RELATIONSHIP BETWEEN MACROECONOMIC VARIABLES AND

GOVERNMENT MONETARY POLICY INITIATIVES IN KENYA

NOVEMBER 2017
 DECLARATION

This research proposal is my original work and has not been submitted to any other
university for award of a degree.

Signature.Date.

This research proposal has been submitted for examination with my authority as the
university supervisor

Signature.Date.

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 ABBREVIATIONS AND ACRONYMS
CBK Central Bank of Kenya
CBR Central Bank Rate
CPI Consumer Price Index
CRR Cash Reserve Ratio
GDP Gross Domestic Product
MPAC Monetary Policy Advisory Committee
MPC Monetary Policy Committee
OMO Open Market Operations
TBR Treasury Bills Rate

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 TABLE OF CONTENTS

DECLARATION...............................................................................................................ii
ABBREVIATIONS AND ACRONYMS.........................................................................iii
CHAPTER ONE: INTRODUCTION..............................................................................1
1.1 Background of the Study...............................................................................................1
1.1.1 Macro Economic Variables................................................................................ 2
1.1.2 Monetary Policy................................................................................................. 3
1.1.3 Macroeconomic Variables and Monetary Policy... 3
1.1.4 Monetary Policy in Kenya.................................................................................. 4
1.2 Research Problem..........................................................................................................5
1.3 Research Objectives.......................................................................................................7
1.4 Value of the Study..........................................................................................................7

CHAPTER TWO: LITERATURE REVIEW.................................................................8

2.1 Introduction....................................................................................................................8
2.2 Review of Theories........................................................................................................8
2.3 Determinants of Government Monetary Policy...........................................................11
2.4 Empirical Review........................................................................................................15
2.5 Conceptual Framework................................................................................................18
2.6 Summary of Literature Review...................................................................................18

CHAPTER THREE: RESEARCH METHODOLOGY..............................................19

3.1 Introduction..................................................................................................................19
3.2 Research Design..........................................................................................................19
3.3 Data Collection............................................................................................................19
3.4 Data Analysis...............................................................................................................20

REFERENCES................................................................................................................22

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1
 CHAPTER ONE: INTRODUCTION

1.1 Background of the Study

Most nations around the world do roll out continuous noteworthy improvements in the plan and
direct of their fiscal approach with a specific end goal to address the predominant financial
conditions. These alterations in money related approach are embraced by both created and
creating nations with a specific end goal to react to the progressions in macroeconomic factors in
different nations or districts. Fiscal arrangement is an exceptionally basic component in
accomplishing wanted targets, for example, advancing monetary development, accomplishing
full work level, decrease in the level of expansion, support of solid adjust of installment,
sustenance of development in the economy, increment in industrialization and financial strength.
Late research has affirmed that money related arrangement has other essential goals, for
example, smoothing of the business cycle, diminishing odds of financial emergencies;
adjustment of loan costs and genuine conversion scale adjustment (Mishra & Pradhan, 2008).

This study is anchored on four theories: Keynesian theory, monetary theory, quantity theory of
money and the theory of monetary neutrality. Keynesian economics is the concept of aggregate
expenditure in the economy (called total demand) and its effect on inflation and output.
Monetarists believe that the central bank ought to conduct pecuniary plans to keep up with the
progression of the economy over time. As a result, government monetary policies can be
anticipated, and this expectation may alter the predicted outcome of those policies. The quantity
theory of money is a hypothesis of how the ostensible estimation of total wage is resolved. It
likewise tells how much cash is held for a given measure of total salary - a hypothesis of the
interest for cash. Financial impartiality reveals to us that over the long haul, the ascent in the
cash supply would not prompt an adjustment in the domestic interest rate.

Monetary policy activities have their most immediate and prompt consequences for the more
extensive money related markets, including the administration, securities exchange and corporate
security markets, contract markets, markets for shopper credit, outside trade markets, and
numerous others (Mishkin, 2000). Here in Kenya, Central bank is charged with the responsibility of
ensuring that sound monetary measures are in place. In order to carry out this regulation effectively,
government employs monetary policies as the primary tool to regulate the banking sector. Embedded
1
in these monetary policies are the different types of instruments that are used to regulate the
operations of banks in attaining efficiency in the economy (Zhang, 2011).

1.1.1 Macro Economic Variables

Macroeconomic variables are statistics that indicate the current status of the economy of a state
depending on a particular area of the economy such as industry, labour, and market, trade, etc. It
is therefore important to understand what these macroeconomic indicators represent (Simon &
Robert, 2011). Interest rates play the most critical part in moving the costs of monetary forms in
the remote trade advertise. Interest rates determine movements of investment. Since financial
structures are the depictions of a country's economy, differentiates in advance expenses impact
the relative worth of money related structures in association with each other. Right when national
banks change advance costs, they cause the remote exchange market to experience improvement.
In the area of outside exchange trading, exact speculation of national banks' exercises can
enhance the agent's chances for a powerful trade (Oxelheim & Wihlborg 2007).

