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IEA Discuss The Effect Of The Exchange Rate On Prices And Inflation
 
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30-Jul-2015  
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Recently, Ghana has been experiencing high rates of inflation and rapid depreciation of the cedi with adverse consequences for Ghanaians, especially the poor.

This has raised concerns among economists, politicians, policy makers, and businesses. Some business associations have called for a national debate on how to moderate the rate of depreciation of the cedi. A rapid rate of depreciation of the cedi increases the costs of imported capital equipment and raw materials creates uncertainty affecting businesses and their planning horizon.

While the call to take appropriate policy measures to stem the depreciation may be appropriate in view of the high rate of volatility and depreciation of the cedi, care also needs to be taken in order not to further destabilize the markets as happened in 2014. Policy must be based on evidence and distinguished between short and long run.

The empirical effect of changes in exchange rate or depreciation on prices and inflation have been examined. The results show that depreciation or changes in the exchange rate result in an increase in both prices and inflation even though the size of the pass-through to inflation ranges from 28.6% to 31% in the short-term and 17.6% to 23.8% in the long-run. Thus, when compared with the 5% size of exchange rate pass-through in most developed countries, the Ghanaian economy is vulnerable to fluctuations in exchange rate -- i.e. depreciation or appreciation of the cedi -- than most developed countries.

The short-term dynamics show that inflation in the country is self perpetuating in the sense that it reinforces further inflation. In fact more than 95% of the variance in inflation is due to its own innovations. Additionally, inflation is observed to be the chief source of depreciation of the cedi. The effect of inflation on the depreciation of the cedi is much stronger than the effect of depreciation on the country’s inflation. This is because 44.5% to 62% of the variance in exchange rate is due to innovations in inflation, while own innovations explain 29.7% to 38% of the said exchange rate variance.

Consequently, any attempt to arrest depreciation of the national currency must first be directed towards reducing inflation in the country. It must be emphasized that generally in a stable monetary policy environment, where central banks have pursued independent policy devoid of fiscal considerations and political pressures, exchange rate pass-through to consumer prices and
inflation tend to be low.

This has been the case in most developed countries, so the fact that ‘almost always and everywhere inflation is monetary phenomenon’ lead us to recommend that the Bank of Ghana undertakes policies to ensure a stable monetary policy environment in the country.

This will require that monetary authorities in the country stop monetizing the budget deficits to reduce the nation’s inflation. Once inflation is reduced, it will have lesser effect in reinforcing itself further, and that will in turn reduce inflation sparks which drive the depreciation of the cedi.

It should also be noted that the desirable monetary/economic policy goal so far as exchange rates is concern is stable exchange rate. This is because depreciation negatively affects importers and appreciation negatively affects exporters, so stabilizing the exchange rate benefits both exporters and importers, not to mention market participants in general.

Furthermore, we observe among other factors, that improvement in cocoa prices in the world market, which is determined abroad, is very important in reducing the country’s interest rates and strengthening the value of the cedi. Additionally, increase in the price of petroleum, which is also determined mainly abroad, has a significant effect in driving down (or depreciating) the cedi value.

It also plays an important role in driving up interest rates in the country, although contrary to expectation, it is not a chief source of fuelling inflation in the nation, although it remains inflationary.

Considering that the cedi is a fiat or paper money which is not a nominal anchor in the sense that it is not backed by gold or other precious commodity, an inflation target regime will provide a nominal anchor in the form of rules to dissociate the Bank of Ghana from acquiescing to monetize the government’s budget deficit.

In conclusion, we note that monetary policy is effective and can serve as a stabilizing policy instrument which can be employed to curb inflation and stabilize the national currency. However, we caution that when it is abused through excessive expansionary monetary policy shocks engineered by monetary authorities, it results in inflation, which then serves as the primary source of depreciation of the cedi in the country
 
 
 
 
 

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