Exchange rate and macroeconomic stability: Determinants and Pass-through effects

Since the liberalization of the foreign exchange market in the mid-1980s (as a component of the broad structural adjustment and economic reforms programmes), the rate at which a unit of Ghana’s currency (the cedi) exchanges for the US dollar and the currencies of her major trading partners has seen substantial swings. On the average, the cedi has depreciated against the US dollar since the adoption of managed floating exchange rate regime in 1986. For instance, at the time that Ghana redenominated its currency on July 1, 2007, about 90 pesewas could exchange for a dollar, while one requires something in excess of three cedis to obtain a dollar as at the end of November 2014. This fact suggests that from mid-2007 to November 2014, the cedi has depreciated against the dollar in excess of 300%. The objective of this paper is to examine both real and nominal exchange rate dynamics in Ghana and their implications for domestic price stability. In particular we identify the sources of exchange rate movements and estimate the degree of exchange rate pass-through effect on consumer price inflation.

A study of exchange rate dynamics and their relationships with economic fundamentals and shocks (real and nominal shocks) in Ghana is motivated by the following reasons. First, both the real and nominal exchange rates play a key role in the international transmission mechanism and therefore changes in their dynamic behavior have important consequences for a small open economy like Ghana. Second, changes in the nominal and real exchange rates affect foreign currency denominated assets and liabilities, with dare consequences for the stability of financial system. For instance, with the government of Ghana’s issue of international (Euro) bond, changes in the nominal and real exchange dynamics have implications for debt servicing and eventual payment of the principal on maturity. Third, changes in nominal exchange rate dynamics have repercussions on domestic price stability. The knowledge of the precise magnitude of the pass-through effect is therefore important for the conduct of monetary policy under inflation targeting regime. Last but not least, the study will provide a clear understanding on the relative importance of various kinds of shocks (monetary, demand, and supply) on both the exchange rate dynamics and the pass-through effect. This will aid policy prescription as it will highlight whether demand side or supply side policies or a combination are likely to be more effective in managing exchange rate movements and pass-through effect on inflation.

In line with the above motivation, there has been a number of studies on the sources of real exchange fluctuations since the collapse of Bretton Woods which saw many countries shunning fixed exchange rate regimes to the adoption of different forms of floating regimes (see for instance: Mussa, 1982, 1986; Stockman, 1987, 1988; Huizinga, 1987; Cambell and Clarida; 1987; Meese and Rogoff, 1988; Clarida and Gali, 1994; Chowdhury, 2004; Hamori and Hamori, 2011; Mumtaz and Sunder-Plasssmann, 2012).

In this paper, we follow Clarida and Gali (1994) and identify the sources of real exchange dynamics using structural vector autoregression (SVAR) approach. In addition to estimating the fixed-coefficient SVAR model, as done in Clarida and Gali (1994), we also examine dynamics of the real exchange rate using time-varying SVAR model. The augmentation of the analysis in this paper by the time-varying structural VAR model is motivated by the following, as argued by Muntaz and Sunder-Plassmann (2012). First, Ghana has a history of both fixed and managed floating exchange rate regimes and hence the real exchange rate might have behaved differently under these regimes. Second, Ghana has moved away from monetary targeting to inflation targeting regime. Since both inflation and money supply (nominal shocks) have implications for both the nominal and real exchange rate, the dynamics of the real exchange rate might differ under these monetary policy regimes. Third, elections and political regimes in Ghana have had significant impact on the relative tightness of fiscal and monetary policies and the degree of harmony between the conduct of fiscal and monetary policies. There is thus the likelihood for the dynamics of the real exchange rate to behave different under different regimes and elections cycles. If these potential sources of time-variation in the real exchange rate dynamics is significant (in statistical sense), then the estimates from the fixed-coefficient SVAR model could be biased. In order not to impose any structure on the data generating process (DGP), both the SVAR and time-varying SVAR are subjected to various model diagnostics testing to assess the relative performance in fitting the data.

This study makes and important contribution to both the academic literature and the conduct of monetary policy in Ghana and other developing countries. First, we do not know any recent study on Ghana that has applied time-varying SVAR model to examine the sources of exchange rate fluctuations in Ghana and explores the implications of exchange rate pass-through effects on consumer price inflation. Thus, the evidences on the sources of exchange rate movements reported in this study are more robust and reliable than reported in previous studies. Second, though Acheampong (2004), Sanusi (2010) and Loloh (2014) have reported some estimates on the exchange rate pass-through effects, these studies ignored the question of what causes fluctuations in the Ghanaian cedi. In this paper, we explore both the effects of economic fundamentals and structural shocks in accounting for the sources of exchange rate fluctuations in Ghana and pass-through effects on consumer price inflation and the policy implications thereof.