The Gross Domestic Product (GDP) is the widest measure of a nation's economy, and it speaks to
the aggregate market estimation of all products and ventures created in a nation amid a given
year. The Consumer Price Index (CPI) is likely the most critical pointer of swelling. It speaks to
changes in the level of retail costs for the essential customer wicker bin. Inflation is tied directly
to the purchasing of a currency inside its outskirts and influences its remaining on the global
markets. On the off chance that the economy creates in ordinary conditions, the expansion in CPI
can prompt an increment in fundamental loan costs. This, in turn, leads to an increase in the
attractiveness of a currency (Kwon & Shin, 2009).

Employment indicators mirror the general soundness of an economy or business cycle. Keeping
in mind the end goal to see how an economy is working, it is essential to know what number of
employments are being made or destructed, what level of the workforce is effectively working,
and how many new people are claiming unemployment. The retail sales indicator is discharged
on a month to month premise. It shows the overall strength of consumer spending and the
success of retail stores. The report is particularly useful because it is a timely indicator of broad
consumer spending patterns that is adjusted for seasonal variables. Stabilization of the economy

2
(e.g. full employment, control of inflation, and an equitable balance of payments) is one of the
goals that governments attempt to achieve through manipulation of monetary policy.

1.1.2 Monetary Policy

Ajayi and Atanda (2012) define monetary policy as the regulations instituted by any government
in order to control the amount of money circulating within an economy. These regulations are
usually developed by the central bank of a country. Therefore, Central Banks around the globe
utilize certain money related approach instruments like bank rate, open market operation
changing store prerequisites and other particular credit control instruments. National bank
additionally decides certain objectives on financial factors. Ajayi and Atanda (2012) however
argue that when the Central bank of any country institutes actions and regulations limit the
exercises and operations of benefit making budgetary organizations, for example, business
banks, back organizations and non-money related establishments, for example, co-agents, thrift
foundations and annuity stores, there is a propensity of these organizations moving to elective
methods for making their benefits and improve their execution to the disservice of financial
development and advancement.
Kashyap and Stein (2000) assert that, the monetary policy activities and controls received by any
Central bank don't influence monetary exercises specifically yet rather through their
consequences for money related markets. The most essential starting effect of financial approach
instruments is seen on the interest for and supply of stores held by storehouse foundations and
thus on accessibility of credit. The financial approach embraced must affect rate of development
of the cash supply, the level of loan cost, security costs, credit accessibility and liquidity creation
from business banks. The conceivable result of these variables is money related awkward nature
or stuns on the economy through affecting the level of venture, utilization, imports, trades,
government spending, add up to yield, wage and value level in the economy (Mishra & Pradhan,
2008). Amidu and Wolfe (2008) also confirm that monetary policy has an effect on changes on
credit supply of less liquid banks, store base and initiate banks capacity to play out their normal
parts inside the financial system.

1.1.3 Macroeconomic Variables and Monetary Policy

Macroeconomic environment which consists of inflation, exchange rate, gross domestic product,
investments and savings, demand for higher wages and salaries and a growing current account
deficit are affected by the implementation of either expansionary or contractionary monetary

3
policies. Expansionary policies are aimed at stimulating economic growth during recession by
lowering interest rates thereby enticing businesses to take cheaper credit and expand.
Contractionary policies are mainly intended at slowing inflation to avoid deterioration of asset
values. There are several instruments or tools used by Central Banks to implement the monetary
policy of choice. The three traditional instruments used across many countries are the base
lending rate also called the discount rate, Open Market Operations (OMO) and reserve
requirements (Simon & Robert, 2011).

1.1.4 Monetary Policy in Kenya

The Monetary Policy Committee (MPC) is the organ of the Central Bank of Kenya responsible
for formulating monetary policy. The Committee was formed vide Gazette Notice 3771 on 30th
April 2008 replacing the hitherto Monetary Policy Advisory Committee (MPAC). The early
years of independence did not invoke the need for monetary controls since the inflation rates of
2% and a growth rate of 8% were favourable. The 1990s realized the advancement of the
economy where loan fee controls were evacuated and conversion standard made adaptable,
introducing another period in financial arrangement where open market operations (OMO) was
the fundamental device. This was a period described by high loan costs and broadening interest
spread, which hindered the advantages of adaptable financing cost arrangement, for example,
expanding money related funds and diminishing expense of capital. Going up against twofold
digit swelling rate prodded on by exorbitant cash supply and convenience of pained banks, CBK
utilized roundabout devices to tame expansion in an air of insecurity and outrageous
vulnerability (Kinyua, 2001).

Monetary policy by CBK is achieved through three major instruments; changing the Central
Bank Rate (CBR) which is the lowest rate of interest it charges on loans to commercial banks
and therefore the financial institutions have to consider this rate as they set the interest rates for
its borrowers, varying the amount of money banks need to keep as reserves known as reserve
requirement and finally through Open Market Operations (OMO). The CBK has continuously
refined monetary policy processes and procedures to improve their capability and usefulness in
improving financial and economic situation in the country. In framing the monetary program,
CBK begins by approximating the money required in line with the targeted inflation and GDP
growth (Nyamongo & Ndirangu, 2013).

