Foreign Exchange Volatility Under Inflation Targeting in Uganda: An SVAR Approach

Abstract

In July 2011, Uganda reformed its monetary policy framework citing “challenges of macroeconomic management and the rapid growth and diversification of the financial system” MPC July (2011). This paper reviews the effect of foreign exchange interventions on the inflation target policy in Uganda, with the aim of including a target in the framework. By including exchange rate within the model, the volatilities in the exchange rate can be captured at an early stage and therefore are less costly in terms of the depression (below potential output) that is foregone by targeting inflation alone. In the most recent inflationary episode, the economy’s output above potential reached the country’s historical lowest and hence cannot be ignored. An SVAR approach reveals that exchange rates did not have significant effect on changes in both inflation and output in the first four quarters accounting for only 3.8% and 0.14% variations respectively. Therefore there is no need to change from exchange rate interventions to fixing a target exchange rate band in Uganda. Furthermore the exchange rate should be left to float in the midst of the inflation rate targeting to avoid the risk of conflicting targets. Another interesting revelation is that although the central bank highlighted the depreciating exchange rate as one of the main causes of inflation in the country, the results indicate that the causes could be other factors such as increased aggregate demand or reduction in aggregate supply.