Discussion Paper No. 123 of 2010 on Contractionary Monetary Policy Effects on Aggregate Income when Exchange Rates Overshoot in Kenya: a Policy Paradox?

Abstract

With the liberalization of the exchange rate market in Kenya, it is expected that contractionary monetary policy meant to reduce inflation will lead to exchange rate overshooting. Exchange rate overshooting on the other hand, reduces aggregate output through the exchange rate channel of the monetary policy transmission mechanism. Contracting monetary policy with the objective of reducing inflation has the potential to restrict output growth, if exchange rates overshoot, putting the policy makers in a dilemma. This paper examines whether exchange rates overshoot in Kenya, and its impact on output when monetary policy contracts. Using Kenyan data and error correction modeling, the short-run results show that following a contractionary monetary policy, exchange rates undershoot in Kenya instead of overshooting. The undershooting is attributed to the intervention in the exchange rate market by the Central Bank of Kenya (CBK). It addition, undershooting of the exchange rate has positive impacts on output but the full impact is restricted again by the Bank’s intervention. Therefore, for the full impacts to be realized, the CBK needs to leave the exchange rates fully to the market forces when the disturbances are identified to monetary policy shocks. The study also finds that the exchange rate channel of monetary policy transmission mechanism in Kenya is effective. The study recommends that the CBK recognizes this channel, and incorporates exchange rates in its monetary policy formulation by constructing and using the Monetary Policy Conditions Index (MCI).