UNIVERSITY 
Monetary Policy Effectiveness 
The Role of Financial Frictions on the Effectiveness of the Kenyan Monetary Policy 
Namasaka N. Purity 
071114 
Submitted in partial fulfillment of the requirements for the Degree of 
Bachelor of Business Science in Financial Economics at Strathmore University 
School of Finance and Applied Economics 
Strathmore University 
Nairobi, Kenya 
[November, 2015] 
DECLARATION 
I declare that this work has not been previously submitted and approved for the award of a 
degree by this or any other University. To the best of my knowledge and belief, the Research 
Project contains no material previously published or written by another person except where due 
reference is made in the Research Project itself. 
©No part of this Research Project may be reproduced without the permission of the author and 
Strathmore University 
Namasaka N. Purity 
·············~············································[Signature] 
........... .? e{!d::?..c:r.l.L ............................... [Date] 
This Research Project has been submitted for examination with my approval as the Supervisor. 
William Ng'ang'a 
[Signature] 
............... ?:.1-.~d?-.t!.{L ........................ [Date] 
School of Finance and Applied Economics 
Strathmore University 
le 
list of figures .............................................................................................................................................. iii 
list of abbreviations ................................................................................................................................... iv 
Abstract ...................................................................................................................................................... 1 
CHAPTER 1 .................................................................................................................................................. 2 
INTRODUCTION ....................................................................................................................................... 2 
1.1 Background of the study ............................................................................................................... 2 
1.2 Problem statement ....................................................................................................................... 5 
1.3 Research Objectives ...................................................................................................................... 6 
1.4 Significance of the study ............................................................................................................... 6 
CHAPTER 2 .................................................................................................................................................. 7 
LITERATURE REVIEW ............................................................................................................................... 7 
Introduction ........................................................................................................................................ 7 
2.1 Theoretical Literature Review ....................................................................................................... 7 
2.2 Empirical Literature Review ........................................................................................................ 11 
2.3 Summary of Literature review .................................................................................................... 17 
CHAPTER 3 ................................................................................................................................................ 18 
METHODOLOGY .................................................................................................................................... 18 
3.11ntroduction ................................................................................................................................ 18 
3.2 Research Design .......................................................................................................................... 18 
3.3 Data collection and specification ................................................................................................ 18 
3.4. Preliminary diagnostics (Stationarity tests, cointegration tests and lag length selection) ......... 20 
3.5 Model identification and specification ........................................................................................ 20 
3.6 Financial frictions and monetary transmission mechanism ........................................................ 22 
3.7 Summary of methodology ........................................................................................................... 24 
CHAPTER 4 ................................................................................................................................................ 25 
DATA ANALYSIS AND INTERPRETATION ................................................................................................ 25 
4.1.1 Unit root tests of stationarity ................................................................................................... 25 
4.2 The Vector Error Correction Model. ............................................................................................ 26 
4.3 SVAR Impulse responses ............................................................................................................. 28 
4.4 Monetary policy effectiveness and financial friction ................................................................... 32 
CHAPTER 5 ................................................................................................................................................ 33 
CONCLUSION ........................................................................................................................................ 33 
5.1 Summary and conclusion ............................................................................................................ 33 
5.3 Limitation of the study ................................................................................................................ 34 
REFERENCES ............................................................................................................................................. 35 
APPENDIX 1: .............................................................................................................................................. 39 
SVAR impulse response graphs ............................................................................................................. 39 
APPENDIX 2: ............................................................................................................................................. 40 
Financial friction and monetary policy effectiveness ............................................................................ 40 
ii 
Figure 1: The balance sheet and bank lending channels .............................................................................. 9 
iii 
CBK- Central Bank of Kenya 
MPC-Monetary Policy Committee 
CRB-Credit Reference Bureau 
iv 
MONETARY POLICY EFFECTIVENESS: THE ROLE OF FINANCIAL FRICTIONS 
THE EFFECTIVENESS OF THE KENYAN MONETARY POLICY 
This paper examines the role of credit market frictions on the effectiveness of the Kenyan monitory 
policy .Following from the credit channel theory, of particular interest is the credit channel of the 
Kenyan monitory policy and its interaction with financial frictions. I test the theoretical prediction 
of the theory that monetary policy transmission mechanism through the credit channel is more 
effective and stronger in countries and periods ofhigh levels of financial frictions, hence with low 
levels of financial frictions, the monetary policy transmission mechanism is less effective. SV AR 
impulse responses of output and prices are analyzed with respect to monetary policy shock, where 
both the credit and exchange rate channels of monetary policy are found to be present. A regression 
analysis between proxy of financial friction (interest rate spread) and the maximum amplitude of 
output and price responses depicts a positive and statistically significant relation between financial 
frictions and monetary policy effectiveness after controlling for factors such as financial 
development and firm size. Results from this research will help inform policy decisions of the 
CBK through the MPC and CRB. 
Key words; financial frictions; monetary policy effectiveness; credit channel 
1 
ON 
1.1 Background of the study 
Financial markets according to Mishkin (2010) aid in channeling of funds from surplus units to 
deficit units within the financial system to support productive investment opportunities which lead 
to economic growth. Where the role of the financial system is hampered, financial markets cannot 
operate effectively since they cannot identify a more credit worthy investment to finance, bringing 
forth problems associated with information asymmetry where the cost of acquiring information 
and controlling borrowers' behavior drives the wedge between the cost of internal and external 
finance, Adrian (2010) and Aysun et al (2013). 
Information asymmetry has over the years been a major cause of frictions on the financial markets 
as sited by Bernanke et al (1995). Adverse selection and moral hazard are effects of information 
asymmetry which lead to market inefficiency, (Akerlof, 1970). With adverse selection lies the 
probability that more risky individuals or entities are likely to seek out loans even at higher interest 
rates while moral hazard presents the possibilities that the borrower may engage in rather risky 
investment ventures which will undermine his ability to repay the loan advanced. Moral hazard 
as cited by Mishkin (20 10), creates a situation of conflict of interest between the lender and the 
borrower. The lender in the effort to mitigate moral hazard, places restrictive covenants on loan 
contracts. However the cost of monitoring the behavior of the borrower are generally high, the 
lender will therefore resort to lending less than otherwise he would have. The results of both 
adverse selection and moral hazard are lending and investments at suboptimal levels, (Monacelli, 
2007). 
Major global crisis such as the Great Depression in 1930's, the recession in 1990-1991 and the 
global financial crisis in 2007-09 have been attributed to a large extend to frictions emerging from 
financial markets .According to Mishkin (1995, 2010) , the smmd operation of the financial 
markets in the crises were restored upon the monetary policy intervention of Central Banks. The 
aftermath effects of the global financial crisis spark up various debates on the effectiveness of the 
monetary policy. Some researchers such as Mishkin (2010) and Bernanke (2010) argue for the 
case of effectiveness monetary policy intervention while others such as Woodford (2010) 
conclude that monetary policy is inetiective and other interventions by the central bank such as 
direct liquidity provisions may work better than standard open market operations. Curdia and 
2 
Woodford (2008), further state that assuming a situation of complete breakdown of intermediation, 
the central banks should focus more on the rate which the ultimate borrower can borrow rather 
than the rate it directly controls. 