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The CBK has been effective in taming inflation in the last 3 years through the monetary policy.
However, recently limits to cap the lending rate have been introduced and this is likely to
undermine the monetary policy signals. This implies that the MPC will need to revise the other
monetary policy instruments to contain inflation. The central bank works at maintaining
efficiency in banks through controlling money supply. In this regard, monetary policy
instruments stabilize the economy by influencing banking efficiency in a number of channels.
Such channels include the direct foreign exchange rate channel to inflation and Real interest rate
channel to aggregate demand. Also among the most used channels are not only the Exchange rate
channel to aggregate demand but also the demand channel to inflation and the expectations
channel to inflation (Ajayi & Atanda, 2012).

1.2 Research Problem

Macroeconomics is concerned with the behaviour of the economy as a whole or in aggregate.
Monetary policy endeavors to accomplish an arrangement of targets that are communicated as
far as macroeconomic factors, for example, expansion, genuine yield and work. Be that as it may,
the impact of money related approach activities, for example, changes in the national bank rate
(CBR) on these objective factors are circuitous, best case scenario with a more prompt and direct
impact on the more extensive budgetary markets, for example, the share trading system,
government and corporate security markets, outside trade markets and home loan markets which
rush to fuse new data. While a moderately vast number of national banks have received a formal
expansion target, it is in no way, shape or form all inclusive. One of the charges some of the time
forced against having an expansion target is that it gives careful consideration to monetary
destinations other than swelling. This is combined with questions on the components to choose
how much weight a national bank looked with a double order should put on each command
(Ioannidis & Kontonikas, 2006).

Kenya has experienced low and volatile economic growth in the past four decades with better

performance in the last decade (2000-2010). According to Ramey and Ramey (2005) volatility

reduces growth and is detrimental to welfare of the poor. The Gross Domestic Product (GDP) in

Kenya grew by 5.6 percent in 2015, compared to a 5.3 percent growth in 2014. The World Bank

forecasts Kenyas GDP growth at 6.6% for 2016. This is worrying and should be an issue of

5
concern given Kenyas ambitious vision 2030 of achieving and maintaining a sustained

economic growth of 10% per annum for the next 25 years. Besides Kenya has relatively

developed capital market and low investment therefore limited access to finance; this inhibits

investment and therefore economic growth by extension since domestic investment stimulates

economic growth (Moritz & Thomas, 2010).

Ajayi and Atanda (2012), research on the monetary policy, bank lending and inflation in Nigeria.
The paper investigated whether bank lending behavior can provide convincing explanations for
the effects of monetary policy on inflation over the period 1993-2009. The findings of the study
revealed that, monetary policy done through setting of interest rates does not have the intended
effects on bank lending behavior more so bank lending has no significant effects on inflation.
Here in Kenya Njiru (2016) looked at the effects of monetary policy on inflation. The study
concluded that, there was a positive association between the rate of inflation and the independent
variables which were total monthly money supply, average monthly exchange rate and the 91-
day Treasury bill rate. The 91-day TBR was the main influencer of inflation in Kenya. The
research gap exists in this research since other monetary policy instruments other than the
interest rates were not included in the model. Wanjiaya (2010) focused on the effects of monetary
policy on bank lending rate in Kenya and the signaling effect on the international investment
community. The findings was that tight monetary policies raises the nominal interest rate and
inflation and reduces long run output such as supply of bank loans, leading to raising lending rate
thus discouraging bank dependent borrowers activities, in the condition of easing, more liquid
money is available for banks, thus as the supply of money increases the interest rate decreases. In
this study the researcher model did not include the other monetary policy instruments other than
the interest rate. Kithuka (2015) looked at the effect of monetary policy on the financial performance
of commercial banks. The study established that monetary policy tools employed by central bank of
Kenya do not have a significant effect on the commercial banks of Kenya. This study is inconsistent
with other studies that have been conducted as it did not find any significant effect of monetary
policy on commercial banks.

These studies provide conflicting results which prompt further research to establish whether
there is a relationship between macroeconomic variables and government monetary policy
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initiatives in Kenya. The current study seeks to answer the following research question: what is
the relationship between macroeconomic variables and government monetary policy initiatives
in Kenya?

1.3 Research Objectives

The objective of the study will be to determine the relationship between macroeconomic
variables and government monetary policy initiatives in Kenya.

1.4 Value of the Study

The findings from this study if adopted is relevant to the public sector in contributing to the
highly needed knowledge for formulating and establishing proper monetary policy initiatives
which results into desired macroeconomic indicators. The findings would also be beneficial to
local companies who are affected by government monetary policy initiatives. As a result of
appropriate implementation of proper monetary policies, the consumer will have high disposable
income for expenditure and savings. This study also hopes to contribute to the body of
knowledge by outlining the effects of the concepts to the existing theories and the findings will
be used for further research by academicians.

