EFFECTS OF MONETARY POLICY ON ECONOMIC GROWTH IN UGANDA

ABSTRACT

This study bases  on the effects of monetary policy on economic growth in Uganda specifically to establish the effects of interest rate and money supply on Economic growth.

It was based on time series data obtained from the International Financial Statistics (IFS) is employed for the analysis. Univariate analysis, correlation matrix for the variables, Augmented Dickey Fuller test for stationarity, Normality tests and finally the model estimation.

The findings revealed that money supply has a positive significance on GDP. However, interest rate has a negative effect statistically insignificant at 5% level of significance. That is to say as Money increases also GDP increases, however, increase in interest rate reduces GDP. This is because investments rely on the rate of interest, High interest rate makes borrowing expensive to the investor. Thus reduced investments leads to reduced GDP.

The government should explore rational mechanisms of stimulating increased demand through money supply since it has emerged as a key element that promotes economic growth. Secondly the government and the concerned bodies should be in position to regulate the amount of interest rates charged to the borrowers so as not to scare borrowers from borrowing as it constrains the rate of growth of the economy.

TABLE OF CONTENTS

DECLARATION.. i

APPROVAL.. ii

DEDICATION.. iii

ACKNOWLEDGEMENT.. iv

ABSTRACT.. v

TABLE OF CONTENTS. vi

IST OF TABLES. vii

LIST OF FIGURES. viii

CHAPTER ONE.. 1

INTRODUCTION.. 1

1.1 Background to the study. 1

1.2 Statement of the problem.. 2

1.3 Objectives of the study. 3

1.3.1 General Objective. 3

1.3.2 Specific Objectives. 3

1.4 Research Hypotheses. 3

1.5 Scope of the study. 4

1.6 Significance of the study. 4

CHAPTER TWO.. 4

LITERATURE REVIEW… 4

2.0 Introduction. 4

2.1 Conceptual framework. 5

2.2 Effect of money supply on economic growth. 5

2.3 Effect of interest rate on economic growth. 7

CHAPTER THREE.. 8

METHODOLOGY.. 8

3.0 Introduction. 8

3.1 Research Design. 8

3.2 Data and Source. 9

3.4 Description of variables. 9

3.5 Data Analysis & Data presentation. 9

3.6 Model specification. 9

CHAPTER FOUR.. 10

RESULTS AND PRESENTATION OF FINDINGS. 10

4.0 1ntroduction. 10

4.2.2 Regression Equation. 13

CHAPTER FIVE.. 14

SUMMARY, CONCLUSIONS AND RECOMMENDATIONS. 14

5.1 Introduction. 14

5.2 Results of findings. 14

5.3 Conclusions. 15

5.4 Policy Recommendations. 15

5.5 Suggestions for further research. 16

BIBLIOGRAPHY.. 16

Appendix. 18

LIST OF TABLES

Table 3.1: Description of variables. 9

Table 4. 1: Summary of descriptive statistics. 11

Table 4. 2: Unit root test results: (ADF: GDP,MS, IR). 12

Table 4. 3: Correlation Matrix/Pairwise correlation for the variables under study. 13

Table 4. 4: Multiple Linear Regression model 14

LIST OF FIGURES

Figure 2: Graphical analysis of the study variables (Dependent: GDP, Independent: Money supply and Interest rate)  15

CHAPTER ONE

INTRODUCTION

1.1 Background to the study

Monetary policy is one of key drivers of economic growth through its impact on economic variables. Economic growth is essential in an economy as it reduces poverty as well as improving livelihoods. The growing importance of monetary policy has made its effectiveness in influencing economic growth a priority to most governments (Okorie, 2016).

The role of monetary policy on the economic development and the changing in aggregate economic activity depend on how monetary policy is conducted and the independency of the central bank to choose the appropriate monetary tools to formulate the monetary policy of macroeconomic objectives (Alavinasab, 2016).

Despite the lack of consensus among economists on how monetary policy actually works and on the magnitude of its effect on the economy, there is a remarkable strong agreement that it has some measurable effects on the economy (Jerome, 2014). Monetary policy as a combination of measures designed to regulate the value, supply and cost of money in an economy, in consonance with the expected level of economic activity (Okubala, 2016). For most economies, the objectives of monetary policy include price stability, maintenance of balance of payments equilibrium, promotion of employment and output growth, and sustainable development. The pursuit of price stability invariably implies the indirect pursuit of other objectives such as economic growth, which can only take place under conditions of price stability and allocate efficiency of the financial markets. Monetary policy aims at ensuring that money supply is at a level that is consistent with the growth target of real income, such that non-inflationary growth will be ensured. Monetary policy is used as inflation is generally considered as purely a monetary phenomenon (Jerome, 2014).

