflation in Kenya

The deregulation of economic activities in 1990s established great milestone in the conduct of

monetary policy in Kenya. This is in terms of Objectives, monetary instruments in place and

policy and regulatory and institution framework. In 1996 the Central Bank of Kenya (CBK)

Act was amended to allow CBK more independence and greater operation autonomy in its

functions of formulating and implementing monetary policies. The Act stipulated the main

objective of CBK as formulation and implementation of monetary policy geared to achieving

stability in the general level of prices. The CBK is also by the Act expected to foster liquidity,
solvency and proper functioning of stable market-based financial system.

Although economist universally agree that money supply in a market is the main determinant

of general level of prices and that therefore by extension surplus quantity of money supply is

the main cause of inflation, the monetary policy transmission mechanisms, which is a

transmission process staring with monetary policy statements, followed by monetary

instruments then real output and inflation, it is not very transparent and clear in most

economies or markets.

1.1 Research Problem

The quantity theory of money explained that increasing quantity of money supply would lead

to a almost equal percentage of the increase in price of commodities. The theory asserts that

general changes in price are primarily caused by changes in the money in circulation .

The Keynesian theory on the other hand states savings have no positive effect on
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investment as long as the economy suffers under employment Keynes explained that an

increase in the general price level or inflation is created caused by an increase in aggregate

demand which is above the aggregate supply. Monetary theory advocates for the idea that

market to regulate itself through market efficiency and reject most of government

intervention. Monetarist argue that an increase in money supply will only lead to increase in

output or production and employment levels in the short run and not in the long run.

Study revealed that in the short run expansionary monetary policies will lead

to a decrease in the natural rate of unemployment and increase the production but the

effectiveness of expansionary policies will be inhabited in the long run because they lead to

increase in inflation. Concludes that there is there is a positive linear relationship between the
money supply and inflation.

The study found out that monetary policy tools are very important in ensuring stable markets.
study on the relationship between the macroeconomic policies and inflation. found that in
Australia. The study however did not find a direct linear relationship between monetary policy
and inflation.

The Monetary policies are geared towards achieving some specific set economical objectives

that are expressed in macroeconomic variables such as real output, employment and inflation.

In practice however the effects of the monetary policies are rather indirect than direct. Most

central banks have adopted certain formal inflation target. The target is not universal but

varies with the dynamics of the market in concern. The problem with inflation targeting is that

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there is a tendency to ignore other variables of economy at the expense of inflation; this may

cause even more disastrous effects in the economy.

The impact on monetary policy intervention in Kenya showed that

there were significant relationship between the monetary policy and inflation. However the

study established significant time lags. The Central bank Of Kenya (CBK), just like other

monetary controlling institutions in the world is entrusted with the task of formulating and

implementing monetary policies geared towards maintaining a relatively low inflation. In

additional CBK should ensure that there is regulation to maintain a sound based financial

system. In the recent years there has been increasing rate of inflation. Between 2016 and

2021 inflation has fluctuated despite frequent intervention by the central bank monetary

Committee. Most prices of goods have sky rocketed in the same period making the cost of

living unbearable to most Kenyans. The central bank is tasked with the responsibility to

intervene to ensure that inflation is kept at reasonable levels. Whereas CBK has to some

extent managed to intervene, mostly the intervention is too late when the damage is already

caused or the time lags between response and effect have been big or other adverse effect of

monetary policies meant to only controlling inflation.

The Keynesian theory suggests that inflation changes are a result of forces of aggregate

demand and supply. On the other hand Quantity of money theory suggests that Quantity of

Money in circulation has a direct impact on inflation. Past studies have showed varying

results on relationship between inflation and monetary policies. The central bank has in the

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last few years has mainly focused on the treasury bill rate, the REPO rate, the exchange rate

and the money supply in trying to bring inflation to set levels. In the process of using these

instruments CBK has been met with mixed reactions by the markets and its participants. With

some questioning the impact of CBK tools on inflation .This paper therefore seeks to answer

the question what is the relationship between monetary policy and inflation in Kenya.

1.3 Research Objective

1.3.1 Main Objective

The objective of this research was to establish the relationship between monetary policy tools

employed by Central Bank of Kenya and inflation in Kenya.

