Monetary Policy, Exchange Rate Fluctuations and Trade Balance: The Sierra Leone Experience

Abstract

This study investigates the effect of monetary policy and exchange rate fluctuations on trade balance in Sierra Leone using the autoregressive distributed lag (ARDL) bound testing framework with annual times series data covering the period 1980 to 2020. The results from the unit root test reveal a combination of I(0) and I(1) series, while the bound test result confirms there is cointegration, which validates the existence of a long-run relationship. The long run results reveal that, money supply, real effective exchange rate and real GDP are the main determinants of trade balance in Sierra Leone. The findings indicate that money supply and real effective exchange rate have negative impact on trade balance, whilst a positive relationship exists between real GDP and trade balance. Furthermore, results from the beta coefficients confirm that real GDP has the greatest effect on trade balance in the long run, followed by real effective exchange rate, whilst money supply has the least effect. Also, the short run ARDL error correction model results reveal that real GDP, government expenditure and foreign direct investment are the main determinants of trade balance in Sierra Leone. The diagnostic result posits that about 85% of the variation in trade balance is explained by the independent variables, as evident by the R-square value of 0.85. The CUSUM and CUSUMSQ tests indicate that the model is stable. A major policy recommendation is to maintain exchange rate stability consistent with its equilibrium path, and ensure that money supply growth is in tandem with domestic demand for non-tradeable goods and services.