Exchange Rate Policy and Inflation in Ghana

Abstract

The study aims at examining the relationship between exchange rate policy (adjustment) and inflation in Ghana. Using the Auto Regressive Distributed Lag (ARDL) method was used to compare the effects of devaluation on inflation in short run and long run periods in the economy of Ghana. The findings revealed that both the long run and short run devaluations of the cedi have been inflationary. The long run nominal exchange rate coefficient of -0.4052 means a 1% devaluation of the cedi will result in 0.4052% increase in the general price level.  Also the research shows that both the long run and the short run depreciation of the cedi have been inflationary. The long run co-efficient of -0.8244 means a 1% depreciation of the cedi will result in 0.8244% increase in the general price level in the long run. In the ECM model for fixed exchange rate the speed of adjustment of -0.5641 is quite high. The coefficient of -0.5641 implies that it will take less than 2 years for disequilibrium in the dynamic (short run) model to be restored. Also in the ECM model for flexible exchange rate the speed of adjustment is quite low. The co-efficient of -0.3126 means it will take over 2 years for disequilibrium in the dynamic model to be restored. The findings suggest that reduction in the value of the cedi, either through devaluation or depreciation has been inflationary. This is because devaluation under fixed exchange rate and depreciation under flexible exchange rate have the effect of increasing the prices of imported raw materials and capital equipment needed for production with the result of increasing cost of production and prices of final products. It is highly recommended that government pursue policies that will help stabilize the value of the cedi against the major currencies, so as to boost people confidence in the cedi and check inflation. In light of this, policies geared towards encouraging foreign exchange inflows need to be pursued vigorously. Government should also pursue policies to remove bottlenecks (rigidities) in production, so as to increase output and solve inflation.