1.3.1Specific Objectives

(i) Determine the relationship between the quantity of money supply and inflation rate in

Kenya

(ii) Determine the relationship between the 91 treasury bills rate and inflation rate in Kenya

(iii) Determine the relationship between the Repo rate and inflation rate in Kenya

(iv) Determine the relationship between the Central Bank Rate and inflation in Kenya

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1.4 Value of the Study

This study is valuable to different stakeholders such as academicians, Scholars, the central

bank and other monetary policy makers. The scholars will benefit from the above study

because it contributes tom the body of knowledge about various monetary policies and their

effects on inflation. Learners are able to analyse how each of the monetary policy instruments

affects the rate of inflation. The research will fill some research gaps from the previous

research done in the past as well as identify new gaps which need to be filled by future

researchers.

Policy makers in regard to inflation will get various insights from the study. The study will

give a feedback to them on how effective the instruments that they use to manage inflation

works. Hence they will be able to narrow down to most effective and reliable instruments.

These can be used in cases where by immediate quick intervention are necessary. The study

will also highlight inefficiencies that may exist in monetary instruments which prevent a

quick response in the markets. This will help the policy makers consider the tag lags between

their actions and the tie the effects is felt in the markets.

The society at large will benefit from the study. Investors, business community, civil society

and mwanainchi at large will gain comprehensive knowledge of monetary policies and their

effects on price levels. This knowledge will help them make more informed decisions when it

comes to investments because they can easily forecast the trend of inflation based on the

policy tools the Central bank is employing at the moment.

CHAPTER TWO

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 LITERATURE REVIEW

2.1 Introduction

This chapter analysis the literature on monetary policy tools and inflation .It evaluates studies

and research papers done on both monetary policies and inflation. In the chapter an in-depth

study of the theoretical framework on which the study is based, measurements of inflation

rates, empirical literature and lastly the chapter summary.

2.2 Theoretical review

2.2.1 Keynesian Theory

This theory was developed by John Maynard Keynes (1883-1946). His ideas referred to as

Keynesianism became very influential to economic policy after great depression .

Keynes argued that increased savings will not lead to lower interest rates. Therefore

savings have no positive effect on investment as long as the economy suffers under

employment Keynes explained that an increase in the general price level or inflation is created

caused by an increase in aggregate demand which is above the aggregate supply. Keynes

argues that if the economy is at full employment output level, an increase in government

expenditure(G), an rise in private consumption(C) and a rise in private investment(I) will

cause a rise aggregate demand. This leads to a general increase in price levels. This inflation

pressure is due to the fact that at full employment of output with maximum utilization of

scarce resources, an economy is cannot increase its aggregate supply to match the increasing

aggregate demand.

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Keynes established that there is a positive relationship between consumption(C) and

income(Y) as a function C= f(Y).

The national output (Ys), which is today measured as Gross Domestic Product (GDP), as the

sum of consumer spending (C) and all saving (S)

YS=C+S

To keep it simple, all quantities supplied for a set price and everything that is saved, but not

sold, contribute to GDP. From a demand-oriented perspective, John Maynard Keynes

explained that that aggregate demand (YD), as the expenditures for the above produced GDP,

is determined by consumer spending (C) and investor spending (I):

In open markets and economy, policy makers need to determine if the national output is

demanded in such a way: If national income as aggregate demand (YD) equals (YS), saving

(S)would equal investment (I)Keynes achievement was to demonstrate “that there might be a

disequilibrium that could lead to a later equilibrium with unemployment and price instability”

Keynes urged that governments should play a more active role in the economy .He provides a
more specific ways for government to intervene so as to manage the economy targets especially
to the level of employment and inflation.

2.2.2 The Quantity Theory of Money

This theory originated in the sixteenth century when Economist form Europe noticed higher

levels of inflation associated with gold or silver .This theory proposes a

positive relationship between changes in the money supply and the long- term price of goods.

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The theory explained that increasing quantity of money supply would lead to a almost equal

percentage of the increase in price of commodities. The theory asserts that general changes in

price are primarily caused by changes in the money in circulation . The quantity theory has
provided a conceptual framework for interpretation in the contemporary financial events.

The calculation of money circulation is based upon the fisher Equation

Money in supply(M)X velocity of money(V)= The average price level(P) X The volume of

transactions in the Economy or simply the aggregate output( Q). Causation is assumed to run

from the left side of the right side the equation. Total spending impacted by changes in

monetary base. The real output growth varies over different periods.

Empirical research papers of the quantity theory of money (QTM) have focused directly on

the relationship between the rate of change of the money stock and inflation. In monetary

Economics, the quantity theory of money is the theory that money supply has a

direct,Proportional relationship with the price level. The theory was challenged by Keynesian

Economics, but updated and reinvigorated by the monetary school of economics. While

Mainstream economists agree that the quantity theory holds true in the long run, there is still a

disagreement about its applicability in the short run. Critics of the theory argue that money

velocity is not stable and, in the short-run, prices are sticky, so the direct relationship between

money supply and price level Money is endogenous and passive, driven by socialist planning.

