Effect of Financial Innovation on Money Demand in Kenya

Abstract

The demand of money is crucial in the determination of the effectiveness of monetary policy. Key financial innovations have taken place in Kenya due to the Structural Adjustment Programs and the technological advancements which have affected demand for money. Previous Studies used number of M-pesa and ATMs as a measure of financial innovation which did not give accurate results since not all registered M-pesa users carry out financial transactions and not all ATM card holders use their cards in doing transactions. This study therefore aimed at overcoming these challenges by using the Volume of M-pesa transactions and volume of ATMs transactions since it would capture the actual effect of financial innovation in the economy by factoring in all the transactions carried out through M-pesa and ATMs. The general objective of the study was to establish the effect of financial innovation on money demand in Kenya while the specific objectives were: To investigate the effect of the volume of M-pesa transactions on money demand, to determine the effect of the volume of ATMs transactions on the money demand. According to the World Bank, Kenya is leading in financial innovation in East Africa in terms of money transfer thus warranting this study. Study period was 2008-2016 based on data availability since data on volume of M-pesa transactions was available beginning the year 2008. The study was based on Keynesian Theory of Demand for Money. This study used secondary data drawn from Kenya National Bureau of Statistics (KNBS), World Bank (WB) Central Bank of Kenya (CBK) and Safaricom. VECM model was employed in the analysis since some variables were found to be non-stationary after unit root test. Unit root test was conducted using the augmented Dickey Fuller test. Johansen Co-Integration Test was conducted and the results showed co-integration which was later addressed using Vector Error correction model. Autocorrelation was tested using Breausch-Godfrey LM test in which two lags were applied to correct its effect in the model. The study found positive correlation between financial innovation and money demand which was statistically significant at 5% significant level. This study recommended that the government should regulate volume of transactions done through means such as mobile money and ATM cards. Government should regulate credit accessibility via mobile phones and ATMs. Government should also regulate Financial sector by setting minimum interest rate charged by all money lenders irrespective of the sector and means. This would ensure a stable monetary system and a stable economy. Inclusion of other mobile money such as Airtel money, Orange money and equitel money in the study of financial innovation was recommended as the area of further research.

Keywords: Automated Teller Machine, Money Demand, M-pesa, Financial innovation, Vector Error Correction Model