Exchange Rate and Inflation Dynamics in a Resource Rich Setting: The Case of Zambia

Lionel Roger,Gregory Smith,Oliver Morrissey

doi:10.1111/saje.12236

Abstract

AbstractThis paper investigates the relationship between copper prices, the exchange rate and consumer price inflation in Zambia using a structural vector autoregression with quarterly data for 1995–2014 and a combination of sign and zero restrictions to identify relevant global and domestic shocks. The paper makes two contributions. First, it provides new measures of exchange rate pass through (ERPT), based on less restrictive assumptions than previous estimates, to show how changes in the value of the kwacha are reflected in changes in consumer prices (distinguishing food and non‐food inflation). Second, the ERPT is disaggregated to demonstrate that measured ERPT depends on the nature of the shock, with implications for policy responses. Although the price of copper is the most important driver of the exchange rate, the fluctuations it caused are associated with a low pass‐through of about 7% (consistent with a period of relatively low inflation). Exchange rate fluctuations caused by monetary shocks, in contrast, come with a pass‐through of up to 25% (and even more for food prices). A fast response by monetary authorities can mitigate the adverse effects of exchange rate shocks.

Highlights

As economies become more open to the rest of the world, understanding the effects of global shocks has become an important issue in macroeconomic policy management (Kenourgios and Padhi, 2012; Essers, 2013), and the literature has devoted particular attention to commodity price shocks (Charnavoki and Dolado, 2014; Drechsel and Tenreyro, 2018)
We present the basic impulse response functions of our main variables of interest, the exchange rate and inflation. These indicate a strong dependence of the exchange rate on copper, as well as a moderate effect of the exchange rate on price levels
The paper investigated the dynamics of the exchange rate and its interaction with consumer prices in Zambia in a structural VAR framework, identifying shocks with a combination of theoretically plausible zero and sign restrictions

Summary

Introduction

As economies become more open to the rest of the world, understanding the effects of global shocks has become an important issue in macroeconomic policy management (Kenourgios and Padhi, 2012; Essers, 2013), and the literature has devoted particular attention to commodity price shocks (Charnavoki and Dolado, 2014; Drechsel and Tenreyro, 2018). The aim of this study is to shed light on the interrelationship of export commodity (copper) prices, the exchange rate, and consumer price inflation in the case of Zambia. The country has high dependence on one export commodity, copper, the price of which has experienced large fluctuations, and, in 1994, was one of the first of the thirteen SSA countries that had adopted floating exchange rate regimes by 2016 (IMF, 2016). Open commodity-dependent economy and regularly faces challenges from supply shocks. These include shifts in the global copper price, rain-fed agricultural outputs, hydro-electric generation output, and the global price of fuel. As the production of copper increased and the economy prospered, much larger foreign exchange inflows followed

Objectives

Methods

Results

Conclusion