The theory therefore asserts that if the money supply growth rate, is greater than the growth of

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real output, then velocity moves in the opposite direction in the short run. Excess money

supply growth causes velocity to slow down momentarily, until prices can adjust. Explains that
in a socialist country, the money is influenced by a large number of economic and political
factors, this is more felt when the government is responsible for providing the purchasing power,
industrial and agriculture procurements, wage payments to city workers and other state
financing.

2.2.3 Monetarism Theory

Monetarists like Milton freedman advocates for the market to regulate itself through market

efficiency and reject most of government intervention. Friedman (2000) strongly opposes the

Keynesian view that government spending stimulates the national output. The monetarism

assume a crowding-out effect of governments spending on private investment, especially if

the latter is deficit-financed.

The whole monetarist argumentation will be carefully policy is needed to have been mentioned
at this point. According to the monetarist, the money supply though important is the not the only
exclusively determinant of both the level of output and prices in the short run .However they
argue that in the long run the prices are not influenced by the monetary policy.

The monetarist theory explains that when the money supply is increased in order to grow or
increase production and employment, creating an inflationary situation within an economy.
Monetarist argue that an increase in money supply will only lead to increase in output or
production and employment levels in the short run and not in the long run (Stanislaw &

There is a positive linear relationship between the money supply and inflation. They explain the
relationship by the natural rate of unemployment. The theory of natural rate of unemployment
argues suggests that there will be a level of equilibrium output, employment, and corresponding

23
level of unemployment naturally decided based on the features such as resources employment,
and technology. This kind of un employment is refereed to us the natural un employment. It also
notes that there people who are unemployment because they wish to be unemployed. These are
people who are jobless but are not looking for a job. In the short run expansionary monetary
policies will lead to a decrease in the natural rate of unemployment and increase the production
but the effectiveness of expansionary policies will be inhabited in the long run because they lead
to increase in inflation

2.3 Monetary Policy Tools

Monetary policy tools refer to the instruments used by the CBK in line with achieving the

target inflation rates. CBK used several tools to achieve its economic objectives this include

measures aimed at influencing the interest rates and liquidity in the markets.

2.3.1 Interest Rates

The interest rate that concerns the central bank as a monetary policy is the 3 months‟ short

term interest rate also called the Treasury bill rate which it influences through the sale of short

term government securities and forms the basis for the setting of commercial bank lending

rates showed that very little of the market's reaction can be attributed to the

effect of monetary policy on the real rates of interest.the financial system does not spur economic
growth and that, instead financial development simply responds to developments in the real
sector. Thus, many influential economists give very minor role, if any, to the role of financial
system, particularly the stockmarket in economic growth.Argue in their book that, equity prices
just like the price of all assets will respond to changes in interest rates. That is to mean, if the
Central Bank raises the interest rates, for instance, the rate available on the risk-free assets goes
up and if more can be earned on risk-free assets, then the holders of risky shares will want a

24
higher return as well. The share prices will also fall if the equity market as a whole becomes

more risk averse and demand a higher premium for any level of risk.

2.3.2 Open Market Operations

Open Market Operations (OMOs) refers to the purchase and sale of securities in the open

market by the central bank. Open markets is defined as a perfectly competitive market for

securities though congenitally it indicates the institutional framework of purchase and sale of

approved securities by the central bank.Open markets Operations have been

used by the central banking the Kenya in the implementation of monetary policy. Usually the

central bank outlines the objectives of the OMOs. The central banks usually use the OMOs to

as to correct the supply of the reserve balances as well as adjust for the fluctuations of interest.

Monetary policies have undergone significant shifts over the years.

He gives an example the Federal Reserve which in early 1980s places special emphasis on

objectives for the monetary aggregates as policy guides for indicating the state of the

economy and for stabilising price levels. However the ongoing and far reaching changes in the

financial have reduced the usefulness of monetary aggregates as policy guides. This has led

the bans to not only us monetary aggregates at policy guided as a control mechanism is

achieved pre set economic targets.

