Financial Innovations and Their Implications for Monetary Policy in Kenya

This study investigates the effect of financial innovation on monetary policy in Kenya during the period 1998-2013; that is, whether the waves of financial innovation that have occurred during this period have impacted the long-run stability of the money demand relations. Results obtained through the autoregressive distributed lag approach to cointegration show that the fast pace of financial development in Kenya has not caused structural shifts in the long-run money demand relation. Although the test for cointegration for the monetary aggregate M1 were inconclusive, the error correction estimates and stability test using the cumulative sum (CUSUM) of squares of recursive residuals show the long-run money demand function to be stable. The CUSUM results for M3 also show some instability in some periods, and the results show that the broad money demand is well cointegrated with its determinates. Given that broad money (M3) has been the operational target for the Central Bank of Kenya, monetary targeting was a feasible policy stance for Kenya during the period of study.