Recommendations from this study on effective monetary policy such as increasing money supply
in the economy will benefit the investors. In addition establishing proper monetary policy
initiatives will result to competitive credit markets thus benefiting the creditors in determining
the value of lending relationships by financing credit constrained firms when credit market are
concentrated because it is easier for those creditors to internalize the benefits of assisting the
firms. Lastly, effective interaction between monetary policy and macroeconomic indicators result
to balanced economy which benefits the general public.

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 CHAPTER TWO: LITERATURE REVIEW

2.1 Introduction
This chapter focuses on the theoretical and empirical review of macroeconomic variables and
monetary policy. The theoretical review covers the theories of monetary policy. The last section
reviews the empirical evidence on monetary policy and summary of literature review.

2.2 Review of Theories

Several theories exist that seek to explain the relationship between macroeconomic variables and
government monetary policy initiatives. The theories discussed are; Keynesian theory, monetary
theory, quantity theory of money and the theory of monetary neutrality.

2.2.1 The Keynesian Theory

This theory was postulated by Keynes (1937) and it states that certain microeconomic actions
when undertaken collectively by individuals may lead to undesirable aggregate microeconomic
outcomes. In this case, the economy is compelled to operate below its potential whereby the
output cannot achieve a specific growth rate. As a result, a large number of the Keynesians
propose for the adoption of active stabilization policy that helps in reducing the amplitude of
businesses cycles, which they regard as one major economic problem to any economy (Canova
& Pappa, 2011). According to Keynes, the answer to the Great Depression was supposed to be
stimulation of the economy by encouraging individuals to invest through a blend of tactics like
through the reduction of interest rates and state investment in development projects. By
investing, the government introduces income, which causes people to spend more in the general
economy. This ultimately stimulates an increase in production that still involves more income
and spending as well (Burgess, 2013).

In this theory therefore, monetary policy plays a critical part in influencing economic
undertakings and banking efficiency. The theory by Keynes asserts that an adjustment in the
supply of money can as well interfere with microeconomic variables such as output, income,
interest rates and aggregate demand for goods and services (Bibow, 2000). Keynes advocated for
the adoption of cheap monetary policy in case of unemployment. Therefore, when the supply of
money is increased in an economy, there is a direct effect on the interest rates which tends to

8
reduce. A reduction of the interest rates will stimulate investment due to capitals marginal
efficiency. This will in turn increase income, employment rates and output due to the multiplier
effect. According to Keynes, the rate of interest is coined by the demand for and supply of
money which consequently leas to change in interest rates (Aziza, 2010). According to Aziza
(2010), the original incentive starts a flow of events, whose entire escalation in monetary activity
is a manifold of the first investment. A major conclusion of the Keynesian theory is that under
certain circumstances, no specific mechanism leads to the acquirement of full employment as
well as an increase in total output. Previous economics concentrated on the specific case of
complete utilization while Keynes saw it as a common theory where the utilization of resources
could either be high or low depending in the supply of money. Financial strategy diffusion
through the interest rate avenue is established on the obsolete Keynesian comprehension of the
part of cash for genuine loan fee developments. A modification in loan fees impacts an
association's venture use, purchaser use on settlement and individual utilization of versatile
items. A challenging remark from Mishkin (1995) is that the rate of interest cannot be recognized
as quantitatively significant cost-of-capital variable for combined expenditure. The inadequacies
in the old-fashioned interest rate channel are clarified with monetary marketplace limitations and
the credit understanding of the spread instrument as Bernanke and Gertler (1995) points out.

2.2.2 The Modern Monetary Theory

This theory was put across by Eric and Randall in (1995) holds a totally diverse view. The
theorists are for the idea that when the Central Bank procures securities in open market, not only
do motion substitution effects arise but also wealth effects. This is true because the public
portfolio comprises of a variety of assets including mortgages and shares. These later increase
aggregate demand for money and increase output. Among the major contributions of MMT
theory is that monetarily independent states possess a policy space that is unfettered by financial
limitations (Bernanke & Gertler, 1995).

Modern monetary Theory provides policy intuitions regarding financial stability, price stability,
and full employment. As expected, several authors have been quite critical of MMT. Every single
transaction in the world economy affects financial statements of those involved (Adegbite &
Alabi, 2013). A typical example used by the developers of the theory is a framework used in
conventional economics known as loanable funds market (Bergo, 2002). The theory is connected
to fiscal economics which is fundamentally concerned with the role of money in the economy.
9
The theory focuses on the expansion of financial model and policy, and it is applied in
manipulating the economic activities and currency in exchange. Financial rule shakes all sectors
of the economy including both inflation and interest rate and also employment. Additionally,
fiscal economics study the behavior of monetary institutions like banks which are substantial in
defining the speed of progression and expansion in the economy (Vijaya, Ramachandran, Manju
& Shah, 1994).