Literature surrounding the effectiveness of the monetary policy has over the years grown to 
account for factors such as financial frictions and financial developments which have been 
considered to alter the structure of financial markets consequently impacting on the effectiveness 
of the monetary policy. Kim (1990) argues that financial market deregulations and innovations 
observed at the end of the 201h century have weakened the traditional monetary policy channels by 
significantly altering the link between monetary policy and bank lending channel. Credit market 
frictions, as held by Salmon ( 1997) and Ibrahim (2005), play an important role in the transmission 
mechanism, follo\ving the accelerator theory by Bernanke et al (1996) which asserts that there 
exists a positive relationship between levels of financial frictions of infonnation asymmetry and 
effectiveness of the monetary transmission mechanism. In periods of financial distress such as 
during crisis periods, the credit view of monetary policy holds that the credit channel is more 
effective. 
Most research on financial market frictions and the effectiveness ofthe monetary policy have been 
centered on the developed economies such as the US, Japan and UK. However, developing 
economies such as those in Sub Saharan Africa have been known to be characterized by high levels 
of financial frictions attributed to the factors such as political instability and structural features of 
the financial markets, (Frankel, 2011). 
Financial markets of emerging economies such as that of Kenya have been dominated by the 
banking sector which play a crucial role in the monetary transmission mechanism in Kenya, 
(Makambi, 20 14 ). The effectiveness of the monetary policy is based on the ability of the Central 
Banks to affect the operations of the banking sector through manipulation of the central bank rate 
(CBR).A weak monetary transmission system may be attributed to disconnect between monitory 
policy actions and behavior of commercial banks. Documented research on the effectiveness of 
the Kenyan monetary policy has been carried out by various researchers such as Elias (2014), 
Kaaman (2014) and Cheng (2006).Applying a Vector Autoregressive model, similar results and 
conclusion are made where the three studies find a positive but insignificant impact of monetary 
policy on output and price levels in Kenya. This research was done between 1983 and 2012, a 
3 
period which was characterized by various reforms, developments and innovations on the Kenyan 
financial market. 
Financial reforms in the Kenyan financial market in 1990 gave independence to both the CBK and 
the commercial banks, Ngugi (200 1) . CBK pursued a tight monetary policy through indirect 
monetary tools by increased reserve and cash ratios, Ngugi (200 1) . 
According to Jagongo (20 13) and Ngugi (2001), financial liberalization in 1990 gave commercial 
banks the independence to formulate credit policies and therefore make decisions on credit 
allocations. However this independence brought forth issues with credit risk that gave rise to issues 
such as high levels of non-perfonning loans and thereby credit rationing. Credit risk arose from 
the problem of information asymmetry that consequently gave rise to a banking crisis that led to 
bank failure where period between 1993 and 1997, cases of insolvency and statutory management 
of both non-bank institutions and commercial banks occurred. This financial distress period as 
sited by N gugi (200 1) was characterized by dominance of commercial banks, constraint borrowing 
and tight monetary policy. 
Kenya has generally pursued an expansionary/ accommodative monitory target from 2002 to date 
aimed at stimulating economic growth (CBK, 2014) .The banking sector has also experienced 
growth in perfonnance which has boosted economic growth by contributing to 71.2 %to Gross 
Domestic product as at 2013, (CBK, Kenya Financial Sector Stability Report, 2013) . Instances 
of contractionary monetary policy have been in place in periods of currency crisis such as 2011 
and 2015, aimed at stabilizing the Kenyan currency against the dollar and high inflation due to 
increased prices in oil. 
Various developments and innovations have occurred during periods between 2002 and 
2010.Major development include mobile banking in 2007 and the establishment of the Credit 
Reference Bureau in 2008 to enhance information sharing. The government introduced financial 
refonns to improve credit accessibility such as licensing of more commercial banks and other 
financial institutions such as Micro finance institutions. The Kenyan banking sector remains 
se!,rmented into fonnal banking institution dominated by commercial bank which provide credit 
for households and private investments. Due to information asymmetry, majority of the Kenyan 
population have failed to acquire credit from the formal institutions and have resorted to the 
infonnallending institutions that are characterized by flexibility and easier access to credit. 
4 
1.2 Problem statement 
The Kenyan monetary policy plays a crucial role in maintaining economic stability which provides 
a conducive environment for economic growth through aspects such as investments. Such 
investments are facilitated through credit offered by financial institutions such as commercial 
banks that have remained the dominant source of credit to households and private sectors, 
Makambi (2014).Hence commercial banks play an important role in the monetary policy 
transmission mechanism which has been considered weak by various researchers such as Kaaman 
(2014), Elias (2014) and Cheng (2006). 
The Kenyan banking sector in the 1990's after liberalization of interest rates, was faced with the 
severe problems of non-performing loans which were as a result of information asymmetry in the 
credit market (Wanjau, 2011) . This period was characterized by high interest rates and tight 
monetary policy that led to the collapse of financial institutions within the banking sector, Ngugi 
(200l).In 2008, the CBK formed the Credit Reference Bureau (CRB), to facilitate infonnation 
sharing among credit lending institutions which according to Wanjau (2011) and Gaitho (2013), 
has led to a reduction in borrowing cost and loan delinquencies to moderate extent. 
The link between the effectiveness of monetary transmission mechanism and frictions in the credit 
market particularly frictions resulting from infonnation asymmetry such as adverse selection and 
moral hazard, has been provided by the credit channel of monetary policy and the accelerator 
theorem, where the tvvo are positively correlated such that in the presence of financial frictions, a 
credit channel of monetary policy is created through which a tight monetary policy is propagated 
to the economy. 
Research on the effectiveness of the Kenyan monetary policy sited above has focused on the 
detennining the effectiveness of the transmission mechanism considering its impact on the output 
and price levels in the Kenyan economy using Vector autoregressive model (VA R ). However, 
factors such as financial frictions arising from infonnation asymmetry may have an impact on the 
effectiveness of the transmission mechanism. Therefore this study, based on macroeconomic data 
between period of 1993 and 2013, seeks to analyze the relationship between the financial frictions 
captured by interest rate spread and the effectiveness of the Kenyan monetary policy using the 
structured Vector Autoregressive model (SV AR). 
5 
1.3 Research Objectives 
1.3.1General objective 
The objective of the study is to determine the effectiveness of the Kenyan monetary policy with 
reference to the credit channel theory and the accelerator theory. 
1.3.2 Specific objective 
In particular, the study seeks to determine the role of credit market frictions on the effectiveness 
of the Kenyan monetary policy. 
1.4 Significance of the study 
Given the relationship between monitory policy and financial market frictions, the findings of this 
study will help influence policy decisions when it comes to tackling financial market frictions 
using the monetary policy. This will help the central bank through the monitory policy committee, 
formulate an appropriate monitory stance expected to signal and alter other market rates in the 
economy to achieve economic stability. 
Whether financial frictions play a significant role in effectiveness of the monetary policy 
transmission mechanism will help inform the CBR on strategies to put in place when dealing with 
effects of information asymmetry. The CBK will also be infonned on whether to pursue monitory 
policy through the bank credit channel especially in times of financial frictions or concentrate on 
other channels of the transmission mechanism. 