Monetary policies vary from country to country depending on various factors such as the legal

and institutional setting, the structure of financial system, stages of development in the

25
securities markets and the existence and efficiency of other monetary policy instruments

In Great Britain, and the United states and several open markets are applied

only to purchase or sale of government securities, both long and short term, and also only to

the outright purchase or sale thereof. This narrow definition is because the markets for

governments of bonds and treasury bills in these countries are sufficiently broad and active for

all the purpose of open market policy; the central bank and not the market took the initiative

in outright purchases or sales of government securities; and lastly because such operations

therefore reflect the deliberate credit policy of the central bank.

The preparedness of the central bank, for instance to buy such securities and acceptances at all
times at or close to market rates was based on its desire to develop and maintain an active money
market. On the contrary, in other countries where government also deals outright in the
governments- guaranteed securities or for other reasons, such transactions should be included
under Open market Operations .

The central bank of Kenya open market operations refers to action by the CBK through

purchase and sales of eligible securities to regulate the monetary supply and their credit

conditions of the economy (Central Bank of kenya, 2011). OMO can be used to stabilise the

short term interest rates. This is because when the central bank buys securities on the open

markets, it leads to increase of the reserves of commercial banks, making it possible for them

to expand their loans. This leads further lead to increase of money supply so as to achieve the

desired level of money supply.

2.3.3 Repo Agreement Rate

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Short term interest has not been the most important instruments in conducting monetary

policy in Kenya because of many interrelated factors. This has largely been caused by the

dynamics of the market and the inefficiencies which exist in the financial markets. The

competitiveness of the banking sector has also not made it easy for the central bank. This has

made the central bank to place a lot of weight on the attention to the quantity base instruments

to monetary control, exchange rate interventions and the changes in minimum reserve

requirements in conducting monetary policy. CBK has therefore naturally resulted to using
mainly monetary policy as the main tools in maintaining the inflation to the preferred levels.

As a result of uncertainty in measuring real interest rates and large external and domestic shock
makes monetary aggregates a preferred instruments Taylor (1993).

Repurchase Agreements (Repos) entail the sale of eligible securities by the CBK to reduce

commercial banks deposits held in CBK. Currently, Repos (often called Vertical Repos) have

a fixed tenor of 7days. Reverse Repos are purchases of securities from commercial banks by

the CBK during periods tighter than desired liquidity in the market. Horizontal Repos are

transactions between commercial banks based on signed agreements using government‟s

securities as collateral and have negotiated tenors and yields .

Commercial banks short of deposits at the CBK, borrow from banks with excess deposits on

the security of an appropriate asset, normally government securities. The horizontal repos help

banks to overcome the problem of credit limits hence promoting interbank liquidity.

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2.3.4 Central Bank Rate

The level of the CBR is usually reviewed by the Monetary Policy Committee (MPC) at least

once after every two months. The level of CBR usually is seen to reflect or signal monetary

policy stance at the specific time.CBR can be argued to be the base for all monetary policy

operations in order to enhance clarity and certainty in monetary policy implementation.

Whenever the central banks are injecting liquidity through a reverse repo, the CBR is the

lowest acceptable rate. (Central Bank of kenya, 2016). On the other hand whenever the bank

intends to withdraw liquidity through a Vertical repo, the CBR is the highest rate that the

CBK will pay on any bid received (Central bank of kenya, 2021).

Movements in the CBR are reflected in the short-term changes in interest rates. When the

Monetary Policy Committee reduces the CBR it signals a easing monetary policy and a desire

for markets rates to move downwards. When there is lower markets interest rates, economic

activities are spurs hence more growth. When the interest rates decline, the quantity of credit

demanded by the market should increase. Efficiency in the repo and interbank is crucial for

transmission of the monetary policy decisions (Central bank of kenya, 2021).

2.3.5 The Cash Reserve Ratio

The Kenyan Banking law requires that a proportion of commercial banks deposit liability

must be deposited at the CBK. This proportion is referred to as the Cash Reserve Ratio

(CRR). The deposits are held at the CRR account. The current ratio stood at 5.25 percent of

28
total bank deposits both domestic and foreign currency deposit liabilies (Central bank of

kenya, 2012).To facilitate commercial banks liquidity management, commercial banks are

currently required to maintain their CRR based on an average from the 15th of the previous

month to the 14th of the current month and a minimum CRR of 3 percent on a daily basis.

When there is a reduction of the CRR leads to more liquidity levels by the commercial bank

thus enhancing their capacity to expand more credit to their customers. However an increase

the CRR tightens liquidity and could also reduce demand driven inflationary pressures.

