Monetary Policy of the United Kingdom and Kenya - Admission/Application Essay Example

Monetary Policy of the United Kingdom and Kenya Monetary policy determines the interest rates or regulates the quantity of money in an economy by altering the base interest rate. The central bank in every country uses monetary policy to influence money supply credit in the economy to promote economic growth by minimizing massive price fluctuations. This guards people against inflation and ensures that there is stability of interest rates, prices, and exchange rates. Through this, the purchasing power of local currency is protected. It also promotes savings, investments and growth of the economy. The monetary policy, therefore, enables the central bank to create a suitable condition for increased output of goods and services within an economy and consequently improves people’s living standards. Both developed and developing countries use monetary policies to regulate financial conditions within their economy to influence their economic growth. This paper will examine and compare financial policy in United Kingdom and in Kenya. Kenya is a developing country and, therefore, its economy is not very stable. Inflation is a common phenomenon in the Kenyan economy. The Central Bank of Kenya serves to protect the value of the Kenyan shilling against what it can buy (Sicheni, and Kamau 2012). Sometimes, the value of the shilling diminishes and the monetary policy helps to restore its value. The monetary policy controls liquidity circulating within the Kenyan economy to a level that is consistent with prices and growth objectives. The volume of liquidity in circulation affects the interest rates and the value of the Kenyan Shilling relative to other currencies. The Monetary Policy Committee is mandated to formulate monetary policy for the Central Bank of Kenya (Nyamongo and Ndirangu 2013). Inflation being one of the biggest problems in the Kenyan economy, the Central Bank of Kenya has set a policy to maintain inflation levels below five percent. Given that inflation affects product prices greatly, there is need to maintain it low. Stability of prices in any economy enhances the good performance of market-based economy. It also encourages long-term stability and investments (Nyamongo and Ndirangu 2013). Low and stable inflation does not adversely affect decisions of both producers and consumers. Price stability creates a favourable condition for achieving sustainable employment and economic growth. High inflation rates on the other hand, cause market economy inefficiency and lower rates of economic growth. The amount of money in circulation is one of the main factors influencing fluctuations in prices (Nyamongo, Sichei & Mutai 2009). The Central Bank of Kenya, therefore, comes in to regulate the volume of money in circulation as stated in the Monetary Policy Statement. In order to implement the monetary policy appropriately, the Central Bank of Kenya uses three major tools. These are open market and discount window operations, together with reserve requirements. With respect to open market operations, the bank buys or sells government or bank securities in secondary markets so as to ensure that desired levels of bank reserves are maintained (Gichuki, Oduor, and Kosimbei, 2012). When there is excess money in bank reserves, the bank buys securities from the secondary market. This helps to increase money in circulation. When there is excess money in circulation, the bank reduces it through selling of securities in the secondary market. When the money situation cannot be solved through buying and selling of securities, the Central Bank of Kenya injects money into the Kenyan economy. Money stock adjusts itself as the law of supply and demand determines the interest rates (Gichuki, Oduor, and Kosimbei, 2012). These processes determine the amount of money in supply. With resp3ct to the discount window operations, the Central Bank of Kenya is a lender of last resort. The central bank in this case furnishes commercial banks with short-term secured loans. These loans are given at punitive rates which scare commercial banks away from borrowing (Nyamongo, Sichei & Mutai 2009). This is done so as to ensure that monetary policy objectives are achieved. Kenyan law empowers the central bank to retain a given proportion of deposits of commercial banks at the central bank as non-interest bearing reserve. The central bank increases or decreases reserve requirements depending on the conditions. This restricts commercial banks from expanding their credits. This practice is known as credit easing practice (Gichuki, Oduor, and Kosimbei, 2012). When there is a lot of money in circulation, the Central Bank of Kenya increases its reserve to reduce the money in circulation and vice versa. Kenyan money circulation and inflation levels have been relatively stable since 1998. Inflation rates remained below 5% which is the target of the Central Bank of Kenya. The introduction of money transfer in Kenya in 2007 and the global financial crises caused instability in the Kenyan money system (Sicheni, and Kamau 2012). This led to the creation of the monetary policy committee to help in regulating the Kenyan money characteristics. At the time, there were many financial matters that the committee needed to address in as much as the inflation rate remained stable. In 2010 inflation rates started to increase and by September 2011, it reached 17.32% (Sicheni, and Kamau 2012). This was characterized with increased prices for fuel and energy. In response to the situation, the Monetary Policy Committee raised the Central Bank of Kenya rate by 75 bases, from 6.25% to 7.00% (Sicheni, and Kamau 2012). This did not solve the inflation problem as it continued to rise until it hit 18.31 percent by the end of 2011. The Monetary Policy Committee increased central bank rate by 400 base points to 11.0. The committee increased the central bank rates further to 18 percent in December 2011. This move was caused by the further increase in inflation after the initial increase of central bank rates. The cash reserve requirement was also raised from 4.75% to 5.25% to reinforce the monetary policy stance. The monetary policy stance saw the increase in the average interbank rates from 8.61% to 28.9% (Nyamongo and Ndirangu 2013). Both the inflation and bank rates were high in the first half of the 2011/2012 financial year but dropped in the second half of year (Nyamongo and Ndirangu 2013). In June 2012, inflation rate dropped to 10.1% from the 18.31% reported in January 2012. This was characterized with decreased food and fuel inflation. Amid this, annual inflation increased from 6.9% reported in 2011 to 16.0% in June 2012 (Nyamongo and Ndirangu 2013). All the monetary tightening activities were aimed to contain domestic inflation which had attracted complaints from members of the public. In September 2011, money supply slowed to 15.5 percent from 19.3 percent. The reserve money on the other hand grew from to 17.6 percent which was above the target of 14.2% (Nyamongo and Ndirangu 2013). There are various channels through which monetary policy changes affect the Kenyan economy. These channels include: interest rate, asset price, exchange rate, expectations and credit channels (Nyamongo, Sichei & Mutai 2009). The credit channel works through bank lending and household and firms’ balance sheet. When the Central Bank of Kenya reduces reserve money, the money available for lending by the commercial banks increases. When the central bank increases reserve money, the opposite happens. Reduction of money stock worsens firms and households balance sheet through the decrease in equity and assets prices (Nyamongo and Ndirangu 2013). The commercial banks lend to less borrowers to avoid moral hazards. There exist very few substitutes to bank loans and consequently firms cannot borrow money from anywhere else. The interest rate channel is the most vital channel of monetary policy transmission. It involves initiation of nominal interest rates which influences long term lending and consequently reduces investment expenditure demand. This raises the cost of borrowing and, therefore, reduces the demand for durable goods due to their high cost. Inflationary pressures are lowered as aggregate demand falls (Sicheni, and Kamau 2012). When the central bank adopts tight monetary policy, domestic interest rates increase relative to foreign interest rates. In response, the domestic currency depreciates in relation with the interest condition which is uncovered. This serves to restore the equilibrium within the foreign exchange rate market. When interest rates rise above the foreign interest rates, capital inflows may be encouraged and consequently domestic currency depreciates (Sicheni, and Kamau 2012). Net exports falls because locally produced goods becomes more expensive than foreign goods. When official interest rates change, the expectations about the future course of economic activity are influenced either positively or negatively. This affects participation of different agents in the financial markets. In UK, the monetary policy mainly operates through interest rates. Monetary stability in the UK means stable prices and confidence in the pound. Stability of prices is determined by the inflation target set by the government. The inflation target is set by the monetary policy committee. Just like in Kenya, prices of goods in the UK remained stable from 1998 to 2006 when it was destabilized by the global financial crisis (Bank of England 2013). The stability that resulted led to the creation of the monetary policy committee which immediately recorded notable achievements. Before 2003, the target inflation for the UK was 2.5% but it was revised to 2% in 2003. The rates remained stable until 2006 only to shoot up in 2007, to 3.1% (Bank of England 2013). This was characterized by the instability in prices which made the then governor of the Bank of England to write a letter to the Chancellor under the Bank of England Act. The Monetary Policy Committee was able to keep interest rates between 3.5% and 7.5%. From October 2008, the committee predicted deflation and consequently cut