The transition toward independency of the central bank to choose the market oriented-economy was accompanied by the appropriate monetary tools to formulate the monetary expansion on monetary policy that can be seen by the policy of macroeconomic objectives (Alavinasab, 2016). Money supply as the proportion of gross domestic The accurate information on the effectiveness of the product increased rapidly from 20% in 1999 to 58% in policy on the macro economy is the main issue of the 2015 and interest rate decreased from 30% in 1990 to policy maker to successfully implementation of any 20% in 1999 and 3.5% in 2015 respectively, the annual economic policy in general to achieve the sustainable gross domestic product grew up by 8% averagely. Output growth, the authority and policy maker always Nevertheless, the Lao economy also suffered high targets on the intermediate variables include the short- fluctuation of inflation and dollarization continuously (Alavinasab, 2016).

Monetary policy as a combination of measures designed to regulate the value, supply and cost of money in an economy, in consonance with the expected level of economic activity (Okubala, 2016). For most economies, the objectives of monetary policy include price stability, maintenance of balance of payments equilibrium, promotion of employment and output growth, and sustainable development. Monetary policy aims at ensuring that money supply is at a level that is consistent with the growth target of real income, such that non-inflationary growth will be ensured. Monetary policy is used as economic instability is generally considered as purely a monetary phenomenon (Corazon, 2015).

In Uganda, the monetary policy is conducted by the Bank of Uganda (BOU). Monetary policy influences economic growth through aggregate spending. Changes in money supply and interest rates influence consumer spending as well as investment decisions. Consequently, aggregate demand changes in response to monetary policy adjustment (Nuwagaba, 2018).

The link between monetary policy and economic growth has been found to be weak, particularly in developing countries (White, 2013). In addition, some studies confirm a weakening relationship between money supply and policy objectives (White, 2013). In some instances, the appropriateness and relevance of monetary policy has been questioned, particularly for some developing countries with informal sectors, a poorly integrated financial sector, low financial development, and where the fiscal policy plays the dominant role in the economy.

1.2 Statement of the problem

Over the last 50 years, Uganda has made significant development progress. Since the mid 1980’s, the economy has moved from recovery to growth from -3.39% to 4.89% IMF (2004). However, the significant effect of average price and labour force on Gross Domestic Product (GDP) suggest that monetary policy as a policy option had been active in influencing these macroeconomic variables to achieving economic stability and sustainable growth in the long – run. While the insignificant effect of broad money supply and interest rate revealed that the adoption of monetary policy tools such as cash reserve ratio or open market operation by the monetary authority has no significant impact on the variables to regulate interest rate and mitigate price instability in Uganda (Nuwagaba, 2018).

With the estimated Vision 2040 economic growth rate expected to rise from the current 6.4 % to a five-year average of 8.4per cent per annum by the year 2025 has challenged the monetary authority to direct its macroeconomic strategy towards sustainability of growth rate by more than 8.2 % annually through low and stable rate of inflation, stable levels of growth, employment creation and poverty reduction (Simpson, 2017). It’s on this basis that this study seeks to establish the effects of monetary policy on economic growth in Uganda with interest rate and monetary supply as the variables of interest.

1.3 Objectives of the study

1.3.1 General Objective

The overall thrust of this study was to examine the impact of monetary policy on economic growth in Uganda with consideration to policy variables of Money supply and Interest rate

1.3.2 Specific Objectives

1. To assess the effect money supply on economic growth in Uganda
2. To ascertain the effect of interest rates on economic growth in Uganda

1.4 Research Hypotheses

1. There is no significant relationship between money supply and economic growth

There is a significant relationship between money supply and economic growth

1. There is no significant relationship between interest rates and economic growth

Ha 2: There is a significant relationship between interest rates and economic growth

1.5 Scope of the study

The study was carried out between August and November 2019 because the researcher was able to collect the information required for the study. Secondary data that was explored was between 1990-2018.