2.3.6 Foreign Exchange Market Operations

CBK control liquidity in the banking system by engaging in foreign exchange transactions. A

sale of foreign exchange to banks withdraws liquidity from the system while the purchase of

foreign exchange injects liquidity into the system. Participation by the CBK in the foreign

exchange market is usually motivated by the desire to prevent excessive volatility in the rate

at which the Kenyan shilling exchange against various foreign currencies or to acquire

foreign exchange to service official debt and build its foreign exchange reserves where the

statutory requirement is to use the banks best endeavours to maintain a foreign reserves

equivalent to a three year average of four months import cover. The CBK does not participate in
the foreign exchange market to defend a particular vale of the Kenya shilling but may intervene
to stabilise excess volatility in the exchange market. (Central bank of kenya,

29
The central bank of Kenya has among others implored the following measures to enhance the

stability of the exchange rate. First the bank has limited the tenor of swaps and Kenya

shilling borrowing where offshore banks are involved to a tenor of not less than one year.

The bank has limits the tenor of swaps between residents to not less than seven days. The

bank has reduced the foreign exposure ratio of the core capital from 20 percent to 10 percent.

The bank has made a requirement that local banks obtain supporting documents for all

transactions in the nostro accounts of the offshore banks. The banks also suspended the use

of the Electronic brokerage System (EBS) by the Central bank Kenya (2021).

2.3.7 Money Supply

Money supply can be defined as the sum of currency outside banks and deposit liabilities

commercial banks (Central bank of kenya, 2021). Deposit liabilities are defined in narrow

money(M1), broad money(M2) and extended broad money(M3). These are defined s below

M1 this refers to currency outside banking system + Demand Deposits

M2 = M1 + time and savings deposits +certificates of deposits + deposits liabilities of Non-

bank financial institutions (NBFIs).

M3 = M2 + Residents foreign currency deposits.

The Central banks majorly targets broad money (M3) in its policy targets and interventions.

2.4 Empirical Studies

Several studies have been done on monetary policy and inflation rates.

30
Studies the relationship between monetary policy, inflation and un employment. The study

showed that the monetary authorities in South Africa put more weight in inflation than on

employment. This was because the monetary authorises were seen to abruptly respond to

inflation than to the rate of unemployment. The study suggested that the monetary authorities

take more public expectations when it comes to formulation policy statement. The study

showed that technological advancement has a bearing on the effectiveness of monetary policy.

The fact that technological trend variable was positive and significant. Hence financial

engineering was seen as critical in affecting the speed of monetary policy effects.

Conducted a study on inflation targeting in Columbia through monetary policies

concluded that in Colombia, monetary policy converged fully fledged inflation targeting with

an independent floating regime. The performance of the strategy was found satisfactory

overall. Starting from a deep recession the study found that a policy stance which was

expansionary led to decline in inflation along the targets, the output had recovered and

international reserves had reached levels that limit the external vulnerability of the economy.

However the study found that drawbacks of substantial intervention were difficulty of

communicating policy to the public and the market. The study further found that fiscal

imbalances posed a credibility and power of the monetary policy through several political

channels.

A study on the effectiveness of monetary policy. In their

analysis they addressed changing views of the role and effectiveness of the of monetary policy

in inflation targeting. The monetary policy influence of short run stabilisation was evaluated

31
together with challenges of implementing a short-run stabilization policy. The study found out

that central banks were successful in hitting targets for on the medium term horizon. However

the study revealed that it was not very clear of the marginal contribution of inflation targeting

beyond commitment to price stability. It was also established there were no clear what would

happen to low stable inflation if bad shocks were realized. The study also showed that the

central banks operate in the environment of many dimensions and uncertainty that it is

problematic for consistently short run money stabilization policies.

Monetary policies in regard to lessons from the financial crisis.

The study was done to find out if monetary policies were any relevant and why the established

policies did not avert the financial crisis. The study concluded that the economist and

monetary economist did not have to go back to the drawing board because much of the

science of monetary policy remained intact. The study concluded that monetary policy were

still effective. However it was noted a stronger case for monetary policy to lean against credit

bubbles rather than just cleaning up after the bubble has burst.

Out of the 13 leading emerging economies, only two had not adopted inflation targeting (IT), a
related type of rule- based policy. The study found out inflation targeting leads to a more
systematic reaction to inflation.

The study mainly concluded that in emerging economies, central banks, most of the time,

change short-term interest rate in response to deviations in inflation and exchange rate

movements. The study also noted that price stabilization remains a main objective of central

banks in emerging countries, other objectives such as output stabilization, stability of

32
exchange rate and few cases, stability of assets prices and current account deficit.