Other researchers may incorporate other variables in a similar model or alternatively use a different 
model to try and draw inferences from the data analysis and compare results obtained to the results 
from this research. 
6 
2 
Introduction 
This section explores both the theoretical and empirical literature on financial frictions, credit 
channel of monetary policy and further the interaction of the credit market frictions and monetary 
policy. With particular interest is information asymmetry as the major source of financial frictions 
and the credit channel of monetary policy, drawing inferences from the "credit view" of monetary 
policy by Gertler et al ( 1998) and the financial accelerator theorem by Bernanke et al (1996). 
2.1 Theoretical Literature Review 
2.1.1 The credit view 
The credit channel is not thought as an alternative to the traditional monetary transmission 
mechanism but as asset of factors through which conventional interest rates are amplified and 
propagated within the economy as held by (Gertler B. a., 1998). The credit view of monetary policy 
gives an overview of how credit market imperfections create a credit channel for monetary policy. 
Additionally, such imperfections make disruptions in the credit availability hence a source of 
fluctuations in economic activities. 
Endogenous changes in the external finance premium are thought to amplify the direct effects of 
monetary policy on interest rates. Therefore, the size of external premium reflects the 
imperfections of credit markets hence, the central role given to credit channel with respect to 
financial frictions. 
The credit view or the lending view is drawn from the financial accelerator theorem put forth by 
Bernanke and Gertler ( 1995), from which they argue that financial accelerator results from changes 
in the credit market conditions associated with information asymmetry, which consequently affect 
the intrinsic cost of borrowing and lending. The financial accelerator theorem if discussed further 
in the section below. 
2.1.2 the accelerator theorem 
The financial accelerator theory, can loosely be considered as a mechanism that has been used to 
characterize how financial factors amplifY and propagate business cycles. Models based on the 
financial accelerator theorem, though they may differ in some ways, the general assumption 
underpinning their development is that financial market frictions which are generally associated 
\vith information asymmetry, generate a wedge between external and internal financing. Following 
7 
the financial accelerator theorem, (Bernanke & Gertler, 1995), examine the linkages between the 
credit channel and external finance premium through the bank lending channel and the balance 
sheet channel. 
Aysun et al (2013) and Ciccarellia (2014), following the credit view of monetary policy, assert 
that monetary policy has real effects through credit supply and demand through its effects on 
balance sheet of lenders and borrowers. The effects of monetary policy on both the demand and 
supply of credit are carried out through two distinct channels, as depicted in figure 1, the cost of 
capital channel or the balance sheet channel and the broad credit channel or bank lending channel. 
The bank lending channel focuses on the possible effect of monetary policy actions on loan supply 
by depository institution. However this channel has been controversial with the developments that 
have occurred in financial sector that have rendered it rather less plausible and on the other hand, 
other developments are thought to increase the importance of the same channel. The balance sheet 
channel is centered on the potential impact of monetary policy on borrowers' net worth and cash 
flow. 
Advocates of the credit channel, hold that monetary policy not only affects the general levels of 
interest rates in the economy but also affect the size of external finance premium whose 
movements aid in explaining the strength, timing and monitory policy composition. The link 
between the two aspects, the external finance premium and the monetary policy is best explained 
through the bank lending channel and the balance sheet channel. 
8 
2.1.3 The bolonce sheet ond bonk 
Figure 1: l'lze balance sheet and bank lending channels 
MONETARY POLICY 
t 
r~--·· ····~·--·-··-···-............ ---·-·---- ........................" z.'  .... --·-------·----·-------·-····-- ·--------·--·····1 
~ ~ 
Cost of Capital Broad Credit 
channel Channel 
Firms and Households Balance Sheet 
Borrowing, Investment (non-financial borrower) Channel 
and spending decisions of balance sheet channel 
household sand firms 
GDP, PRICES 
2.1.3. a. The Balance sheet channel 
The channel is based on the prediction that the external finance premmm depends on the 
borrower's net worth, such that the greater the borrowers net worth (sum of total liquid assets and 
collateral), the lower the external financial premium. Basically, a stronger financial position ofthe 
borrower, the lesser the possibility of occurrence of the problem of moral hazard. Therefore 
fluctuations in the quality of borrowers' balance sheet similarly affects their investment and 
spending decisions. Based on the financial accelerator theorem that is rooted in the imperfection 
9 
of financial systems, a decline in the net worth of a borrower reduces aggregate demand and output 
consequently reduces the borrowers' net worth. 
A tight monetary policy directly affects the borrower's balance sheet such that, with rising of 
interest rates, the net cash flows are reduced hence weakening the financial position of the 
borrower. The rising interest rates also lead to the declining of asset prices which further shrink 
the borrower's collateral. A tight monetary stance has different reactions faced from large and 
small firms. The small firms respond to the cash flow squeeze by cutting work hours and 
production unlike the large finns which are considered to have access to other sources of short 
tenn financing, react by increasing their short term borrowing. 
Models based on the broad credit channel rely on the presence of the moral hazard problem in the 
debt market so as to generate the role of credit in economic fluctuations according to Bean, Larsen 
and Nikolov (2002). Moral hazard makes it cheaper for firms to invest using their retained earnings 
other than external financing implying that with stronger cash flows, firms investment will be 
higher. 
2.1.3. b. The Bank lending Channel 
Monetary policy not only affects the external finance premium but also the supply side of credit 
where it shifts the supply of loans by commercial banks which remain as dominant financial 
intermediaries in overcoming infonnational problems and other credit market frictions. The 
disruption of bank loans may force the bank dependent borrowers to incur costs associated with 
finding new sources of credit. Such costs as a result of reduction in the supply of bank credit, 
holding other factors constant, will likely result to an increase in the external premium. The 
conduct of central banks through open market sales affects the supply of credit through limiting 
the banks; access to loanable funds. Bernanke and Blinder ( 1998). 
The bank lending channel existance and if it's active within a given economy, is determined by 
the extend of response of lending supply to monetary shocks, (Ramos - Tall ada, 20 15). Such that 
higher sensitivity of credit supply imply more effectiveness of the monetary policy.However,ifthe 
lending supply is too sensitive, the balance sheet chanel may give rise to a sudden stop of economic 
activity increasing volatility levels in output. 
10 
2.2 Empirical Literature Review 
2.2.1 Financial innovations and intermediation 
Financial development, innovation and regular changes of financial market has left the bank 
lending channel less dispensable. According to (Woodford M. , 20 10) the three basic assumptions 
the bank lend1n~ durrmelmodei!'l 1urve betm overridden the of nml=bunk 
intefi'I'l®dintiotl 'fhjj~@ tlS~UlUjJtiOJUl d®pmdt!:l fif~ tlS the l'mill'l ~OUI'C~S r\Jndin~ lll 
the flnnncdnl , f®1!l®fW requir\iHfH,t1ttts m'e consid!2ll'ed typicttlly "' bindin~ tmd 
other sub!'ltitutlil~ to llilndin~ to bank deptmdent ''"". .. "'u·"",_" 
Adrian and Shin (2008) explore the role of financial intermediation in financial stability and the 
conduct of monetary policy. According to Adrian and Shin, financial intermediation has evolved 
from the traditional banking system that involved the commercial banks to a market based banking 
system which brings forth the broker dealer intermediations which has increasingly become 
influential in charting the course of economic events. The broker dealer balance sheets as 
compared to the commercial banks' balance sheet, provide more information on the funding 
conditions in the economy hence a better signal of the marginal availability of credit However the 
Central bank via the monetary policy has failed to keep pace with such financial innovation which 
according to Simkovic (2009), intennediaries such as investment banks though subject to central 
bank monitoring, often conduct transactions in a way that do not show up in the conventional 
balance sheets, hence not visible to regulators and unsophisticated investors . Such developments 
have seen the changing structure of financial systems towards one based on capital markets. 