interest rates (Bank of England 2013). In March 2009, the interest rate reached 0.5% which is the all-time low rate in the U.K. Monetary Policy Committee’s history. This reduction helped to avoid deflation and spurred growth. In the same year, the monetary public committee announced that it would start injecting money directly into the UK economy through purchases of assets. This is called quantitative easing and was to be done in addition to setting bank rates. In March 2009, the committee injected the £75 billion into the UK economy. In 2010, the Monetary Policy Committee voted to maintain the interest rate at 0.5%. It also increased the money for quantitative easing from £75 billion to £200 billion (Bank of England 2013). This amount was increased further in 2011 to £275 billion. In 2012, the committee increased the amount two times by £50 billion. This brought the total amount for quantitative easing to £375 billion in July 2012 (Bank of England 2013). Despite this increment of the money to be injected directly into the economy, the banks interest rate remained stagnant at 0.5%. In August 2013, through appropriate guidance, the Monetary Policy Committee followed its American counterpart in setting and keeping interest rates low for a long period of time. Through this means, the committee sought to maintain the favourable monetary policy stance until the UK economy strengthened (Henry 2013). This did not, however, include material risks to financial stability or price stability. The Monetary Policy Committee of the UK maintains that low inflation is not by itself an end but it is an important factor in encouraging long-term stability in the economy with sustainable employment and growth (Henry 2013). The framework on which the UK monetary policy works was designed in 1998. It states the objectives of the Bank of England which include: maintaining prices stability and to support economic policy of the government which entails employment creation and encouraging growth. These objectives are defined in the Bank of England Act. The monetary policy committee of the Bank of England has a mandate to formulate the monetary policy (Henry 2013). Her Majesty’s Treasury, however, specifies for the bank actions that need to be taken to stabilize prices. It also specifies economic policies that the government needs to consider in formulating other policies. Her Majesty’s Treasury does this through annual remit letters to the Governor of the Bank of England. Inflation is determined by an analysis of the Consumer Price Index (CPI), this is found to be about 2% (Henry 2013). The Monetary Policy Committee is required to achieve this and it should be accountable for it. The CPI has been used as a measure of inflation since 20003. The UK government believes that keeping inflation low fosters economic prosperity. Even with undesirable volatility in output and other unfavourable circumstances in the financial market, the committee is required to initiate stabilization within a very short time. In case of any deviation, the remit letter is always written by the governor of the Bank of England showing reasons why inflation has moved from the target (Henry 2013). It also explains the actions the monetary policy committee are taking in order to deal with the inflation problem and the estimated time for the inflation to return to the target. The remit letter also explains how actions taken promote the achievements of the Government’s monetary policy objectives (Henry 2013). Flexible inflation targeting framework has proved to be the best approach to deal with inflation. The governor of the Bank of England, Dr Carney, has expressed desire to institute several changes in the country’s financial policy. These possible changes include; changing the timeframe for meeting inflation target (Henry 2013). The Monetary Policy Committee is expected to provide guidance for future changes in interest rates. There are further changes expected in the mechanism of measuring inflation and setting inflation target. This is expected to improve performance of the monetary policy in UK. Although the Kenyan monetary policy has tried to control inflation in Kenya, it has been faced with many challenges. Corruption is a big problem in many sectors of the Kenyan economy and consequently it is hard to determine forces that influence the prices of important commodities such as fuel (Ndung’u 2009). This renders some instruments of monetary policy ineffective. Kenyan citizens are not informed about various instruments of monetary policy. This makes citizens unable to approve these instruments and consequently do not work in favour of these policy instruments. Most of the Kenyan citizens do not deposit their money in commercial banks and, therefore, financial institutions are not able to use traditional tools to control money in circulation (Ndung’u 2009). There also exist no explainable relationships between lower interest rates, expended output, and higher investment. This makes the Kenya economy experience negative real rates and consequently unable to make constructive investment decisions. Such