2.2.3 Quantity Theory of Money

This hypothesis was portrayed extensively by Irving Fisher (1911). It is the conventional point of
view of how money is used as a piece of the economy, and what factors it impacts. The sum
theory of money is a speculation of how the apparent estimation of aggregate wage is settled.
Since it also tells how much money is held for a given measure of aggregate pay, it is in like
manner a speculation of the enthusiasm for money. The most essential part of this theory is that it
suggests that credit costs have no effect on the enthusiasm for money. Fisher expected to
investigate the association between the total measure of money M (the money supply) and the
total of spending on distinct stock and ventures made in the economy PY, where P is the esteem
level and Y is add up to yield (pay). Signify spending PY is moreover thought of as aggregate
apparent wage for the economy or as apparent GDP. The possibility that gives the association
among M and PY is known as the speed of money, the rate of turnover of money; that is, the
typical number of times every year that a unit of trade is spent out acquiring the total whole of
stock and ventures conveyed in the economy (Canova and Pappa, 2011).

Speed V is portrayed more unequivocally as total spending PY segregated by the measure of

money M. The state of exchange, which relates apparent pay to the measure of money and speed
is given as: MV = PY. The state of exchange along these lines communicates that the measure of
money expanded by the amount of times that this trade is spent out a given year must be
proportionate to apparent pay (the total apparent whole spent on stock and ventures in that year).
Like other neoclassical budgetary specialists, Fisher held the view that in the short run, cash
related effect was overseen by advance expenses that were sticky at first however ascending
thusly while as time goes on, the channel of effect was bona fide cash alter. He fought that when
wealth increases on account of a climb in the supply of money, people try to lessen their cash
modifies by securing stock and undertakings. Using the exchange state of MV= PY, where speed
(V) and yield (Y) are held reliable, increasing money stock (M) would provoke the duplicating
10
of the esteem level (P). This suggests when money stock forms following a development in gold
stock and climb accessible for some other time, for example, in the short run, item expenses will
increase since it is normal that yield and speed were settled at first. This proposes, the rate of
extension in the economy is absolutely a direct result of changes in the money supply (Caruana,
2005).

2.2.4 The Theory of Monetary Neutrality

A crucial proposal in the monetary theory, communicates that as time goes on, a one-time rate
rise in the money supply is facilitated by a comparative one-time rate climb in the esteem level,
leaving unaltered the real money supply and all other financial components, for instance,
advance expenses. Money is said to be neutral if exogenous changes in the supply of money have
no effect on authentic sums and bona fide costs. Money related impartiality uncovers to us that
as time goes on, the rising in the money supply would not speedy an alteration in the private
credit cost (Bergo, 2007).

The way that the development in the money supply has left yield and financing costs unaltered as
time goes on is suggested as long-run monetary unprejudiced nature. The fundamental result of
the extension in the money supply is a higher cost level, which has extended generally to the
addition in the money supply with the objective that veritable money modifies M/P are unaltered.
If the Fisherian sum speculation is appropriate, by then any alteration in M would incite a
looking at change in P, while the authentic variables, Y and V, remain unaltered. This is known as
the absence of predisposition of money, a condition whereby changes to the money supply
impact simply apparent elements (Adegbite &Alabi, 2013).

2.3 Determinants of Government Monetary Policy

In the monetary policy process, factors play important roles, in particular as instruments,
objectives, indicators and targets. The definition of fiscal arrangement by the financial experts
requires suitable factors, on which it can center as markers of the requirement for such a strategy
(Handa, 2005). These instruments include: Open Market Operations (OMO), Repo rate, interest
rates, money supply and exchange rates.

2.3.1 Open Market Operations (OMO)

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Open market operations are the Central banks principal tool for implementing monetary policy.
These purchases and sales of government Treasury and government agency securities largely
determine the Central Bank rate (CBR) which is the interest rate at which depository institutions
lend balances at the Central Bank rate to other depository institutions overnight. CBR in turn
affects monetary and financial conditions, which ultimately influence employment, output, and
the overall level of prices (Sargent and Smith, 1987). Central banks in most industrialized
nations lead fiscal arrangement essentially by means of open market operations, where cash is
provided in return for securities reduced with a short run ostensible loan cost. Henceforth, the
expenses of cash securing rely upon the present rebate rate and the accessibility of guarantee
(Wallace, 1981).

In macroeconomic hypothesis, in any case, is has frequently been guaranteed that open market
operations are insignificant as in they are proportionate to singular amount cash exchanges. The
Central Bank buys or offers (in light of a legitimate concern for the Treasury) securities so as to
the keep cash and non-saving money open (that is in the open market). One such security is
Treasury Bills. At whatever point the Central Bank offers securities, it diminishes the supply of
stores and when it buys (back) securities by recovering them-it fabricates the supply of stores to
the Deposit Money Banks, subsequently affecting the supply of money (Eggerston and
Woodford, 2003).