The developments in the credit markets have been strongly blamed for the origin of the recent 
financial crisis that saw the banking systems of developed economies such as the US, become 
effectively insolvent for the first time since the Great Depression, as sited by Metrick (2012). 
Taylor (2010), drawing lessons from the past financial crisis, attributes the occurrence of the 
financial crisis on the moral hazard problem that developed due to financial institutions considered 
too big to and important to fail which were also under inadequate supervision. Infonnation 
deficiency problem, adverse selection also arose as a result of highly complex financial products 
and the interconnectedness of financial institutions. 
11 
Kiyotaki & Gertler (20 10), financial frictions such as agency cost have disrupted financial 
intermediation which has seen the development of the recent financial crisis, whereby 
intermediaries with deficit funds offered higher loan rates than intermediaries with surplus funds. 
With the widening gap, intervention of monetary and fiscal authorities in various countries were 
used to combat the crisis. Such interventions in countries such as US have employed 
unconventional policy measures such as quantitative easing as a fonn of direct lending in credit 
markets, Gertler and Kiyotaki (20 10  ). 
2.2.2 and 
The Tylor rule model which 1s an interest forecasting model by John Taylor (1992), has 
traditionally been used as a monetary tool for various central banks to foster price stability and full 
employment through reducing uncertainty and increasing credibility of future central bank actions. 
However, the reliability on models based on Tylor rule has over time become questionable with 
the growing concerns on the role of financial frictions within an economy. 
Traditionally, Tylor rule according to Yagihashi (20 11 ), has been viewed as a tool that tries to 
describe or predict the monetary policy behavior and in essence acts as a channel of 
communication of policy intentions to the public. However, over the years, models incorporating 
the tailor rule as a measure of monetary policy, have failed to incorporate credit market friction. 
According to Blas (2009), the traditional Tailor rule assumes perfect credit markets which in reality 
the existence of uncertainty, induced by information asymmetry, in the maturity of contracts in 
financial markets, invalidates the frictionless assumption .T he incorporation of credit market 
imperfection, interest rates not only have a much more amplified stabilizing or destabilizing effect, 
but also a more persistent effect on economic output upon comparison of this results with those 
attained from assuming a frictionless market. 
Credit market imperfection, using a stabilizing interest rate rule can bring the economy closer to 
its frictionless optimum. Similar arguments by Yat,r:ihashi (2011 ) upon extending variables in the 
Tylor rule, by adding credit channel variables which include proxies for net worth of capital ratio, 
bankruptcy cost and default rate, results depicted an significant role played by credit channel 
variables on policy making which upon implementation by policy makers would improve 
communication to the general public on policy matters. 
12 
Monetary policy is conducted through either expansionary monitory policy or contractionary 
monetary policy depending on the optimal target levels of inflation. Through the conducting of 
such stances, there has been observed relationships between the monitory stance and financial 
frictions within an economy. GeneraHy, loose monetary policy gives rise to financial vulnerability 
which in turn necessitates implementation of tighter monetary policy stances to combat effects of 
frictions within an economy. Therefore, loose or accommodative monetary policy propels 
economic growth but at the expense of buildup of financial frictions in the economy as discussed 
below by Adrian & Liang, (2014). 
According to Adrian and Liang (20 14 ), accommodative monetary policy eases financial conditions 
but with it comes the consequence of contribution to build up of financial vulnerabilities and 
frictions hence increased risk to financial stability. Such vulnerabilities include compressed risk 
premiums, excessive leverages or maturity and liquidity transformation which increase probability 
of a financial crisis and severe economic depression and recessions. With looser monetary policy, 
risk return tradeoff increases risk taking which consequently give rise to financial frictions. Similar 
conclusion on the relationship between the monitory policy and financial frictions on credit 
markets are drawn from the model developed by Woodford (2010), where the model implies 
increased leverage in the financial sector owing to the consequence of looser monetary policy. 
Studies on the effectiveness of the monetary policy in the face of financial frictions has been 
carried out by researchers such as Aysun & Hong (2013), who carried out a cross-country 
relationship trying to capture the effects of financial frictions on the monetary transmission 
mechanism, using bankruptcy recovery rates and leverage sensitivities as proxy measure of 
financial frictions in the US economy during the global financial crisis. Results support the 
evidence of a positive relationship between level of financial frictions and the etiectiveness of the 
monetary policy which further suggests the strength of monetary policy during episodes of 
financial distress. Mishkin (2009), concludes that monetary policy is more potent during financial 
crisis than it is during the normal times. Through the unconventional monetary pollcy intervention, 
downside risks of the crisis were reduced. Similar conclusions on the credit channel were drawn 
by Kempa et al (2009), where the credit channel appears to be more active during periods of 
financial distress such as the Great depression and the 1980's Savings and Loan Debacle in the 
US. 
13 
Mody (2007), carried out an investigation on cross country and country specific cycles ability to 
explain output fluctuations. Results from the investigation indicate that the impact of a bank credit 
shock is significant in all countries under investigation but more persistent in the European region 
than the North American region. Such variations, were reasonable on the fact that financial 
frictions are perhaps more substantial in the Europe than Northern America. 
The financial accelerator effects, as sited by Mody (2007), could be tenned more relevant and 
stronger in downturns than upturns since credit crunch are mostly associated with periods of 
economic downturn. The effects could also be stronger for smaller finns than large firms as small 
firms are more prone to credit constraints than larger firms. With such characteristics, 
investigations on developing economies could reveal more significant role of the financial 
accelerator since such countries experiences frequent scenarios of credit rationing. 
2.2.2. a Financial frictions and monetary policy in developing economies 
Developing economies such as those in East Asian such as Korea, in Sub-Saharan Africa, in 
Southern America such as Jamaica, Mexico and Brazil, have common financial market 
characterized by unstable economic fluctuations, uncompetitive financial banking systems, weak 
enforcement of economic contracts and high volatility in exogenous shocks due to terms of trade 
and country risk premium. Such factors according to Frankel (20 11) and Yang (20 13 ) have made 
developing economies highly prone to problems such as information asymmetry, imperfect 
institutions, illiquidity and default risk. Compared to developed economies, developing economies 
are thought to experience higher levels of financial frictions which may be domestically generated 
due to factors such as political instability and fluctuations in domestic food prices. With high levels 
of financial frictions, developing economies provide a promising t:,1found for the financial 
accelerator to be more significant and relevant. 
