Abstract
The Ghanaian Cedi has recently experienced persistent depreciation against its major trading partners. This paper investigates the contribution of inflation and monetary policy in this persistent depreciation. The paper makes use of the Autoregressive Distributed Lag (ARDL) and Bounds test of cointegration and the Toda and Yamamoto (1995) Augmented Granger Causality test to determine the long and short-run dynamics of the impact of monetary policy and inflation on exchange rates in Ghana, using data ranging from 1970 to 2017. The paper finds a short-run depreciation effect of contractionary monetary policy on the exchange rate, reflecting the exchange rate puzzle. The long-run results however show an appreciating effect. Inflation is also found to depreciate the currency both in the short and long-run. The causality tests also reveal a bi-directional relationship between the exchange rate and the inflation rate, while a unidirectional causal relationship exists between monetary policy and the exchange rate. The paper recommends that inflation stabilization policies should be prioritized in Ghana, as a means to curb the rising exchange rates. Improvement in terms of trade through export value promotion should also be given the needed attention as this is found to appreciate the currency in the long-run. Key words: Exchange rate, inflation, money supply, Autoregressive Distributed Lag (ARDL), cointegration, Ghana.
Highlights
The recent surge in free trade among countries has made the exchange rate one of the most significant macroeconomic variables that are widely studied in the literature
The short-run results show that the monetary policy rate, the terms of trade index, debt-servicing, money supply, and GDP growth rate have a significant effect on the exchange rate
To further determine the validity of the long-run model, a levels causality test is conducted between the main variables of interest in the model
Summary
The recent surge in free trade among countries has made the exchange rate one of the most significant macroeconomic variables that are widely studied in the literature. The theory suggests that countries with high-interest rates will have their currencies depreciating with increasing nominal interest rates, compared to their trading partners, reflecting differences in the expected inflation (Ebiringa and Anyaogu, 2014). High rates of inflation in a country are expected to lead to a depreciation of the currency of the country compared to her trading partners This theory, establishes a positive relationship between the exchange rates and the inflation rate. Ali et al (2015) study the impact of interest rates, inflation, and money supply on the exchange rate volatility in Pakistan using a Vector Error Correction Model (VECM), for monthly data from July-2000 to June-2009 They found that contrary to conventional thinking, higher inflation leads to the appreciation of the currency of Pakistan.
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