decisions are made using business expectations which make implementation of financial policy difficult. Some banks in Kenya are branches of major foreign private banking institutions. These banks are able to access their liquid funds when their base is squeezed by the Central Bank of Kenya (Ndung’u 2009). The money and financial markets in Kenya are not adequately developed. This limits the application of the open market operations and, therefore, often renders application of monetary policy unsuccessful. The Kenya shilling experiences volatile exchange rates. This makes Kenya to work under floating rate exchange policies (Ndung’u 2009). The Kenyan economy is also very open and globalized which makes exchange rates more volatile. This makes it hard for the central bank to come up with effective monetary policies. In the UK things are different. Being a developed nation, most of problems faced by developing nations like Kenya are not common and consequently its financial policies have recorded notable success. This has been due to many reasons. To begin with, the Committee of monetary policy is able to accurately forecast inflation (Economics 2007). Prior knowledge about inflation enables the monetary policy of UK to handle inflationary pressures before they occur (Economics 2007). This helps it to monetary policy to achieve inflation targets every time. Changes of interest rates in UK are not implemented immediately. For instance, current increase in interest rates may take effects in 18 months. This means that people may continue with their projects for some time. In Kenya, a rise in the interest rate is implemented immediately and consequently affects the economy. The effects of changes in interest rates are not equally felt by all buyers (Economics 2007). Those with large debts many suffer more compared to those with less debt. This makes people not to be scared to borrow and spend. The expectation of inflation by authorities and members of the public makes it easy to deal with it. This makes it easier to keep inflation low compared to those with no information concerning future inflation (Economics 2007). Monetary policy in all countries is made to ensure stability of prices and promote growth of economy. This may be achieved through regulation of interest rates changed by the commercial banks or direct money injection into the economy. This helps to contain inflationary pressures in the economy. Monetary policy has not been successful in developing countries like Kenya due to variety of reasons. Kenyans are not aware of policy working mechanism hence they do not supports it. The volatility of the Kenyan shilling is high due to interference of Kenyan economy by external forces. In UK such problems are not reported and therefore financial policy has succeeded. All stakeholders possess appropriate information that enables them to plan in advance. Also, new interest rates are not implemented immediately and therefore economy remains stable for a longer time after disturbances are reported. This shows why monetary policy is less successful in developing nations compared to developed countries. References Bank of England 2013, ‘Inflation Report’, viewed 29th March, 2014 www.bankofengland.co.uk/inflationreport/index.htm. Economics 2007, ‘What determines effectiveness of Monetary Policy in UK?’, viewed 29th March, 2014 http://econ.economicshelp.org/2007/03/what-determines-effectiveness-of.html Gichuki, J., Oduor, J., and Kosimbei, G. 2012, ‘The choice of optimal monetary policy instrument for Kenya’, International Journal of Economics and Management Sciences, vol. 1, No. 9, pp. 01-23. Henry, S 2013, ‘U.K. Monetary Policy: Observations on its Theory and Practice’, LSE Financial Markets Group special paper series. viewed 29th March, 2014 http://www.lse.ac.uk/fmg/workingPapers/specialPapers/PDF/sp225.pdf Mihailov, A. 2006, ‘Operational Independence, Inflation Targeting and UK Monetary Policy’, University of Essex, viewed 29th March, 2014 http://www.essex.ac.uk/economics/discussion-papers/papers-text/dp602.pdf Ndung’u, N. 2009, ‘Challenges of Monetary Policy Making in Kenya’, Central Bank of Kenya, viewed 29th March, 2014 http://www.cenbank.org/cbnat50/papers/session1/ Challenges%20of%20Monetary%20Policy%20making%20in%20Kenya%20-Njuguna_Ndungu.ppt Nyamongo, E. & Ndirangu, L. 2013, ‘Financial Innovations and Monetary Policy in Kenya, Central Bank of Kenya’, African Economic Research Consortium (AERC) Biannual Research Workshop on Financial Inclusion and Innovation in Africa. viewed 29th March, 2014 http://mpra.ub.uni-muenchen.de/52387/1/MPRA_paper_52387.pdf Nyamongo, M., Sichei, M. & Mutai, N. 2009, The monetary and fiscal policy interactions in Kenya, Research Department, Central Bank of Kenya, viewed 29th March, 2014 https://editorialexpress.com/cgi-bin/conference/download.cgi?db_name=IIPF65&paper_id=93 Sicheni, M. & Kamau, A. W. 2012, ‘Demand for Money: Implications for the Conduct of Monetary Policy in Kenya’, International Journal of Economics and Finance, vol. 4, no. 8. Published by Canadian Center of Science and Education. Read More