The monetary reaction function for kenya

Abstract

While the empirical investigation of monetary reaction function is not new, available literature is mainly for developed economies. This article aims to fill the gap in the literature by estimating monetary policy reaction function for a small open economy (Kenya) where broad money remains intermediate targets, and uses an implicit inflation targeting strategy as a monetary policy. The focus is to establish empirically what and how the Kenya monetary policy makers react; estimate Kenya monetary policy rule, and explain both the magnitude and the sign. The empirical estimation used seasonally adjusted monthly data sets of the following variables; the real output, real money demand, Exchange rate, Reserves, interest rate; obtained from the Central bank of Kenya and the Kenya National Bureau of Statistics. The variables order of integration and cointegration tests where investigated before employing quantile regression technique to the modified versions of Taylor rule. Quantile regression method is gaining popularity over conventional methods due its attractive properties; its regression estimators are more efficient when disturbances are non-Gaussian and less sensitive to outliers, further, it can investigate the response of the dependent variable to the explanatory variables at different points along the distribution. Employing quantile regression therefore, allows for a wider measurement of interest rates response to the output gap, inflation, exchange rate and reserves in the Kenyan economy. Empirical results show that, monetary policy has been strongly responding to inflation, exchange rate and output gap, but less on reserves. Central Bank Kenya reacts more aggressively to the negative output gap, lower inflation (price puzzle) and exchange rate depreciation; that is, the Kenya’s monetary policy behaves in an asymmetrical manner to the output gap, interest rates and inflation (price puzzle), but symmetrical to exchange rate depreciation. This is suggests that Central Bank weighs negative deviations of exchange rates and output highly. Our results validate the view that the original Taylor rule focusing only on inflation may not be suitable for emerging economies including Kenya. However, the Central Bank asymmetrical approach to inflation, given the discretionary fiscal nature in Kenya, may lead to uncoordinated Fiscal and Monetary policies. This requires further investigation, given it can affect macroeconomic stability adversely.