2.3.2 Repo Rate

Repo rate is the financing cost at which the national bank offers and additionally repurchases
government securities to or from business banks (www.centralbank.go.ke). In Repo exchanges,
securities are traded for money with a consent to repurchase the securities at a future date. The
securities fill in as guarantee for what is adequately a money advance and, alternately, the money
fills in as insurance for a securities credit. There are a few sorts of exchanges with basically
proportionate monetary capacities: standard repurchase understandings, offer/purchase backs and
securities loaning characterized as repos. A key recognizing highlight of repos is that they can be
utilized either to get subsidizes or to get securities (Brunetti, Filippo and Harris, 2009).

This last element is important to showcase members since it enables them to get the securities
they have to meet other legally binding commitments, for example, to influence conveyance for
a prospects to contract. Furthermore, repos can be utilized for use, to support long positions in
12
securities and to finance short positions for supporting loan cost dangers (Ewerhart and Tapking,
2008). As repos are short-development collateralized instruments, repo markets have solid
linkages with securities markets, subordinates markets and other here and now markets, for
example, between bank and currency markets which are critical money related strategy
apparatuses. Repos are helpful to national banks both as a money related strategy instrument and
as a wellspring of data on advertise desires. Repos are appealing as a money related approach
instrument since they convey a low acknowledge chance while filling in as an adaptable
instrument for liquidity administration. Also, they can fill in as a powerful system for flagging
the position of money related strategy (Hrdahl and King, 2008). Repo markets can likewise
give national banks data on here and now financing cost desires that is moderately exact since
the credit chance premium in repo rates is normally little. In this regard, they supplement data on
desires over a more extended skyline got from securities with longer developments (Eggerston
and Woodford, 2003).

2.3.3 Interest Rates

Modigliani and Cohn (1979) introduced the cash deception impact in which markets have a
tendency to be discouraged when ostensible financing costs are high despite the fact that the
genuine loan fee is not high. They contended that securities exchanges respond improperly to
expansion because of financial specialists' obliviousness that loan cost rise is to make up for the
ascent in swelling. Howells and Keith (2000) contend in their book that, value costs simply like
the cost of all advantages will react to changes in loan fees. That is to mean, if the Central Bank
raises the financing costs, for example, the rate accessible on the hazard free resources goes up
and if more can be earned on chance free resources, at that point the holders of dangerous offers
will need a higher return too. The offer costs will likewise fall if the value showcase all in all
turns out to be more hazard unwilling and request a higher premium for any level of hazard.

In any case, Bernanke and Kuttner (2003) reasoned that next to no of the market's response can
be ascribed to the impact of fiscal arrangement on the genuine rates of premium. Robinson
(1952) contended that the money related framework does not goad monetary development and
that, rather budgetary improvement basically reacts to advancements in the genuine area. In this
way, numerous compelling business analysts give an exceptionally minor part, assuming any, to
the part of money related framework, especially the share trading system in monetary
development. The loan fee that worries the national bank as a financial strategy is the 3 months'
13
fleeting financing cost additionally called the Treasury charge rate which it impacts through the
offer of here and now government securities and structures the reason for the setting of business
bank loaning rates.

2.3.4 Money Supply

Money supply is the aggregate of currency outside banks and deposit liabilities of commercial
banks CBK (2015). Deposit liabilities are described in narrower and broader aspects as follows:
narrow money (M1); broad money (M2); and extended broad money (M3). These totals are
described as follows:
M1 = Currency outside the banking system plus demand deposits
M2 = M1 plus time and savings deposits plus certificates of deposits plus deposit liabilities of
non-bank financial institutions (NBFIs)
M3 = M2 plus residents foreign currency deposits.

The CBK has been targeting monetary aggregate (broad money M3) in its policy decisions
implying that at times of high inflation, or positive output, the CBK responded by reducing
money supply (Rotich et al., 2007).

2.3.5 Exchange Rates

Essentially stock exchange market fills in as a channel through which surplus assets are moved
from Lender-Savers to Borrower-Spenders who have deficiencies of assets (Mishkin, 2000). In
view of this start, unpredictability in stock costs can essentially influence the execution of the
monetary area and additionally the whole economy. The budgetary position of an economy that
is basically controlled by the capital market is powerless to its outside trade unpredictability.
Thus, this influences remote trade to showcase improvements to have taken a toll suggestions for
all the monetary specialists. Exact confirmation because of outside trade showcase instability on
securities exchange is to a great extent conflicting.

Mishra (2004) conceded that there is no hypothetical agreement on the communication between
stock costs and swapping scale. For example, Solnik (1987) is of the conclusion that there is a
negative relationship between's securities exchange and neighborhood money. The arrangement
of instruments accessible to financial specialists may vary starting with one nation then onto the
next, as indicated by contrasts in political frameworks, monetary structures, statutory and

14
institutional methods, advancement of cash and capital markets and different contemplations. In
most exceptional industrialist nations, financial specialists utilize at least one of the
accompanying key instruments: changes in the legitimate hold proportion, changes in the
markdown rate or the official key bank rate, trade rates and open market operations (Abaker,
2009).

