Determinants Of Money Demand In Kenya

Abstract

Understanding the demand for money in an economy is an important prerequisite for formulating and conducting monetary policy. The demand for money is mainly influenced by the levels of prices, interest rates, real national output and the pace of financial innovation. Kenya has undergone significant changes in the macroeconomic landscape over the years such as financial liberalization, exchange rate regime changes, liberalization of the capital account of the balance of payment and an array of financial innovations and developments. Such changes in the economy may have caused shifts in the parameters of the money demand function over time, making the function unreliable for policy decisions. It is therefore necessary to investigate the money demand function in the country using the latest data and including financial innovation. Studies in Kenya have not included in the money demand estimations the role of financial innovations witnessed in the country since the financial liberalization of 1980s and 1990s. This study measured and included financial innovations in the money demand function as well as captured the impact of financial liberalization since it used data for pre and post liberalization. Most of the empirical studies reviewed expressed the money demand functions in real terms and specified the models as log-linear with the estimation relying mainly on error correction models. The contemporary studies acknowledged the role of changing external and internal economic and financial landscape, as well as the achievements in the time series econometric estimation of money demand functions. Using cointegration and error-correction model, this study sought to examine the relationship between demand for money and levels of prices, interest rates, real national output, exchange rate and the pace of financial innovation in Kenya using data from 1970 to 2012 The short-run and long-run estimation findings show that only GDP, and inflation are significant determinants of real money demand in Kenya. Specifically, the results show that increased GDP and inflation increases the demand for real money balances. This implies that policies aimed at increasing the country’s GDP should be pursued. Also since money demand is determined by inflationary factors in Kenya, it supports the use of monetary aggregates M3 to target inflation as a policy tool.