Beggs (2010), study on the relationship between the macroeconomic policies and inflation.

found that in Australia financial deregulation was not compatible with monetary targeting, it

was quite compatible with monetary policy and further facilitated a policy based on open

market operations and setting up of stable instrument for the future. The study found out that

monetary policy tools are very important in ensuring stable markets.

A study on monetary policy reaction function for Kenya. The study established that the central
bank of Kenya has been targeting broad money M3, when making its monetary policy decisions.
The results indicate that Central Bank of Kenya has been successful in controlling inflation, at
least for the greater period in the sample. At times of high inflation or positive output, the CBK
responded by reducing money supply. The CBK followed a rule to target inflation with some
allowance for output stabilization. The exchange rate was established as a major concern of CBK
behaviour. The study established that the CBK was found to perform well in the implicit
objective of short run interest rate management. The study concluded that at times of high
inflation the CBK increased the repo interest rate in order to success in mopping up excess
liquidity. The study also suggested that a backward looking specification of the Taylor type were
best foe Kenya. This implied that the CBK to take into account past inflation when implementing
monetary policy.

A Study to establish the effectiveness of monetary policy tools in countering

inflation in Kenya. The study used treasury bills rate, Repo rate, money supply and exchange

rates as the tools used by the central bank. The study showed treasury bill rate was found to

attracts more investors to lend money to the government thus reducing their immediate

purchasing power this reduces the amount of money in circulation this was found to reduces

inflation. The study also found a correlation between inflation and money supply. It was

33
established that more money supply lead to the increased inflation. This was because increase

in money supply leads to people spending the excess of their money supply over the money

demand. The study was established that exchange rate system has an important role in

minimizing the risk of fluctuations in exchange rates. An increase in exchange rates

accompanies higher rates on inflation. This is partly due to increase in the Diaspora

remittances. However, in general, exchange rates have limited effect on the levels of inflation

recorded in Kenya.

2.5 Summary of Literature Review

Many studies have been conducted in regard to money policies. This has been done because

the various theoretical models have been put forward in regard to the conduct of money policy

over the years. The theoretical developments emanate from propositions by diverse competing

schools of thoughts; the Monetarist, the Keynesians and the Classical. The different

approaches agree on some areas while differ on other concepts and reasoning. The fishers

classical quantity theory of money argued for neutrality of money in the economy and

consequently shins intervention by the governments in the markets.The

Keynesians disagreed with the classical proposition, instead they embraced the

idea of the trade off relationship between inflation and unemployment which they seeas an

justification of their policies.

The study has showed that as far as macroeconomics and the conduct of money policy in an

34
economy are concerned there seems to be areas of contentions. This is mainly in regard to

how economic functions and monetary policymakers should seek to achieve their target goals.

Whereas for instance many central banks in the worlds have developments a formal approach

to inflation by ensuring target inflation levels, the approach has proved to overlook other

economic aspects. Therefore its imminent there needs to develop an appropriate framework

that ensures that there is a focal point in order to fully understand the underlying relationships

between inflation and money supply instruments.

Cheng (2006) study established a weak link between output and monetary stance amid strong

link between price stability and monetary stance. The study showed that there seemed little

scope for balancing the two competing goals of output stabilization and price stability. The

study recommended that the near future, the overriding objective of monetary policy,

therefore, should be to maintain low inflation. Looking forward, the study suggested Kenyan

authorities should continue to undertake structural reforms aimed at addressing the

weaknesses in the financial sector, including improving governance of the CBK,

Strengthening regulatory framework, as well as enhancing legal framework, with a view to

improving the monetary transmission mechanism to the real sector.

Based on several studies the research paper seeks to form a clear picture of the Kenyan

perspective by evaluating the relationship between monetary policy and inflation in Kenya

by analysing the effect of various monetary policy instruments employed by the Central bank

of Kenya between 2016-2021

35
 CHAPTER THREE

RESEARCH METHODOLOGY

3.1 Introduction

36
This chapter describes the methodology that was undertaken in conducting the study to arrive

at the finding regarding the effectiveness of the monetary policy and inflation rates in Kenya.

The chapter covers research design, data collection, and data analysis and model specification.

3.2 Research Design

The study employed descriptive research design. The studies used time series empirical data

on the variables to describe and examine the effectiveness of the monetary policy tools in

countering inflation in Kenya for the period 2016 to 2021. This was done by establishing

correlation coefficients between the inflation and the monetary policy tools employment by

the central bank the period.