In many cases, supplementary instruments are utilized, known as instruments of direct

supervision or subjective instruments. Despite the fact that the creating nations utilize at least
one of these instruments, contemplating the distinction in their monetary development levels, the
uniqueness in the examples of their generation structures and the level of their connection with
the outside world, many turn to the technique for subjective supervision, especially those nations
which confront issues emerging from the idea of their financial structures (Adam, 2009). Despite
the fact that the adequacy of money related strategy does not really rely upon utilizing an
extensive variety of instruments, composed utilization of different instruments is fundamental to
the use of a sane fiscal approach. A portion of the normally utilized financial strategy apparatuses
include: Open Market Operations (OMO), Repo rate; Interest rates; Money supply; Exchange
Rates; Balance of Payment (Handa, 2005).

2.4 Empirical Review

Ahumada and Rodrigo (2004) carried out a study on banking industry and monetary policy in
Chile. It was established that banks play a very significant role in the implementation of
monetary policy. Monetary policy generally influences that market loan costs in this manner
compelling banks to change their venture choices. At the point when banks change their
speculation choices their budgetary execution is likewise prone to change or be influenced
because of the progressions in fiscal strategy. The investigation reasoned that administrative
bends importantly affect the effectiveness and productivity of the saving money industry.
Regardless of whether we measure the spread from intermediation or the financing costs charged
for customary saving money exercises, the microeconomic structure affects these factors.

Seppo and Mittra (2002) directed an examination on the execution of money related strategy and
the inward Central Bank estimating. The investigation highlighted the European Central Bank.
The reason for the examination was to inspect the effect of financing costs heterogeneity in
estimates of the European Central Bank. The discoveries from the examination affirm that
15
loanability confinements for financing costs rules determined under the suspicion of
homogenous guaging keep on being essential when homogeneity is available.

Brissimis and Delis (2009) investigated on bank heterogeneity and monetary policy transmission
in Europe. The principle point of the examination was to inspect the part of bank liquidity,
capitalization and market control as inside elements affecting banks' response regarding loaning
and hazard taking to money related strategy driving forces and a definitive effect of a financial
approach change on bank execution is likewise considered. The discoveries affirm that the
normal esteem revealed for the coefficient of the money related approach variable in the loaning
conditions is negative and factually huge paying little heed to which smoothing variable is
utilized. The examination found that, fiscal approach changes cause an altogether different
reaction of bank loaning on the premise of their capital structures, with more promoted banks
reacting less to financial arrangement changes. The same and much more articulated regarding
fluctuation are the outcomes got when the distributional trademark is the market control variable.
Specifically, high capitalization and market control tend to cradle the negative effect on bank
loaning of a move in arrangement rates.

Yener, Leonardo and David (2010) also carried out a study on the role of monetary policy on
bank risk taking. The main purpose of the study was to r investigate the relationship between
short-term interest rates and bank risk. The study made use of a unique database that includes
quarterly balance sheet information for listed banks operating in the European Union and the
United States for duration of 10 years. The study findings confirm that unusually low interest
rates over an extended period of time contributed to an increase in banks' risk.

Cheruiyot (2012) carried out a study on the effectiveness of monetary policy in countering
inflation in Kenya. The examination utilized time arrangement experimental information on the
factors to depict and look at the viability of money related strategy instruments in countering
expansion in Kenya by building up relationship coefficients between the swelling and the
financial approach devices. The discoveries from the investigation uncovered that expansion and
the supply of cash in the economy have a positive relationship. This suggests as the measure of
cash available for use in the economy expands the level of expansion additionally increments.
This generally happens in light of the fact that an expansion in cash supply prompts individuals
spending the abundance of their cash supply over cash request. It was additionally settled that
16
conversion standard changes has an essential part in diminishing or limiting the danger of
vacillations in return rates, which will affect the economy.

Wanjaiya (2015) did a study on the effects of monetary policy on bank lending rate in Kenya and
the signaling effect on the international investment community. The study conducted a causal
comparative research design and used secondary quarterly series data for the time period 2000 to
2014. The result of the study showed that CBR and the TBR were significant monetary policy
instruments in explaining the bank lending rate and the signaling effect to the international
investment community. Reserve requirement was found to be negative and insignificant
monetary policy tool in impacting the bank lending rate and signaling the international investor
community. This study recommended that the central bank should adopt more of the TBR and
CBR in implementing the monetary policy decisions.

Kimani (2013) did a research on the effect of monetary policies on the lending behavior of
commercial banks in Kenya. The study established that CRR, CBR, OMO and uncertainty
brought by likely outcomes shaped by monetary policy variations encouraged lending behavior
by commercial banks in Kenya). The result of the study did not cover the entire sector but
concentrated on the tier one banks.

Njiru (2014) sought to investigate whether commercial banks were actually responsive to
monetary policy. The study used Error Correlation model to estimate a relationship where
lending rates were treated as dependent variables while the independent variables were the
monetary policies. These included the credit channel which was represented by credit to the
private sector, exchange rate channel represented as nominal exchange rate and asset price
channel. Inflation and economic growth were included in the model because these are targets to
the monetary policies. The study findings showed that there was long run relationship between
lending rates and central bank rates, exchange rates asset price, credit to the private sector,
economic growth and inflation rates. The results also indicated that CBR and Inflation cause
lending rates to decrease in the short run. A statistically significant relationship was also
established between lending rates and exchange rates, CBR, private sector credit and inflation
rates. The study also showed insignificant relationship between lending rates and asset prices as
well as economic growth in short run.