To my knowledge Literature on the linkage between financial friction and the monetary policy in 
Sub Saharan Africa, has received little documentation. However much ofthe literature has focused 
on the effectiveness of the transmission mechanism within various countries in Sub Saharan Africa 
as summarized below. Results from majority of the literature reveal a weak monitory transmission 
mechanism which contrasts with results from developed economies where the strength and 
effectiveness of the transmission mechanism is observed during times of financial distress and 
high levels of financial frictions. However such contradictory results may be attributed to lack of 
14 
incorporation of variables of credit channel in models to capture the effects of financial frictions 
on monetary policy. 
Gertler et al (2007) , developed a small open economy macroeconomic model which captured well 
the behavior of the Korean economy during its financial crisis period of 1997- 1998, where they 
observed a drop in economic output, employment and investment with particular results of credit 
market frictions magnifying the drop in investment during the crisis period. The financial 
accelerator mechanism turned out to be quantitatively significant by accounting for approximately 
50 % of the total economic activity reduction. However, a similar research carried out by Yang 
(20 13 ), reveal that financial frictions played a limited role in economic fluctuations in Korea 
basing their study on the 1997 East Asian financial crisis. Hwang, (2012) considering the same 
crisis of 1997, with a time period between 1998-2006, investigates the role of domestic credit 
market frictions using an open economy DSGE model incorporating the banking system and 
results predicted that due to financial openness influence, the effects of the domestic financial 
frictions do not give rise to significant differences brought about by domestic productivity, export 
demand shocks and foreign interest rates. 
Ramos- Tallada, (2015), carried out an investigation on detenninants of the bank lending channel 
of monetary policy in the Brazil economy between time period of 1995 to 2012.From the results 
some factors such as bank characteristics as used in empirical literature, showed no relationship 
with the sensitivity of credit supply to monetary policy. Such a response was attributed to the 
changing patterns of the balance sheet channel observed during the post crisis period, where the 
money market rate no longer affected the lending supply of average banks. However other factors 
such as size of banks, higher market risks in relation to bank securities and uncertainty of money 
markets were consistent with empirical literature where they appeared to enhance efficiency of 
monetary policy through the Bank lending channel. 
Excess liquidity is a factor that affects the effectiveness and strength of monetary policy within an 
economy. Saxegaard (2006), from his research on the transmission mechanism in two sub Saharan 
countries, Nigeria and Uganda, results depicted high levels of excess liquidity, the monetary 
policy transmission mechanism was weakened as commercial banks were unresponsive to signals 
from the central bank as they held involuntary excess reserves. However the weakness of the 
15 
transmission mechanism may not only be attributed to the excess liquidity but may also be as a 
result of developments in the economies such as financial deepening. 
Few strands of research such as Davoodi et al (2013) on the transmission mechanism in the East 
African community, results reveal presence ofboth the exchange rate and credit channel in Kenya, 
the credit channel being more important in Rwanda and the interest rate channel for Burundi. 
Countries such as Kenya and Uganda, with deeper financial markets and more competitive banking 
system, policy rate seemed to matter more to evolution of prices in Kenya and Uganda 
Research with particular focus on Kenya has been carried out by various authors documenting on 
the effectiveness of the monetary policy channels in propagating monitory policy in an economy. 
Results such as those by Elias et al (2014), Kamaan (2014) and Cheng (2006) who carried out an 
auto regressive analysis on the Kenyan monitory policy effectiveness, indicate the positive but 
insignificant impact of monitory policy on output and prices in Kenya. Other factors other than 
monitory policy as sited by Kamaan (2014) may be indicators fl">r Kenyan Economic growth. In 
comparison to the Kenyan fiscal policy using the recursive V AR, Elias (20 14) concludes that the 
monitory policy is less effective in Kenya in affecting output though he does not rule out the 
reliability ofthe monetary policy. 
Were and Tiringo (2012) using a VAR analysis to assess the effectiveness ofmonetary policy in 
Kenya from 2004-2010, results show that there is a weak transmission mechanism which as other 
sub Saharan countries, arise from shallow and less developed financial markets and limited 
competition in the banking systems. Sub Saharan economies are characterized with structural 
weaknesses which according to Were and Tiringo, affect the conduct and effectiveness of the 
monetary policy. The Kenyan economy due to its agri-based nature and large informal sectors, 
fluctuations in real output and inflation are likely to be caused by the supply side shocks rather 
than aggregate demand shocks. 
Generally, the monetary transmission mechanism in developing economies has been considered 
weak based on quantitative factors. However various qualitative factors affecting the effectiveness 
of the monetary policy have been identified. According to Mishra (2012), the bank lending 
channel, though likely to be the dominant channel in developing economies, may be weaker and 
in effective due to factors such as the degree of independence of the central banks, the nature and 
16 
characteristics of financial institutions which are thought to affect the nature of central banks 
reaction function. Such factors have contributed to the weaker link between the monetary policy 
instruments and aggregate demand, hence weakening the effectiveness of monetary policy. 
2.3 Summary of Literature review 
In developed countries such those in Northern America and Europe, the credit channel of monetary 
policy is more effective during times of financial distress which are characterized by high levels 
of financial frictions. Therefore with high frictions in the economy, the monetary policy 
transmission mechanism through the credit channel is considered more active and effective. 
Developing countries, generally thought to have higher levels of financial friction, following 
various results from research, the monetary transmission mechanism seems to be weak which 
contradicts the underlying empirical literature of the financial accelerator and the credit view of 
monetary policy. The two theories assert that with high levels of financial frictions such as those 
arising from information asymmetry, should lead to the strengthening and efficiency of the 
monetary policy transmission mechanism. The contradictory results may be attributed to the 
structural inefficiencies of the financial sectors and also considering an open economy the effects 
of domestic financial frictions may be eroded away. Other factors such as the degree of 
independence of the central banks have been identifies as potential factors that affect the 
effectiveness of the monetary transmission mechanism. 
The inclusion of financial frictions in various models determining the effectiveness of the 
monetary transmission mechanism, should help in detennining the relationship between financial 
frictions and effectiveness of monetary policy which has been observed to be positive. In 
developing economies such as Kenya, incorporating financial frictions and controlling for recent 
developments and innovations in the financial sector while coming up with models depicting the 
effectiveness of the transmission mechanism, results from this research may help explain the 
positive and insignificant effectiveness of the Kenyan monetary policy. 
17 
3 
DO 
3.11ntroduction 
This chapter covers the procedure that is used to conduct the study, including data and model 
specification. The section is divided into various sections namely the research design, data 
specification and model specification. 
3.2 Research Design 
With reference to the objective of the study which is to assess the effectiveness of the Kenyan 
monetary policy, monthly macroeconomic data from 1993 to 2013, is used to quantify the 
effectiveness of the monetary policy using the structural autoregressive model (SVAR), from 
which impulse responses are generated. Thereafter, the relationship between financial frictions and 
the monetary policy is determined through involve a regression analysis between the financial 
friction proxy measure, control variables and the impact of monetary transmission mechanism. 
Results from the regression will form the basis of analysis and interpretation in the consequent 
chapter. 
3.2.1 Justification of research design 
The study period from 1993 to 2013 encompasses crisis periods in Kenya such as the banking 
crisis in the 1990's, periods of financial distress and recessions owing to political instability and 
domestic food prices. 