3.3 Data Collection

The study used secondary data on Money supply (M3), Consumer, Price Index, exchange

rate, 91-day treasury rate, Central bank rate and Repo rate. The money supply (M3), 91-day

treasury rate, exchange rate and REPO rate will be obtained from the CBK. The date for

inflation (CPI) will be obtained from the KNBS. The study will use the USD Kenya Shilling

exchange to measure the general strength of the exchange because the USD constitute the

main currency exchanged against the Kenya shilling. The study focused on five year period

between 2016 and 2021.The five year period date was analysed on quarterly basis. In the

analysis the study will make of monthly data in analysis of the relationship between inflation

and monetary policy tools.

3.4 Data Analysis

37
The study used well a graphical analysis. Because the study model was a

multivariates one, the study used multiple regression technique in analyzing the relationship

between the inflation and the monetary policy tools. The study computed various coefficients

of correlation denoted as ß in the model to determine the relationship between the monetary

policy tools and inflation countering inflation in Kenya.

CHAPTER FOUR

DATA ANALYSIS, FINDINGS AND DISCUSSION

4.1Introduction

38
This chapter evaluates the analysis and findings of the study as set out in the research

objective and methodology. The study presents a relationship between the monetary policy

tools as applied by the central bank and the rate of inflation in Kenya. The data used for the

purpose of this study was secondary data from records and publications from Central bank of

Kenya (CBK) and Kenya Bureau of Statistics (KNBS).

The table below shows the descriptive statics of the variables under consideration. For the five

year period evaluated; 2016 to 2021, inflation mean for the period was 10.68 with a standard

deviation of 5.33. The exchange rate between the USD and Ksh mean was 79.82 with a

standard deviation of 7.67. REPO rate between the banks mean for the period was 7.11 with a

standard deviation of 6.1.The Central Bank Rate mean for the period was 9.2 with a standard

deviation of 3.9. The treasury bill rate mean was 8.05 with a standard deviation of 4.35The

money supply mean for the period was 1333.9 billion with a standard 675 billions.

Table 4.1 Descriptive Statistics

Mean Std Deviation N

Inflation 10.6850 5.33442 20
Foreign exchange 79.8295 7.67751 20
Repurchase rate 7.1195 6.10051 20
Central Bank Rate 9.2640 3.98222 20
TBR 8.0515 4.35541 20
Money Supply 1333.9 675.81007 20

4.2 Consumer Price Index

Consumer price index data which in the study reflect the level of inflation was obtained from

the data banks of the KNBS and is freely accessible. In 2016 Consumer price index

39
fluctuated between 7.9 and 17.6 with the lowest being in the month of January and the highest

level in November. In January 2017 the CPI eased to a level of 13.3. In this year the lowest

level being in October at 7.1 and the highest in February at 14.6. The year closed at the level

at 8.0 at December. The year 2020 CPI started at 7.5 at January which was the highest in the

year and closed at 4.5 at December being the lowest in the year hence presenting easing trend.

In the year 2011 the level of inflation in January was 5.4 while in December the level was

18.9.Inflation at its highest in November at 19.7. In 2020 CPI in January was 18.3 which was

the highest while in December the same year while in December it was 3.2 which was still the

lowest in the year.

4.3 Money Supply

The study established the trend of the money supply in Kenya in the period between 2016 and 2021. In
June 20 the supply was ksh 840 billion while in the same year in December the supply had risen to 901
billion. In 2009 the supply was about ksh 950 billion in June while in December the same year the supply
was at ksh 1,045 billions representing a rise.In June 20117the supply was at ksh 1,1198billions, which
increased to Ksh 1,272 billion in December. In 2018 June the supply was Ksh 1,380 billion which
increased to Ksh 1,514 billion in December. In 2020 the money supply steadily rose to Ksh 1,594 in June
2021 .

Table 4.2 Quarterly Average Money Supply(M3)

Quarterly Average in Billions

Q4 BILLIONS Q3BILLIONS Q2BILLIONS Q1BILLIONS

2021 1723 1640
2020
2019

40
 2018
2017

4.9 Summary and Interpretation of the Findings

Fluctuations in inflation distort the smooth functioning of the economy because of its effect of

the economic value of the local currency. Governments have mandated the Central Banks to

put up strategies that will ensure price stability. In Kenya, the inflation rate as measured by

the consumer price index has fluctuated over the period of study. There are several factors that

can be attributed to this cause.

