Macroeconomic policy co-ordination lessons for Kenya

It provides a compass to predict, advise and harness a country’s macroeconomic opportunities aimed at maximising economic growth performance and employment in the medium term.

IS-LM stands for investment-savings, liquidity-money. AS/AD stands for aggregate supply and aggregate demand. It baffles most people, but it makes a lot of sense in a market economy, especially interacting markets.

In combining detailed fiscal and monetary policy, a country can determine the direction of GDP growth as well as interest rates. The appropriate policy mix reaps new output gains from potentials as policy cuts spending or expands it, in concert with monetary policy that is similarly tightened.

All the better if the economy has an GDP output gap — producing under capacity. A policy mix in the short-to-medium run will pull out a miracle of growth with negligible inflation.

The thinking and implementation also helps knowledgeable citizens to sidestep simplistic economic fallacies. For example, some might preach the fallacy that because savings must equal investment, government spending cannot lead to a rise in growth of GDP despite an output gap. It does, if the policy mix is appropriate under IS/LM and AS/AD, which provides headline answers to most questions of direction of economic policy.

While not a rulebook for blind decisions, countries ignoring the IS/LM, and AS/AD system pay heavily in economic misery for their citizens. A key modern lesson is the Euro zone. When in the face of the last financial crisis of 2008-2009, it took austerity (spending cuts) while the monetary policy of the European Central Bank was also contractionary.

The double policy of contraction sent economies such as Portugal, Italy, Greece and Spain (PIGS) into a free fall. They have yet to recover the disastrous policy mix.

In contrast, the United States took expansionary fiscal policy while reviving failed banks with easy money (to the extent of the unconventional quantitative easing that involved buying bonds from the banks in exchange for money that banks could on-lend to revive private sector investment).

Leave the IS/LM and AS/AD mechanics for another day. This article sheds light on its relevance to the current stance of the Central Bank of Kenya’s Monetary Policy Committee (MPC) versus the position of the Treasury, and on why CBK’s latest decision could trigger spectacularly better economic policy-making and debates.

Any economic analyst following the historic CBK policy outline towards the Treasury in May in a press conference would be rewarded with hope for Kenya’s economic policy going forward. It could start an era of rational tracking of macroeconomic policy coordination that combines fiscal and monetary policies for optimal growth prospects.

The CBK discussion explained the latest MPC key indicators that showed an estimated GDP output gap; mild inflation expectations; the shilling trending on strengthening; a diversifying menu of exports with favourable volumes and prices; a falling premium on (rising) foreign direct investment inflows; and vibrant accelerating Diaspora remittances.

READ: Why Kenya’s future lies in rethinking the growth path

This led the MPC to take a forward position of easier monetary policy (lower interest rates) against a tighter fiscal policy already forced on the Treasury as spending cuts become inevitable. The policy mix supports a favourable climate of growth expected in the medium term.

Without CBK invoking acceleration of the economy through monetary policy, the much valued GDP output gap, medium-run GDP growth, new jobs, wealth creation and confidence would be lost. In fact, the economy would shrink in theory if both the CBK and Treasury took a contractionary stance.

What does the appropriate policy mix mean? From a menu of essentially four options economists chose the one appropriate to prevailing economic circumstances.

A tight fiscal policy/easy monetary policy mix is appropriate when easing government from a high deficit and where monetary policy is used to offset reduced growth momentum caused by cuts in fiscal spending.

The policy mix allows for growth of output to continue on target, but mainly shouldered by the private sector. It is thus a “switching” policy mix whose main effect is to shift output momentum from government to the private sector.

Mbui Wagacha is an economist.