The SVA R model is preferred over the nonnal VA R model since V AR it does not solve the 
fundamental economic problem of identification. In addition, the SV AR model enables the 
identification of exogenous monetary shocks 
3.3 Data collection and specification 
Monetary policy actions as reviewed in section 2 is aimed at affecting output and prices in the 
economy. Through the variables of output and prices, we are therefore able to determine the 
effectiveness of the monetary policy propagated through the monetary transmission mechanism 
by measuring the impact of monetary stances on the variables. 
18 
The identification of the macroeconomic variables is based on the availability of macroeconomic 
data in the study from 1993 to 2013. Monthly secondary data will be collected from various sources 
such as the World Bank Database, IMF Database, the Intemational Country Risk Guide (ICRG) 
and the Kenya National Bureau of Statistics. 
Variables identified include those directly affected by monetary policy such as short term interest 
rates and the govemment securities and aggregate macroeconomic variables such as output and 
prices. A brief description of the variables chosen are put forth below. 
Variables 
3.3.1 Output 
Various measures have been used as a measure of output such as GDP and the GDP deflator. These 
factors according to (Gertler & Bemanke (1995), respond to an unanticipated tightening of the 
monetary policy by declining approximately four months after the shock. Other measure of output 
such as industrial Production Index (IPI) and Gross National Product (GNP) can be used. However 
due to the availability of data, GDP will be used in this study instead. 
3.3.2 Price levels (CPI) 
The consumer price index will be used to represent the price levels. According to Bemanke and 
Gertler ( 1995), CPI inclusion in the V AR model serves the purposes of controlling oil price shocks 
and other factors influencing output and inflation. 
3.3.3 Short term interest rates (r J 
A tight monetary shock in the economy is often associated with the increase in short term interest 
rates. Therefore, to represent the policy instrument, the Treasury bill short term in interest rates 
are used in the model. 
3.3.4 The real effective exchange rate (REER) 
The real exchange rate is used as a measure of the response of the exchange rate to a monetary 
policy shock in the Kenyan economy. 
3.3.5 The monetary aggregate ( M3). 
19 
The monetary aggregate is used to separate money demand and money supply shocks. According 
to (Aysun, Honig, & Brandy, Financial frictions and the strength of monetary transmission, 2013), 
the monetary aggregate accounts for the liquidity puzzle as well as minimizing the risk of 
dependency of monetary policy shocks on money demand shocks. 
3.3.6 World Commodity Price Index (WCpi) 
Aysun et al (2013), in trying to identify monetary policy shocks, their results reveal the 'price 
puzzle' and liquidity puzzle problems which have a wide documentation as frequent shortcomings 
in identification strategies. To solve the problem such as the price puzzle, (Christiano, 1994 ) 
advocates for addition of the commodity price index. In this study we use the world fuel 
commodity price index. 
3.3.7 The federal fund rate(FFR). 
Following the assertion put forth by Kaaman (2014), the inclusion of (FFR) and WCpi, serves 
the purpose of controlling for changes in the overall global economic stances. 
3.4. Preliminary diagnostics (Stationarity tests, cointegration tests and lag length selection} 
The study employs time series data which is prone to various issues such as non stationarity leading 
to spurious results. Therefore to obtain consistent results, unit root tests such as augmented Dickey 
Fuller (ADF) and Philip- Peron (PP) tests are carried out. Consequent tests such granger erogeneity 
(co integration tests) to ensure stability of the model and information criterion tests to determination 
of the optimal lag length of the variables. 
3.5 Model identification and specification 
The vector Autoregressive model (VA R), has been identified in various literature to study the 
macroeconomic effects of an unexpected change in monetary policy. Christopher Sims (1980) 
provided a new macroeconomic framework known as V AR, which as described by Bernanke et.al 
(1999), is a system of ordinary least square rebrressions involving the regression of the variables 
on the lagged values of themselves and other variables hence, each variable is treated as an 
endogenous variable. 
20 
The basic VA R model can be modified into the structural Vector Autoregressive model (SVA R) 
or the reduced form VA R. This study will employ the SV AR, to analyze the impact response of 
monetary transmission mechanism. 
3.5.1 SVAR model 
Structural Vector Autoregressive models have in the recent past gained popularity with the earlier 
documentations by Christiano et al (1999) and Kim (1999).Recent use of the model has also been 
seen in the work by Aysun et al (2013). 
The SVA R model is an extension of the V AR model which involves adding constraints on the 
matrix. Generally, it's a VA R with restrictions. However, too many constraints can lead to failure 
of convergence process but also enough constraints are needed to allow identification.SVAR 
model are well suited for the analysis of the monetary transmission mechanism with focus on the 
role of shocks for the variables in the model. 
3.5.l.a Model specification 
The SVA R unlike VA R, involves the specification of both the exogenous and endogenous 
variables which in the study will involve the macroeconomic variables identified earlier. The 
general form of the model is therefore; 
Yt = ( GDP, Cpi, REER, rt ·' M1, WCpi, FFR) 
The reduced form estimation of structural parameters requires some restrictions on the matrix 
elements. These restriction are made based on existing theories. However for the study we follow 
the same non recursive approach strategy by Aysun (2013) borrowed from (Kim, 1999). Hence 
restrictions on the contemporaneous structural parameters are summarized in an equation matrix 
eGDP 1 0 0 0 0 0 0 0 rUGDP 
ecpt azl 1 0 0 0 0 az7 0 Ucpt 
eM3 a31 a32 1 0 0 0 a37 0 UM3 
er-bl a41 a42 a43 1 0 0 a47 a4s Ur-bl 
ecrdt as1 asz a 53 as4 1 0 a46 0 Ucrdt 
eNEER a61 a61 a62 a63 a64 1 a67 UNEER 
ewcpi 0 0 0 0 0 0 1 TJ uwcpi eFFR 0 0 0 0 0 0 an UFFR 
21 
Where eij , uij and aij represent the structural disturbances, reduced form residuals and 
contemporaneous structural parameters respectively. 
Estimation equation 
The respective reduced form estimation equation of the model is given as; 
yt = B(L)Yt + C(L)Xt + et 
Where Yt is the endogenous variable vector denoted by: 
Yt = ( GDP, Cpi, REER, rt ,, M3). 
Xt, is the vector of exogenous variables given by; Xt = (WCpi, FFR) 
B(L) , C(L) represent the matrix polynomials of the lag operators, et is the disturbance tenn or 
the innovation term that is assumed to be serially uncorrelated. 
In the model the forecast error variance decomposition (FEVD) of variables will be computed to 
measure the impact of monetary policy shocks on variables. 
3.6 Financial frictions and monetary transmission mechanism 
3.6.1 measures 
Bemanke, Gilchrist and Gertler (1999) framework is an example of a cost state verification model 
which identify the bankruptcy recovery rate as the key parameter to capture financial frictions on 
the credit market. Aysun (2013), defines the recovery rate as a measure of the percentage of value 
of a loan that banks recover in case of default. Higher recovery rates indicate lower levels of 
financial frictions on the credit market. 