1.6 Significance of the study

This study will be of immense value because it highlights the mechanism for the operation of monetary policy towards achieving national development goals.

The study will also be relevant as it contributes to the debate on the relevance of monetary policy as presented in Uganda’s Vision 2040.

CHAPTER TWO

LITERATURE REVIEW

2.0 Introduction

This chapter discusses the conceptual framework and related literature. It was drawn in line with the objectives of the study.

2.1 Conceptual framework

Independent Variables                                                Dependent Variable

From the conceptual frame work above, the independent variable for the study is monetary policy and this can be measured by looking at money supply and interest rate. These variables are assumed to influence economic growth which is the dependent variable for the study and this can be measured by looking at the Gross domestic product (GDP).

2.2 Effect of money supply on economic growth

Money supply and mild inflation rate are key determinants of high economic growth rate capable of creating employment opportunities, poverty reduction, higher per capita income and standard of living that culminate into economic development (Jenson, 2011).

Apart from this, most of the earlier empirical studies focused on the short run impacts, underestimating the fact that long run behavior of variables might deviate totally from the short run behavior of variables. Therefore making achievement of proper mixed of monetary aggregate with level of interest necessary for a targeted level of inflation that is growth driving elusive (Taiwo, 2011). The present study accounts for this shortcoming, by investigating both the short run and long run relationship between monetary policy indicators and economic growth. In addition, apart from the fact that most of the related empirical works uses data spanning over a short period,  works conducted in Nigeria on these macroeconomic variables do not considered causal connections among the variables of interest, thus making inferences drawn in such circumstances having a long term negative impact on policy implementation and outcomes.

Monetary policy is conducted by the central bank of many countries. So, the monetary policy is an important tool for maintaining economic stability and promoting economic growth as well. However, monetarists believe that an increase in the money supply will not affect to output or gross domestic product (GDP), but money supply will affect mainly on inflation. In past decade, the global financial crisis was observed. It was only found when the crisis, turned into a global economic recession that affected developed and developing countries. Even though, the economic in many developing countries consequences of these indirect effects were as severe as the direct effects were on developed countries. Nevertheless, the crisis has had various other impacts. The worldwide recession led to a reduction of global GDP growth by -0.35% in 2009, which lower than was 4.85% in 2007 and was 2.21% in 2008 respectively. In order to resolve the issues and stimulate economic growth, the government of AEC countries passed an alternative policy in every way. One of the measures of government spending based on monetary policy to stimulate the economy have been adopted, together with fiscal policy (Taiwo, 2011).

The central bank’s monetary policy (expansionary money policy) to stimulate economic growth by lowering interest rates in order to increase the supply of money into the economy. Due to monetary policy plays as an important role in boosting the economic growth of many countries provided money as exogenously determined within the economy. So, changes in the quantitative money lead to change on aggregate demand sequence of AEC economic events of the number of sectors is still a very researchable subject, and for the third millennia there is the main arrangement modern. Our own academic dates represent an attempt to employ the economic research arrangement originally worked out. Therefore, to understand the role of monetary policy in the macroeconomics evens more. The research question of this study is to determine how the relationship between money supply and economic growth could be found. From the previous study there are a lot of studies examined the role of monetary policy on Gross Domestic Product (GDP) (Kraige, 2010).

The first year after expansionary monetary shock, most of the impact is on real output, which die down quickly while in the second year, price die out over a long horizon thus confirming Friedman findings (Shen, 2011). The results of impulse response functions revealed that monetary policy innovations have both real and nominal effects on economic parameter depending on the policy variable selected. The study also revealed that price-based nominal anchors (MRR and REER) do not have a significant influence on real economic activity. Whereas, innovations in the quantity-based (Klein, 2012).

GDP is greatly affected by monetary policy of the state. By using regression method, the study concludes that growth in money supply has high influence on GDP of an economy and there are various unknown factors that affect the GDP (Muraya, 2011).

2.3 Effect of interest rate on economic growth

Interest rates are the costs a borrower has to pay when obtaining a loan in any economy. This definition implies that, interest rates are the determinants of the cost of credits in an economy. The impact of high cost of interest rates in the society is not unconnected to the fact that borrowers may hesitate to borrow when they should. This may be because the cost of credit and the credit itself may aggregate to an amount that may be unaffordable to the borrower to pay back within the stipulated due date of the loan. The implication of this on the economy is that GDP of the economy would be low since equity financing alone cannot adequately sponsor the production activities in an economy (Lubega, 2015).

