The Effect of Financial Innovations on Money Velocity: Evidence From Kenya.

Abstract

Money velocity is a key aspect in the short-run implementation of monetary policy. The study investigated the effect of financial innovation on money velocity in Kenya. It analyzed the effect of opportunity cost variables which include: T-bill rate, commercial banks’ lending rate and inflation rate on money velocity in addition to exchange rate and real GDP which were intervening variables. Time series data collected from KNBS and the CBK from Q4 2009 – Q4 2019 was used. The Augmented Dickey Fuller test showed all variables in model were stationary at their first difference. The bound co-integration test found a conditional long-run relationship existed. The short-run and long-run relationships for money velocity function was estimated using the Autoregressive Distributed Lag Model. The diagnostic tests which include: Breusch-Godfrey, ARCH, Ramsey RESET and Jarque Bera confirmed that the ARDL model suited the data adequately. From CUSUMSQ statistic, money velocity has not been constant in Kenya as it experienced instability at certain periods. The study found that 1-unit increase in measure of financial innovations (ratio of mobile money transactions to nominal GDP) made velocity of money in circulation to fall. The study also established that in the short-run, 1 percent increase of T-bill rate was significantly related with an increase in money velocity. In the long-run, real GDP, exchange rate depreciation, and opportunity cost variables which include: the inflation rate and lending rate positively and significantly affected money velocity. On policy recommendations, CBK should monitor financial sector development and enact policies to make money velocity and money multiplier stable, and thus ensuring the money demand function in Kenya remains predictable.