Rayner & Jacobs (2012), identifies two possible proxies of credit frictions which are the interest 
rate spreads on corporate bonds and the interest rate spreads on bank lending where the bank 
lending is identified as the predominant source of business debt. Ngugi (2001), analyzing the 
Kenyan interest spreads from 1991 to 1999, results from her research indicate that there was an 
increase in the interest rate spread in the post liberalization period. The high levels of non-
performing loans during this period is a clear indication of high levels of financial frictions. 
22 
Therefore financial frictions of information asymmetry and interest rate spreads are positively 
correlated. In the study, interest rate spread is used as a proxy measure of financial frictions. 
Given interest rate spread (IRS) as a measure of financial friction, an estimation ofthe following 
equation will be carried out. 
X , denotes vector of control variables such as stock capitalization to capture the presence of small 
firms that are considered to be bank dependent. Other control vmiables used are such as turnover 
rate of CBK governors Mishra and Montiel (2012), and institutional quality variables such as 
corruption and bureaucratic rights which are obtained from ICRG. 
The control variables above, according to Aysun (2013), affect the monetary transmission 
mechanism. Therefore a regression on the control variables and the MTS is carried out to detennine 
whether the relationship between credit market frictions and MTS still holds. 
23 
3.7 Summary of methodology 
Stepl: Generating proxy measures of monetary policy effectiveness. This is achieved through 
determining of impulse responses of macroeconomic variables to monetary shocks using SVA R 
model and computing forecast error through forecast error variance decomposition (FEVD) 
Step 2: determining the relationship between credit market frictions and monetary transmission 
mechanism. This is done through an OLS regression of the measures of effectiveness of monetary 
transmission system on the measure of financial frictions. 
Step 3: Regression analysis between control variables and the measure of monetary transmission. 
The aim is to determine whether the relationship obtained in step 2 holds after introducing control 
variables in the regression. 
R4 
Dl N 
Preliminary diagnostic tests of stationarity, cointegration and lag selection are carried out on data 
where variables are first transformed into natural logs for statistical reasons such as avoiding 
problems such as heteroscedasticity. 
4.1.1 Unit root tests of stationarity 
The Augmented Dickey Fuller (ADF) test and Philip Perron (PP) tests of stationarity are carried 
out where all variables are found to be non-stationary at level , but stationary at first difference 
except federal fund rate which was stationary at second difference as shown below; 
VARJABLES c.v 1% 5% 10% CONCLUSION 
-3.461 -2.880 -2.57 
ADF t-statistic PP t-statistic 
Log T-bill -9.591 -23.831 station my 
Log Private credit -8.439 -16.325 station my 
dlog Cpi -8.439 -18.217 station my 
dlog Gdp -8.108 -16.479 stationmy 
dlog M3 -8.582 -18.240 stationmy 
dlog NEER -10.636 -23.338 station my 
Dlog int rate spread -9.399 -23.049 station my 
dlog stock cap -6.919 -21.330 stationary 
dlog Wcpi -5.718 -17.170 Stationmy 
Log federal Fund Rate -10.422 -32.88 Stationmy (at 
second 
difference) 
25 
The johansen cointe!:,rration test results depict the presence cointegration at 5% confidence intervals 
as shown below; 
Rank Eigenvalue Trace -stat 5%CV conclusion 
0 603.17 82.49 Reject null 
1 0.5938 379.16 59.96 Reject null 
2 0.5069 204.390 39.89 Reject null 
3 I 0.4188 69.825 24.31 Reject null 
4 0.2334 3.939* 12.53 Fail to reject null 
Results from the cointegration analysis with no restrictions, indicates the existence of a long run 
relationship among the variables hence the need for an error correction model to determine both 
the long run and short run effects. 
4.2 The Vector Error Correction Model 
The long run effects interpretation is based on the analysis of the significance of the error 
correction term (speed of adjustment towards long run equilibrium). The short run causality effects 
are analyzed using the granger causality technique so as to determine the joint causality effect of 
the lags of independent variables on the dependent variable. 
Results from the VECM model indicate that all variables have a si!:,>nificant error correction term 
depicting a long run causality from in depended variables, as summarized in the table below. The 
analysis of the short run dynamics revealed the presence of bidirectional causality between both 
GDP, CPI and M3.There is no short run causality between GDP and short term T-bill rate. 
Unidirectional causality is observed from NEER to all other variables. 
26 
The VECM results are summarized in the table below. 
Endogenous Variable Error Correction term (Ll) Conclusion 
Speed of adjustment to long run 
equilibrium 
LogGDP -2.41 (p = 0.0000) Long run causality 
Log CPI -5.42 (p = 0.0000) Long run causality 
LogM3 -7.57 (p = 0.0000) Long run causality 
Log T-hill -11.022 (p = 0.0000) Long run causality 
Log credit -2.41 (p = 0.0000) Long run causality 
LogNEER -1.21 (p = 0.0000) Long run causality 
The LM test for serial correlation was carried where the null hypothesis of no autocorrelation was 
rejected, indicating existence of autocorrelation among the endogenous variables. Treatment of 
autocorrelation required ditierencing and use of lagged variables. Test on normality of the error 
tenns indicated that most of the variables except for CPI and NEER were not normally distributed. 
27 
4.3 SVAR Impulse responses 
The analysis of monetary policy effectiveness in the East African Community (EAC) has been 
carried out on a short tenn basis, since the effects of monetary policy in the region has been found 
to be short lived relative to those in advanced economies. 
To measure the effectiveness of the Kenyan monetary policy, an analysis of the impulse response 
of output and prices to one standard deviation shock to money reserve and short term interest rates 
is carried out. In line with theory, Cheng (2006) and Davoodi (2013) impulse response functions 
results depict a significant and permanent effects on CPI follovving a positive shock on both the 
money reserve and short term interest rates. However, similar monetary reserve and interest rate 
innovation on GDP, are statistically insignificant. 
Conclusions on the effectiveness of the monetary policy is based upon the statistical and economic 
significance of the impulse responses of output and prices, Davoodi (2013).Monetary policy is 
considered weak if the confidence interval of the impulse response includes zero. 
4.3.1 responses and to shocks in 
SVARi: logM3 -> logGdp SVARi: iogM3 -> logcpi 
0 2 8 0 2 
step 
95°/o CJ for sui 
SVARi: logTbill-> logGdp SVARi: logTbill-> logcpi 
8 8 
CPI response to a one standard deviation shock on both monetary reserve and short term interest 
rates is significant. However, the effect of interest rate peaks earlier than the etiect in monetary 
28 
CPI response to a one standard deviation shock on both monetary reserve and short term interest 
rates is significant. However, the effect of interest rate peaks earlier than the effect in monetary 
policy. The effect of both monetary policy innovations on GDP is rather transitory and 
insignificant as the effect of both shocks tends to die out over time. 
4.3.2 the existence credit channel 
Appendix 1 gives the remaining SV AR impulse responses where impulse response of CPI to 
credit and NEER innovation is statistically significant which gives a partial indication of the 
existence of the credit and exchange rate channels of monetary policy. 
Following the steps by Davoodi (2013). we estimate SVAR model with the six exogenous 
variables and SV AR model with five endogenous variables where credit IS an exogenous 
variable. Impulse response functions from the models are analyzed below. 