Money is borrowed at a cost and the cost associated with the borrowing of funds is referred to as interest rate. It is not just production of goods that are negatively affected by increased interest rates but also affected are those involved in real estate business. The increase in interest rates affects demand for mortgages posing a challenge on the prices of residential real estates. On the contrary, proponents of high interest rates are of the opinion that high interest rates encourage the supply of idle funds in the market making an improvement in the cycler flow of funds and making accessibility of funds quite easy for businesses to flourish (Lubega, 2015).

There are two main channels of monetary policy. One is through the effect that interest rate changes have on the exchange rate of a currency, and the other is through the effect that interest rate changes have on demand. Therefore, monetary policy has an impact on economic activity and growth through the workings of foreign and domestic markets for goods and services (Muluk, 2015).

Efforts should be put in place to minimize the effects of the above risks, if they do eventually occur. For the projected economic growth to be realized, government and other development partners need to improve complementary services that support the agriculture sector that employs most Ugandans. This could be attained through increasing the coverage of the agriculture insurance scheme, as well as investment in the water for production in agriculture (Muluk, 2015).

CHAPTER THREE

METHODOLOGY

3.0 Introduction

The chapter presents the empirical model that was adopted for the study. The variables that were used in the study are defined. The data, the data sources and the methods that were employed in data analysis are presented in this section.

3.1 Research Design

This study is a time series descriptive research that is aimed at establishing the effects of monetary policy on economic growth. With secondary data between 190-2018 being used, Augmented Dickey Fuller (ADF) test for stationarity, normality tests and regression analysis was employed in this analysis

3.2 Data and Source

Secondary data for years between 1990-2018 was used in this study and was obtained from IFS (2015), International financial statistics with raw data for GDP, Money Supply and Interest rate.

3.4 Description of variables

Table 1: Description of variables

3.5 Data Analysis & Data presentation

The eviews software was used to analyze data. Data generated by the reports was analyzed using descriptive and inferential statistics. Descriptive statistics (Sekaran, 2003) refers to statistics that describe the phenomena of interest. These phenomena include; mean, variance and skewness

3.6 Model specification

In this study, economic growth (GDP) in Uganda was specified as a function of money supply and Interest rate. The variables are noted as GDP=Gross Domestic Product, MS= Money supply and IR=Interest rate,

Thus GDP=f (MS, IR) ……………………………………………………….………. (i)

The model expressed as

GDPLOG = C(1) + C(2)*IN + C(3)*MSLOG

3.7 Testing for stationarity

For a stochastic process to be non- stationary, its moments (mean, variance, auto-covariance) are time variant. A time series is stationary if its mean, variance, and auto covariance are independent of time. The use of non-stationary data generates poor forecast and may generate spurious regression results. Each of the variable in the model is subject to unit root test under the null hypothesis.

Ho is that the series has a unit root i.e. the series is non-stationary.

Ha, the series is stationary.

CHAPTER FOUR

RESULTS AND PRESENTATION OF FINDINGS

4.0 1ntroduction

This chapter presents analysis results, interpretation and key findings of the study. Descriptive, correlation and regression analysis is employed.

4.2 Descriptive statistics Table 4.1 Descriptive statistics shows that the data is either normally distributive or not. If selected variable skewness is between 1 to -1 than the data is normally distributed and if it more than 1 to -1 the data is not normally distributed. The selected data having skewness more than -1 so as show in the table. This suggests that the selected data is not normally distributed and spearman correlation analysis is best fit on this data

The average GDP is moderately positively skewed ().

Table 2:Descriptive statistics

Source: secondary data

The average Money Supply  is moderately positively skewed ().

The minimum interest rate is 18.7 while maximum value is 34.4. The interest rate charged on borrowing is highly positively skewed ()

The variables LOGGDP, LOGMs have been observed to have skewness less than one unlike the interest rates. The variables with skewness less than one is said to be uniform, equally distributed and thus does not have outliers and extreme values whereas those variables that produce skewness above one are basically said to violate normality.

Figure 2: Graphical analysis of the study variables (Dependent: logGDP, Independent: Money supply and Interest rate)

Source: Author

Findings from the figure above indicates that the interest has been unstable its constantly changing and log gdp together with logms .