The five factors studied in this project have contributed for about 67% of the reason for the

fluctuations of the consumer price index. This means that there other variables which

contributes to inflation but have not been considered in this study. From the findings the

inflations seems to be increasing with the increase in money supply, exchange rate and 91-day

Treasury bill rate. This means that is positive relationship between these variables and

inflations. Central bank of Kenya, which has been mandated with formulating strategies to

control inflation, therefore, needs align its policies so as to avoid excessive fluctuations which

distorts.

41
 CHAPTER FIVE

SUMMARY, CONCLUSION AND RECOMMENDATIONS

5.1 Introduction

This chapter summarizes the study and makes conclusions based on the results highlighted

form the findings. The chapter outlines policy implications from the findings and areas of

where more research need to be carried out.

5.2 Summary

42
The study set to establish the relationship between monetary policy tools and inflation in

Kenya. In achieving this, the study used variables such as the REPO rate, Money supply,

Exchange rate (USD) and 91-day Treasury Bill rate. The independent variable was the

Consumer Price Index (CPI).From the findings outlined in chapter four, the study showed that

as that Inflation and money supply correlate with each other. The study showed that as the

money supply in circulation increased inflation also increased. This can because increase in

money supply leads to people having more disposable income. This causes the amount of

demand demanded to exceed the supply of goods hence leading to a rise in prices of goods.

The government therefore should in its policy application through the central bank monitor

the amount of money in circulation through its monetary policies. The government also

through its fiscal policies should ensure that wherever the money supply exceeds the set level,

appropriate measures to stimulate production to ensure demand does not exceed supply of

goods and services.

5.3 Conclusion

The 91-day treasury bills have been used as a tool by the CBK to wipe out excess liquidity in

the country. The study shows that there is Inverse relationship between an the Treasury rate

and the level of prices. This can be explained by the fact that when the Governments increases

the 91 treasury rates, the commercial banks short term interest rates increase, this reduces the

access of funds by the public. In this case even the citizens with more disposable incomes

tend to save to attract increasing levels of interest hence this leads to a down ward push on

43
general prices due to reduced aggregate demand.

The study also concludes that REPO rate has the little effect on the level of inflation in the

economy. This because the REPO is a short term facility that enables the commercial banks

meets their minimum statutory balances. Hence the rate has insignificant effect on the retail

prices. This in effect does not influence to a great extent the amount of money in supply

hence little affects on the prevailing rates of inflation. The little effect is attributed to the fact

that it only controls the balance in each individual bank‟s balances

The study concludes that exchange rates are critical element of general price levels in Kenya.

This is because Kenya has a negative balance of trade, therefore being a net importer which

means that in purchases more in foreign currency than it exports. The prices of imported

goods heavily correlate with the prevailing rates of foreign exchange.

5.4 Policy Recommendations

The study recommends that the policy makers mainly the Central Bank should make a critical

analysis of the intended inflation targets when setting the 91 Treasury bills rate. This is

because it was found that the rate has a significant impact on the price levels.

The Policy makers should align the money supply targets with the medium and long-term

economical goals. this is because the level of supply affects aggregate demand a key element

in any economical set up.

The study recommends that the policy makers involved in setting economic goals to ensure

that that there are geared towards maintaining a stable foreign exchange rate. Thus is because

Kenya being an net exporter the fluctuations of the exchange rate significantly affect the

44
general price level.

5.5 Limitations of the Study

The main limitation of the study was that the study relied on the secondary data mainly from

the Kenya National Bureau of Statistics and the Central Bank. Hence the data might not have

necessarily collected by the two institutions for the purposes of which same was used in this

study.

Consumer Price Index used has been used as the measure of inflation in this study is derived

by a weighted consumer basket. The weights as assigned by the KNBS may not reflect the

actual level of changes but are used as an indicator of the trend movement. The study also

assumed that the data used was objectively gathered and analysed by these institutions

without any bias.

5.6 Suggestions for Further Research

The study focused on relationship between the central bank monetary and inflation in Kenya.

Therefore studies need to be carried on other Fiscal policies and their effect on inflation. It is

also a common knowledge that there could be black markets and other factors that might

affect inflation hence more studies need to be carried to ensure all factors that affect inflation

are studied. The study also recommends that because inflation affect many other variables in

the economy study of effect of inflation on other elements of economy like economic stability

and growth.

The study also suggests a study on the action reaction time lapse between actions of the

monetary policies and time the actions are reflected effected in the financial markets. This

45
will provide an insight on how effective the central bank can timely intervene in the financial

markets.

46