The effect of monetary policy and inflation on the exchange rate: A case study of Ghana

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.

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