SERIES: Africa Growth Initiative Publications | Number 23 of 39 « Previous | Next »

Divisia Monetary Aggregates and Demand for Money in Kenya

In designing monetary policy, many countries assign greater weight to the role of the stock of money in the economy. However, during the last three decades, measurement of aggregate money has become a subject of extensive research and policy debate. The standard monetary aggregates (such as M1, M2 and M3 money), published by central banks and used for monetary policy purposes have come under criticism that they suffer from aggregation bias and do not effectively capture changes in the financial sector. It is in this regard that Divisia monetary aggregates—also referred to as monetary services indices (MSI)—have attracted interest, and thus are presented as an alternative or complement to simple sum monetary aggregates (Barnett, 1980; Barnett, Offenbacher and Spindt, 1984; Barnett, Fisher, and Serletis, 1992). A Divisia monetary index measure of money is based on an alternative method of aggregation where different weights are attached to monetary (sub)components, reflecting the flow of monetary services (Barnett,1982).The simple sum monetary aggregates treat all (sub)components of money as being the same in their “moneyness.” The components, including currency, demand deposits, and savings and time deposits are given equal weights rather than unequal ones that reflect the monetary aggregates’ usefulness in making transactions or flow of monetary services. Simple sum aggregates have thus been criticized for failing to account for substitution among components of money.

The purpose of this paper is to construct Divisia monetary aggregates for Kenya and compare them with standard simple sum monetary aggregates. The paper also attempts to assess the usefulness of Divisia aggregates for monetary policy purposes by examining their importance in the demand function for money. This study is of interest to Kenya because the Central Bank of Kenya (CBK) has largely relied on targeting monetary aggregates in the conduct of monetary policy. In addition, various financial sector reforms and innovations have taken place that might not be adequately captured by the simple sum aggregates. The CBK has sought to enhance the effectiveness of monetary policy by changing the policy framework, but Divisia monetary aggregates have not been tried as an alternative or complement to the simple sum aggregates. In the 1990s, M2 (currency in circulation plus demand deposits) money was the intermediate monetary policy target. However, following financial deregulation and further opening up of the economy, the relationship between M2 and nominal gross domestic product (GDP) was found to be unstable. By the end of 1998, the Central Bank of Kenya had shifted to M3 (M2 plus foreign currency deposits) as the policy target (Rotich, Kathanje and Isaya, 2007). In October 2011, the Central Bank of Kenya adopted a new monetary policy framework that gives more prominence to its policy rate—the Central Bank Rate (CBR) (IMF, 2013). We expect that publishing Divisia monetary aggregates for Kenya will encourage policy debate and research on their importance. 

In the 1980s and 1990s, Kenya undertook various financial sector reforms under structural adjustment programs supported by the International Monetary Fund (IMF) and the World Bank. Key reforms included deregulation and liberalization of interest rates and the capital account, and a shift to a floating exchange rate. In recent years, the financial sector has experienced various innovations and developments that may have impacted monetary aggregates. These include financial innovations such as automated teller machines (ATMs), credit and debit cards, mobile banking and mobile money services. The composition of monetary assets has also changed significantly. For instance, currency outside banks as a percentage of M3 declined from about 12 percent at the end of 1995 to about 8 percent by the end of 2011. The share of foreign currency deposits in M3 doubled from about 6 percent in 1995 to about 12 percent at the beginning of 2002 and increased further to 16 percent towards the end of 2011. The importance of non-bank financial institutions (NBFIs) has also been declining. In early 1990s, NBFIs accounted for about 24 percent of total quasi-money, and by early 2012 the share stood at only 2 percent. We expect that Divisia monetary aggregates will capture these changes through their different weighting as opposed to the simple sum aggregates based on equal weights. 

The technique of cointegration developed by Johansen and Juselius (1990) is used to analyze and compare the underlying long-run relationships between the constructed Divisia money index, simple sum aggregates, output, and interest rates, through the estimation of a money demand function. The rest of this paper is organized as follows. In Section 2 we provide an overview of the empirical literature on usefulness of Divisia monetary aggregates. Section 3 discusses how Divisia monetary aggregates are constructed, and compare them to simple sum aggregates. In Section 4, we assess the underlying long-run relationships through cointegration analysis. Section 5 provides an interpretation of the results and conclusion.

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SERIES: Africa Growth Initiative Publications | Number 23