The figure further indicates that the gdp of the country depends on money supply and interest rate.

4.2.1 Unit root tests

Unit root tests were carried out using the augmented Dickey-Fuller test statistic. This was carried out to check whether the series were stationary (integrated) or not. This is because standard inference procedures do not apply to regressions which contain an integrated dependent variable or integrated regressors. The test statistic tested the null hypothesis that the time series has a unit root against the alternative that there is no unit root. The test statistic values are compared to the critical values at five percent significant level. The test statistic values less than the critical values at five percent level of significance indicate that the series are non-stationary otherwise they are stationary.

Table 2: Unit root tests of the series 1991-2014

Source: secondary data

In the table 2, the GDP (LOGgdp), money supply (logms) are stationary in the levels and after the first difference since there ADF statistic are greater than the critical values.

Table 4: Correlation Matrix/Pairwise correlation for the variables under study

considering the correlations, the results indicate that there is a positive and a strong correlation between the country’s GDP and Money Supply, implying that the higher the money circulated in the economy, public consumption tends to increase.

There is a weak negative correlation between the interest rates charged borrowers and the gross domestic product of the country, the negative coefficient reveals that the higher the interest rates charged reduces private investments in the economy.

4.2.2 Regression Equation

Table 4: Regression Equation

The R-square =0.97148, this implies that 97.1% of variation in GDP can be explained by money supply, and interest rate, , hence a  good fit.

The F- probability above (0.000) <0.05, thus I   reject the null hypothesis and conclude that the GDP of the economy depends on money supply and interest rate.

Model

GDPLOG = C(1) + C(2)*IN + C(3)*MSLOG

GDPLOG = 0.9602748392 + 0.1717878984*IN – 0.1673102359*MSLOG

The coefficient of determination reveal that 96% of the variations in the dependent variable (GDP) can be explained by the independent variables, money supply and interest.

There exists a relationship between the variables with model having significant value implying that the model is of a good fit and thus the variables employed to construct the model are credible and reliable.

A unit increase in money supply by one unit increase economic growth by 17.2 where as a unit increase in interest rate by one unit predicts economic growth by 16.7

CHAPTER FIVE

SUMMARY, CONCLUSIONS AND RECOMMENDATIONS

5.1 Introduction

This chapter provides a detailed summary of findings from the previous chapter, the conclusions drawn from the study, suggested recommendations and the suggestions for further research.

5.2 Results of findings

Only money supply significantly affect the variations in GDP with the exception of interest rate. However, the effect is not statistically significant at 5% level of significance. That is to say as Money increases also GDP increases, however, increase in interest rate reduces GDP. This is because investments rely on the rate of interest, High interest rate makes borrowing expensive to the investor. Thus reduced investments leads to reduced GDP.

5.3 Conclusions

Monetary policy for any country plays a key role in its overall economic growth.  Monetary policy of Uganda now for some years has been largely supportive of the dual objective of promoting economic growth and price stability through adjustments of money supply and interest rate.

In this study although the variables indicate a positive impact, only interest rate is significant.

5.4 Policy Recommendations

The government and the central bank needs to avail the public with the funds to allow them to engage in the production of goods and services so as to accelerate economic growth.

Secondly, the government needs to develop policies that variably adjust interest rate with relative objective of stability and promoting investments.

Monetary policies should be used to create a favorable investment climate by facilitating the emergency of market based interest rate and exchange rate regimes that attract both domestic and foreign investments, create jobs, promote non-oil export and revive industries that are currently operation far below installed capacity. In order to strengthen the financial sector, the Central Bank has to encourage the introduction of more financial instruments that are flexible enough to meet the risk preferences and sophistication of operators in the financial sector.

For monetary policy to have a desired impact on the real economy and inflation, which is the fundamental objective of monetary policy, it is essential that changes in the short-term market interest rate should ultimately transform into changes in other interest rates in the economy (that is, interest rate changes are passed through to retail interest rates for loans and deposits), which then influence the overall level of economic activity and prices.

It is therefore prudent that in seeking to promote economic growth, Uganda’s banks should be committed to the mission of price stability, as well as improving the regulatory and supervisory frameworks to secure a strong financial sector for efficient intermediation.

5.5 Suggestions for further research

More studies should be carried out on other variables such as remittances, exchange rate and inflation

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Appendix

TABLE SHOWING

Log ms 1 st difference