Modelling exchange rate volatility in Zambia

Abstract

The sources of volatility in the real and nominal Zambian kwacha exchange rates with respect to the currencies of the major trading partners are examined from January 1964 to December 2006 using the GARCH method. The results reveal that exchange rates are characterised by different conditional volatility dynamics based on the three GARCH models employed. Principal components analysis is used to generate new exchange rate volatility series that capture the common underlying pattern in the estimated conditional variances, as alternative measures of exchange rate uncertainty. In terms of the factors accounting for the volatility in the exchange rate, the switch from fixed to the flexible exchange rate regime had a significant positive effect on the conditional volatility of all exchange rates. In addition, while both monetary and real factors account for the observed volatility in exchange rates, the former had a relatively larger effect than the latter, thus highlighting the important role of monetary policy in exchange rate management. In the short-run, increases in exchange rate volatility are underpinned by money supply due to the existence of nominal rigidities. Thus, a steady growth rate in money supply is recommended to reduce volatility. In the medium to long-term, policies aimed at diversifying trade and integrating the economies of Zambia and her major trading partners will further reduce volatility in kwacha exchange rates as openness has a relatively stronger positive effect among the real factors examined.

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