17
2.5 Conceptual Framework

Macroeconomic Variables Monetary Policy Initiatives

- Inflation rate - Open market operations

- Exchange rate - Central bank rate

- GDP growth rate - Cash reserve ratio

Political
Environment

Independent variables Moderating variables Dependent variable

Figure 2.1: Conceptual Framework

Source: Researcher (2017)

2.6 Summary of Literature Review

From the empirical review there is inconclusive evidence on the effect of monetary policy
measures on macroeconomic variables. While researchers seem to agree that monetary policy
measures influence specific macroeconomic variables, there is no consensus on the relationship
between the macroeconomic variables and monetary policy initiatives. These studies provide
conflicting results which prompt further research to establish whether there is a relationship
between macroeconomic variables and government monetary policy initiatives in Kenya. This
study aims to fill the gap by determining the relationship between macroeconomic variables and
government monetary policy initiatives in Kenya.

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 CHAPTER THREE: RESEARCH METHODOLOGY

3.1 Introduction
This chapter discusses the research methodology that will be used for the study. This includes
specification of models and variables to be addressed by the research, data collection methods,
presentation techniques and finally the data analysis methods.

3.2 Research Design

Research design manages issues identifying with choices in regards to the motivation behind the
examination (informative, clear, speculation testing), its area (the investigation setting), the sort
it should comply with (kind of investigation),its transient angles (time skyline) and the level at
which the information will be dissected. A descriptive research decides and reports the way
things are. Descriptive data was regularly gathered through a poll study, a meeting or by
perception. On the other hand, exploratory outline tends to the need that specific request
concentrate on questions that require replies keeping in mind the end goal to comprehend
individuals, occasions and circumstances (Chandran, 2004).

The objective of a descriptive study is to provide the researcher with a profile or to portray
significant aspects of the phenomenon. Descriptive studies help understand the characteristics of
a group in a given situation as well as offering ideas for further probe and research. This
descriptive research design is preferred because the study needs to establish the relationship
between macroeconomic variables and government monetary policy initiatives.

3.3 Data Collection

Secondary data will be used in this research. Secondary data refers to information gathered by
someone other than the researcher conducting the current study. The study will focus on the
following selected indicators, Gross domestic product which will be sourced from National
Bureau of Statistics, Consumption statistics from National Bureau of Statistics, Investment
Statistics from Institute of Economic Affairs, Government Expenditure from National Bureau of
Statistics, Net Exports from National Bureau of Statistics.

The data will be collected through survey based secondary data. Survey based secondary data
refers usually to data collected by questionnaires that have already been analyzed for their
19
original purpose. The study will focus on continuous and regular surveys and these will be
surveys excluding censuses, which are repeated over time. They include surveys where data are
collected throughout the year, and those repeated at regular intervals (Baker, 2010).

3.4 Data Analysis

The data collected will be counter checked for completeness and consistency. The data will then
be analyzed using descriptive statistics, regression analysis and correlation.

3.4.1 Analytical model

Macroeconomic variables are defined as the GDP growth rate while monetary policy measures
include open market operations, central bank rate, cash reserve ratio, inflation rate and exchange
rate. The relationship between the dependent and independent variables will be expressed using
the regression models as below:

Y1 = + 1 X1 + 2 X2 + 3 X3 + 4 X4 +

Y2 = + 1 X1 + 2 X2 + 3 X3 + 4 X4 +

Y3 = + 1 X1 + 2 X2 + 3 X3 + 4 X4 +

Where:
1, 2, 3, 4 and 5 represent the coefficients of monetary policy variables
Y1 = open market operations
Y2 = central bank rate
Y3 = cash reserve ratio
X1 = inflation rate
X2 = exchange rate
X3 = GDP growth rate
X4 = Political environment
= Constant term

= Error term: representing, other factors other than the above monetary policy factors which
are not defined in the model.

20
Table 3.1: Operationalization of the Study Variables

Symbol Variable Measurement

Y1 Open market operations Average 364 T-Bill rates for the year
Y2 Central bank rate Weighted average CBR for the year
Y3 Cash reserve ratio Weighted average CRR for the year
X1 Inflation rate (CPI) Variables for the year
X2 Exchange rate Variables for the year
X3 GDP growth rate Variables for the year
X4 Political indicator (WGI) Variables for the year
Source: Researcher (2017)

3.4.2 Test of Significance

The T- test will be used at 95 % confidence level to determine the statistical significance of the
constant term , and the regression coefficients; 1, 2, 3, 4,and 5. The study will use the F- test
to establish whether the regression model is of statistical significance at 95% confidence level.
The coefficient of determination, R2 and the adjusted R2 will be used to establish the goodness of
fit of the overall regression model.

21
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