The demand and supply 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 both the demand and supply of money. Previous Studies used the 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 ATMs card holders use their cards in doing transactions. The studies also ignored the supply side of money in the financial sector. 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 and Supply in Kenya. Specifically, the study sought to: investigate the effect of the volume of M-pesa transactions on money demand, determine the effect of the volume of ATMs transactions on the money demand, investigate the effect of the volume of M-pesa ransactions on money supply and determine the effect of the volume of ATMs transactions on the money supply. 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. This study was based on Keynesian Theory of Demand for Money and Friedman Quantity Theory of 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 Cointegration test was conducted and the results showed cointegration 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 and supply 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 such as M-pesa to control the amount of money demand and in the economy due to reduced M-pesa transactions. Government of Kenya should also regulate the amount of transactions done through the ATMs. This will reduce the demand and supply for money as a result of reduced transactions hence controlling money demand and supply in the economy. This will 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.

According to Aspara, et al (2012), financial industry has been immensely transformed by changes in regulation, globalization and digitalization. These changes have highly increased the attention to customer experience and moved the financial industry from using technology only as facilitator of internal processes to being a crucial component in making transactions. Hence, in today’s world where technological innovation can hardly be separated from other forms of innovation, including financial, it becomes even more important to understand how it impacts money demand and supply in Kenyan. 

According to Shirakawa (2011), innovation in the financial industry has been an ongoing process with even more recent innovations such as bank teller replacement by ATM’s and plastic cards, which are becoming increasingly more important than cash. 

Financial innovation has been defined as “...the act of creating and then popularizing new financial instruments as well as new financial technologies, institutions and markets...” (Tufano, 2003,). According to Tufano (2003), product innovations are evidenced by new financial instruments while process innovations embody innovative means of distributing the financial products, executing or pricing the transactions. Financial innovations, therefore, entail new products, new services, new production processes and new organizational forms Frame & White, (2004). These financial innovations are seen as contributing to financial performance in Kenyan market. 

The origin of economic thought which sees innovation as a determinant of economic performance is credited to Schumpeter (1934), whose study fronts innovation as its landmark initial contribution to economic literature. Nevertheless, there is compelling evidence that financial innovations generate returns to innovators and can positively affect the entire economy Lerner & Tufano, (2011). The benefits, according to the authors, are generated when households are able to have investment and consumption choices in addition to lowering the cost incurred in raising and deployment of funds. Consistent with Lerner and Tufano’s (2011) findings, emerging financial innovations, especially in mobile money have propelled Kenya to the global limelight and aroused immense intellectual curiosity in the research community. In order to appreciate the context of this study these developments need to be put into proper perspective the use of electronic card payments systems in Kenya has been there for decades. The most commonly used electronic card payments include credit cards, debit cards, prepaid cards, charge cards and Automated Teller Machine (ATM) cards. The electronic payment card market has been dominated by commercial banks and merchants for years. However, the introduction of mobile money in year 2007 in Kenya by the leading mobile phone service provider Safaricom has dramatically altered the electronic payment landscape in the country. Safaricom launched the world-acclaimed mobile money transfer service M-pesa (meaning mobile money; ‘Pesa’ means money in Kiswahili, one of Kenya’s national language) which has won numerous awards for its role in improving financial access and financial inclusion in the country. The model has been adopted by the other mobile phone service providers in the country and commercial banks, leading to an unprecedented mobile money transaction growth in Kenya. The mobile money services sector in Kenya is one of the most advanced in the world (EIU, 2012). The financial innovation has significantly lowered the cost of money transfer in Kenya and increased the degree of financial deepening and financial inclusion. The country has robust mobile money agent network and adequate regulatory support from the Central Bank of Kenya. According to Demirgüç-Kunt and Klapper (2012), Kenya is Sub-Saharan Africa’s regional leader in mobile money. The emergence of mobile phones is seen as central to the development of many electronic payment innovations Ingenico, (2012). Additionally, Al-Khouri, (2014) observed that advancements in internet technology as well as mobile phones subscriptions have significantly fueled the rise in electronic payments. The low penetration of formal financial services coupled with high rate of mobile subscription has led to rapid growth in mobile payments Capgemini & RBS, (2013). This development in mobile payments has resulted in a situation where the number of customers, number of transactions and the value of mobile payments have substantially dwarfed comparative figures for the combined usage of ATM cards, credit cards, charge cards, POS machines, prepaid cards and debit cards (CBK, 2015). Eight years down the line, mobile payments are the dominant cash transfer options in the country (CBK, 2015). Interestingly, although significant studies in the field of financial innovations are available, most of the studies have concentrated on financial products in developed countries (Lerner & Tufano, 2011). In effect, emerging financial innovations widely used in developing countries in general and Kenya in particular have been given a wide berth. On the other hand, where they have been studied, the emphasis has been on providing descriptive statistics (Jepkorir, 2010) 

Financial Innovations in Kenya 
Kenya has experienced phenomenal growth in financial innovations in the last ten years and some of these innovations have positioned the country as a global leader especially in mobile money innovations (Demirgüç-Kunt & Klapper, 2012). The country’s Sub-Saharan Africa leadership in technological innovations has served to cement Kenya’s leadership in the technologically driven and technology dependent financial innovations. The regulatory framework in the banking and telecommunications sectors strongly supports these innovations. 

Statement of the Problem 
It is important to understand the effect of financial innovation on money demand and supply in Kenya since its instability is a major cause of economic crises. This study aimed at investigating empirically the effect of financial innovation on money demand and supply in Kenya. Earlier studies used the number of M-pesa and the number of ATMs as a measure of financial innovation. This might lead to incorrect results since not all people with registered M-pesa accounts and ATM cards do the transactions using them. Some might obtain the ATM card but does not do any transaction using it. The same applies to some people with registered M-pesa accounts. In addition, most studies have been biased towards money demand ignoring money supply side yet it is also affected by the financial innovation through money multiplier and subsequently affecting money supply and monetary policies. A good economy is the one with Money demand and supply at equilibrium. Distortion of either money demand or money supply leads to negative effects such as inflation and ineffective monitory tools. It is therefore important to consider both money demand and money supply and how they are affected by financial innovation. 

This study sought to overcome the above challenges by using the Volume of M-pesa transactions and volume of ATMs transactions to capture the real effect of financial innovation on money demand and supply in Kenya. The study also considered both money demand and supply on Kenyan economy.

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Item Type: Kenyan Topic  |  Size: 55 pages  |  Chapters: 1-5
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