Impulse response ofCPI  to shock ofivf3 
c.,.... 
oo 
+=i' 
ro 
> 
0 
c 
·C-I.oO  
.8~ 
(!) 
(.) 
c 
0 
a. 
C/JO 
c 
(!) 
0::: 
1.0 
0 
0 
0 2 4 6 8 
Period 
1I ·--- JN: sirf of logM3 -> logcpi I JNN3: sirf of logM3 -> logcpi I 
JNN3 represents SVAR impulse response function with credit as an exogenous variable while JN 
represents SV AR impulse response when credit is endogenous. 
Impulse response ofCPI to T-hill rate 
29 
"0'" " 
cO 
0 
:;:::; 
Ctl 
> 
0.,-
cc o.  
·- I 
.9 
(!) 
ON 
co 
0 . 
a..' 
(/) 
c 
(!) 
O::C'"> 
0 
'<t 
~ 
0 2 4 6 8 
Period 
--- JN: sirf of logTbill -> logcpi 
JNN3: sirf of logTbill -> logcpi 
Given that CPI responds more to innovations in interest rates than in monetary aggregate M3, 
results from the second graph indicate that allowing f()r endogeneity of credit increases the 
impact of monetary policy shocks on CPI hence this can be seen as a direct evidence of existence 
of the credit channel of monetary policy. This results are consistent with (Davoodi S. D., 20 13). 
4.3.3 rate channel 
We carry out a SVAR with nominal exchange rate as an endogenous variable (JN) and a SVAR 
with nominal exchange rate as an exogenous variable (JNN4). The impulse response functions 
are as shown below: 
30 
Response ofNEER to M3 
--
§ 
,· 
0 2 4 6 8 
Period 
--- JNN4: sirf of logM3 -> logcpi 
----- JN: sirf of logM3 -> logcpi 
Response ofNEER to T-bill 
0 2 4 6 8 
Period 
Results from the impulse response depict that the endogeneity of the NEER variable also 
increases the impact of monetary shocks on CPT hence a direct evidence of existence of an 
exchange rate channel of monetary policy. From the two graphs, NEER response is more 
pronounced in shocks to short term interest rates than monetary aggregate. This is in line with 
findings of Cheng (2006), the short term interest rates in Kenya affects the levels of prices 
through prices of imports. 
31 
Results from the forecast error variance decomposition in Appendix II are consistent with the 
impulse response function results. Inflation responds more to shocks in short term interest rates 
than shocks to the monetary aggregate. 
4.4 Monetary policy effectiveness and financial friction 
In evaluating the relationship between financial frictions and monetary policy effectiveness we 
carry out a regression analysis between the proxy of monetary transmission mechanism and the 
proxy of financial frictions (interest rate spread), as shown below. 
MTS = a0 + a1 IRS + {JX + Et 
The MTS proxy is taken from the SVA R maximum output impulse response. 
The analysis of results from the simple correlation aims to assess the effect of monetary policy on 
prices in the economy amidst financial frictions. A positive and significant correlation coefficient 
of 0.88 is obtained from the regression. However, controlling for factors such as financial 
development and firm size using the proxy of stock capitalization, the coefficient is reduced to 
0.203 though it still remains positive and significant. To indicate the presence of effect of financial 
frictions on MTS through response modelling, we introduce a dummy variable into the regression. 
The interaction dummy is fonned between interest rate spread and the short term interest rates. A 
positive and significant coefficient of0.3958 is obtained from the regression. The three models are 
summarized in Appendix 2. 
The positive Results from the simple correlation between financial frictions and effectiveness of 
the monetary policy depict that in times of financial distress, the monetary policy is quite effective. 
Though the models vary in strength of financial frictions effects on MTS, the results are 
statistically significant. 
32 
5 
r"\l  
5.1 Summary and conclusion 
The analysis of the effectiveness of the Kenyan monetary policy is carried out through examining 
the impulse response ofvariables to shocks on monetary policy variables in a SVAR model. The 
macroeconomic variables of interest are output and price levels within the economy. Results from 
the impulse response depict that prices are more sensitive to short tenn interest rates than to shocks 
in monetary aggregate. These results are supported by results from Variance decomposition. 
Output on the other hand is not sensitive to shocks in the monetary variables. 
Tests on endogeneity- exogeneity of credit and NEER variables are carried out. Results from 
impulse responses give a direct evidence of existence of both the credit and exchange rate channel 
in Kenya. 
To test the predictions of the credit theory of monetary policy, a simple correlation analysis 
between financial friction proxy and MTS is carried out. Results are in line with the predictions of 
the theory that in the presence of frictions, the credit channel of monetary policy is amplified. 
One reason that may be attributed to this result is that in the presence of high infonnation 
asymmetry in credit markets, there is constraints in contract enforcement as there is loss in value 
of assets to be used as collateral to access credit from the credit markets. 
5.2 Policy recommendation 
The Kenyan monetary policy is more effective through the use of the short term interest rate when 
it comes to affecting the level of prices within the economy. Output is more responsive to monetary 
aggregate instrument though this response is insignificant. Therefore other instruments of the 
monetary policy other than interest rates and monetary aggregates are to be used when it comes 
affecting output levels. 
The effectiveness of the Kenyan monetary policy upon assessment of its impact on output and 
inflation levels, results from this study reveal that there is need for complementation of monetary 
policy by other policies such as fiscal policies to achieve optimal or near optimal inf1ation and 
output levels following research by (Mutuku & Koech, 2014) whose empirical results depicted 
that Fiscal policy rather than monetary policy affects output in the Kenyan economy. 
33 
The positive relationship betvveen financial frictions and the effectiveness of the monetary policy 
is crucial in times of financial distress. In accordance to the credit theory, the presence of such 
frictions amplifies the credit channel of monetary policy hence, monetary policy is able to alter 
inflation and output levels in the economy. 
None the less, the effect of financial frictions on monetary policy in Kenya is reduced upon 
controlling for other variables such as financial development which tends to have a significant 
impact on the monetary policy of Kenya. This opens up room for more research on the relationship 
between financial development, firm sizes and effectiveness of the Kenyan monetary policy. This 
will shed more light on the role of financial liberalization and institutions such as credit reference 
bureaus in economic growth. 
5.3 Limitation of the study 
The study employs monthly data which is obtained from both local and international databases. 
However, some variables such as GDP, credit to private sector were available on an annual basis 
therefore necessitating interpolation into monthly frequencies. Such interpolation brings forth 
some econometric issues such as lack of precision and loss of statistical significance of data. 
34 
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38 
1: 
---,...-~-----,..----.......... - ---------_..,.....---,-----:- -~---~-----~---~-~-.,..-
' 
step 
95% Cl structural irf J 
Graphs by irfname, impulse variable, and response variable 
39 
2: 
I Model 1 Model2 Model3 
MTS = a0 + a1 /RS MTS = a0 + a1IRS MTS = a0 + a1 /RS + f3X 
+ Et + px + f3zDintbil 
+ Et + Et 
coefficient a1 = 0.88 a 1 = 0.203 [32 = 0.3958 
SD error 0.0807 0.060 0.038 
P value 0.000 0.001 0.000 
I 
40