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Dynamic inter-links among the exchange rate, price level and terms of trade in a managed floating exchange rate system: The case of Ghana

Dynamic inter-links among the exchange rate, price level and terms of trade in a managed floating exchange rate system: The case of Ghana

Paper No. RP_141 | By Vijay K. Bhasin |  July 2004 | English
This study examined the dynamic interrelationships among domestic price level, nominal exchange rate, terms of trade of cocoa, bank rate, domestic credit and foreign exchange reserves using the cointegration, vector error correction (VEC) and vector auto regression (VAR) approaches. The cointegration analysis confirms the presence of three economically interpretable stable long-run relationships among the relevant variables. The speeds of adjustment for the foreign exchange market, the interest market and the market for cocoa are relatively higher than the speeds of adjustment for the markets of non-tradeables and domestic credit. The determinants of domestic inflation in the short run are bank rate, foreign exchange reserves, terms of trade of cocoa and government expenditure. For the short-run depreciation of the local currency, the determinants are the domestic price level, terms of trade of cocoa and foreign exchange reserves. For terms of trade of cocoa (which proxies collusion) in the short run, the determinants are domestic credit, foreign exchange reserves, terms of trade of gold and the price of petrol. The effects of monetary and terms of trade shocks are generally transmitted to the domestic price level, terms of trade of cocoa, and nominal exchange rate. The determinants of bank rate in the short run are the domestic price level, domestic credit and foreign exchange reserves. For domestic credit in the short run, determinants are the domestic price level, nominal exchange rate, bank rate, foreign exchange reserves, government expenditure and terms of trade of gold. The determinants of foreign exchange reserves in the short run are the nominal exchange rate, terms of trade of cocoa and price of petrol. From these results it is observed that the monetary authorities could control the domestic rate of inflation by reducing the relatively high bank rate. In order to arrest the continuing depreciation of the local currency, the Bank of Ghana could sell more foreign exchange in the foreign exchange market. Because the pass-through effect from the domestic price level to the nominal exchange rate is neither complete nor instantaneous, the Bank of Ghana should try to implement a consistent bank rate policy in accordance with the exchange rate intervention policy. Moreover, the Bank of Ghana should try to follow a consistent sterilization policy through domestic credit with respect to the nominal exchange rate, and, by arresting the rate of depreciation of the local currency, could solve the problem of excess liquidity. The Government of Ghana could collude with the other major producers of cocoa in order to improve its terms of trade of cocoa, and the Bank of Ghana should ensure a consistent sterilization policy through foreign exchange intervention with respect to the terms of trade of cocoa.

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