Monetary Policy

  1. What is monetary policy?
    Monetary policy is the process by which the Central Bank influences the level of money supply credit in the economy in order to minimize excessive price fluctuations, and promote economic growth.
  2. What does monetary policy do?
    Monetary policy guards against inflation and ensures stability of prices, interest rates and exchange rates. This protects the purchasing power of the Kenya shilling and promotes savings, investment and economic growth.Through monetary policy, the Central Bank creates conditions that allow for increased output of goods and services in the economy, thereby improving the living standards of the people.
  3. How does CBK conduct Monetary Policy?
    The Central Bank formulates a policy to expand or contract money supply in the economy after detailed analysis and estimation of the demand for money in the economy.The following instruments are used to conduct monetary policy in Kenya:
    • Reserve Requirement: commercial banks are required by law to deposit 6% of their deposits with the CBK. This is used to influence the amount of loans banks can advance the public and thus affects the supply of money. An increase in this proportion reduces the amount of money available for commercial banks to lend while a reduction has the opposite effect.
    • Open Market Operations (OMO): Central Bank buys and sells Government securities in the money market in order to achieve a desired level of money in circulation. When the Central Bank sells securities, it reduces the supply of money and when it buys securities it increases the supply of money in the market.
    • Lending by the Central Bank: The Central Bank from time to time lends to commercial banks overnight when they fall short of funds thus affecting the amount of money in circulation and the amount deposited by banks at the CBK.
    • Moral Suasion: The Central Bank persuades commercial banks to make decisions or follow certain paths to achieve a desired result like changes in the level of credit to specific sectors of the economy.
  4. What is inflation?
    Inflation is the persistent increase in the level of general prices of goods and services over a given period of time.
  5. What causes inflation?
    Prices of goods and services may persistently increase when:
    • People have more money than the goods and services available so that the prices of goods and services are put under pressure to rise.
    • The cost of producing goods and services may increase due to increases in the cost of raw materials, bad weather, increase in the wages, increase in government taxation, increase in international oil prices or other factors that affect the supply and production of goods and services. This increases the prices of final goods and services produced.
  6. Why is inflation undesirable?
    • High inflation reduces the value of money and thereby loss of purchasing power. This makes future prices less predictable. Sensible spending and saving plans are harder to make. People increasingly fear that their future purchasing power will decline and erode their standard of living.
    • High inflation leads to an increase in the cost of living.
    • Inflation causes a loss in the real value of savings, meaning that the savings can buy lesser goods and services than it would have bought before inflation.
    • Individuals with fixed income are more affected as their income does not increase with the increase in prices.
    • Businesses do not venture into long term productive investments as they are not sure whether the prices will continue rising or will drop at a future date. This causes misallocation of resources by encouraging speculative rather than productive investments.
  7. What is low inflation?
    • Low and stable inflation protects the purchasing power of money and encourages savings and investment which improves productivity.High inflation leads to an increase in the cost of living.
    • Low and stable inflation also enables consumers and producers to make plans because they know that their money is keeping its purchasing power over time.Individuals with fixed income are more affected as their income does not increase with the increase in prices.
    • Businesses do not venture into long term productive investments as they are not sure whether the prices will continue rising or will drop at a future date. This causes misallocation of resources by encouraging speculative rather than productive investments.
    • Low and stable inflation therefore, creates a conducive environment that promotes economic growth, thus improving the living standards of the people and reducing unemployment.
  8. What are interest rates?
    Interest rates are prices charged to or paid for the use of money.
  9. What are the common types of interest rates in Kenya?
    • The REPO and reverse REPO rate: When the Central Bank sells securities to commercial banks in the open market operations in order to reduce money supply in the system; it pays an interest called the Repo rate. Conversely, when the Bank releases money into the banking system through purchase of securities, the receiving banks pay an interest called the Reverse Repo rate.
    • Treasury bill rate: Treasury bills are short term market instruments used to finance the short-term financial requirements of the government. The Treasury bills are purchased through competitive bidding and the interest rate applicable to these securities is the Treasury bill rate.
    • Inter-bank rate: This is the rate at which commercial banks borrow and lend money among themselves over a short period of time, usually overnight.
    • Treasury bond rate: A Treasury bond is a long term government debt instrument with a maturity of 1 or more years. The interest rate associated with these instruments is the Treasury bond rate and it is paid semi-annually.
  10. What is Central Bank rate?
    Central Bank Rate (CBR) is the price at which the CBK lends money overnight to commercial banks. It also serves as a signalling instrument for monetary policy.
  11. What is Monetary Policy Committee (MPC)?
    The Monetary Policy Committee is an executive committee of the Central Bank, which is responsible for, formulation of monetary policy.
  12. What is the composition of the MPC?
    The Committee consists of the Governor (Chairman), the Deputy Governor (deputy chairman), two members appointed by the Governor from among CBK staff, and four other members who have knowledge, experience and expertise in matters relating to finance, banking and fiscal and monetary policy, appointed by the Minister for Finance.
  13. What is exchange rate?
    An Exchange rate is the price at which one currency trades for another, e.g. KSh 65 per US Dollar (Equiv. stated as 0.0154 US dollar per Kenya Shilling).
  14. What determines the exchange rate?
    Exchange rate in Kenya was liberalised in October 1993 and since then has largely been determined by demand and supply of the Kenya shilling vis-à-vis other currencies.
  15. Why is Exchange rate important?
    The exchange rate is important because it allows the conversion of Kenya shilling into foreign currencies thus facilitating purchase of goods and services from other countries.
  16. How does exchange rate affect importers and exporters?
    A weak shilling makes Kenyan goods and services cheaper in the international market but makes imports more expensive. So exporters benefit while importers lose (i.e. they import less goods from abroad). Conversely, a strong shilling makes our goods and services expensive in the international market and makes our imports more affordable. In this case, importers gain while the exporters lose.
  17. Exchange Rate Policy?
    The exchange rate is determined by the interaction of supply and demand for foreign currency in the interbank market for foreign exchange. The Central Bank participates in the foreign exchange market only to build reserves to a desired level and smooth out any short-term fluctuations occasioned by speculative behaviour of market players.

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