TABLE OF CONTENTS
DECLARATION……………………………………………………………………………………………. 2
ACKNOWLEDGEMENT……………………………………………………………………………….. 3
ABSTRACT…………………………………………………………………………………………………… 7
CHAPTER ONE: INTRODUCTION……………………………………………………………… 12
CHAPTER TWO: LITERATURE REVIEW……………………………………………………. 21
Overview of Chapter………………………………………………………………………………….. 21
CHAPTER THREE: METHODOLOGY…………………………………………………………. 32
Overview of Chapter………………………………………………………………………………….. 32
CHAPTER FOUR: RESULTS……………………………………………………………………….. 41
Overview of Chapter………………………………………………………………………………….. 41
- Descriptive Statistics…………………………………………………………………… 41
CHAPTER FIVE: CONCLUSION AND RECOMMENDATIONS………………….. 59
BIBLIOGRAPHY………………………………………………………………………………………… 63
LIST OF FIGURES
Figure 1: Ghana Historical Inflation Rates………………………………………………………… 14
Figure 2: USD/GHS Historical Exchange Rate………………………………………………….. 17
Figure 4.1: Graph showing the distribution of monthly Money Supply…………………. 44
Figure 4.2:Graph showing the distribution of log transformed Money Supply……….. 44
Figure 4.3: Graph showing the distribution of monthly Inflation Rate………………….. 45
Figure 4: Graph showing the distribution of log transformed Inflation Rate………….. 45
Figure 4.5: Graph showing the line distribution of the response and explanatory variables 47
LIST OF TABLES
Table 4.1: Summary statistics of macroeconomic variables………………………………….. 41
Table 4.2: Results of the Shapiro-Wilk (1965) Test for normality…………………………. 43
Table 4.3: Results of correlation matrix of all the independent variables……………….. 46
Table 4.4: Critical Values for Dickey-fuller t-distribution……………………………………. 48
Table 4.5: Results of the Augmented Dickey-Fuller Stationarity Test…………………… 49
Table 4.6: Results of the Akaike Information criteria (AIC) estimation………………… 50
Table 4.7: Result of Test for Co-integration Rank………………………………………………. 51
Table 4.8: Results of the Estimated ADRL……………………………………………………….. 53
Table 4.9: Summary of Breusch-Pagan Test for Heteroskedasticity……………………… 57
- 1.1 BACKGROUND
The relationship between exchange rate and inflation is a very significant one as they are both relevant instruments of macroeconomic performance. Inflation can be defined as a persistent rise in price levels in an economy (Mankiw, 2011).
The relationship between inflation and growth is complicated and may differ in the short run compared to the long run. In the short-run there is the well-documented and negative Phillips curve relationship between inflation and unemployment implying that higher levels of employment are consistent with job growth and economic growth (Osiakwan & Armah, 2013). In the longer run, lower levels of inflation are probably beneficial as it may correspond with growth, employment and debt settlement. Extremely high levels on the other hand (typically called hyper- inflation), can be detrimental to the development of an economy in either run.
Hyperinflation devalues the currency of the country, which subsequently corrodes the purchasing power of consumers and in turn lowers spending. Cost of living is increased as a result of high inflation rate, and this increase can possibly decrease standard of living if there is no proportional increase in income (Osiakwan & Armah, 2013). This affects other stakeholders like firms and the government because hyperinflation leads to a permanent reduction in per capita income (making them unable to settle debts), as well as fall in investment and production efficiency (Osiakwan & Armah, 2013). Hence when price levels are relatively stable, monetary policymakers are said to be doing a good job (Sobel et al., 2006)
Exchange rate on the other hand is the value of a country’s currency in terms of another country’s currency (Mankiw, 2011). Exchange rate can be broken down into two concepts; real and nominal exchange rate. Nominal exchange rate is the relative price of two currencies; that is, the price of a foreign currency expressed in terms of a home or domestic currency (Feenstra & Taylor, 2014). Hence, say the nominal exchange rate between the dollar and the cedi is six, then one dollar would purchase six cedis. The real exchange rate, however, looks at the price of foreign goods relative to the price of domestic goods. For a home country, a high normal rate may give the impression of their currency will be able to afford several foreign goods, nonetheless, it is the real exchange rate that determines that. This proves that besides prices of domestic goods, imports and exports prices are also key drivers of growth and development.
The forces of demand and supply of money determine exchange rates. This concept is well explained by the concept Interest Rate Parity. The Interest Rate Parity looks at the equilibrium state of the relationship between exchange rate and interest rate of two countries. When deposits of all currencies conceive an equal expected rate of return, then the foreign market is said to be equilibrium. The condition with which any two currencies expected returns on deposits correspond when measured in the same currency is known as the interest parity condition. This infers that probable holders of foreign currency deposits see them as assets that are equally advantageous, given that expected rates of return are equal. Hence, if for instance, the expected return on the British Pound deposits is five percent greater than that on the Ghanaian cedi deposits, individuals would not be interested in holding Ghana cedi deposits, creating an excess supply of the Ghanaian cedi and on the other hand, excess demand for British Pound on the foreign exchange market (Krugman et al., 2012).
In monetary economics, one of the main issues is the relative benefits of various methods for achieving price stability (Hernandez-Verme, 2004) and in many open economies, consideration of this problem involves weighing out fixed and flexible exchange rate regimes. This was affirmed by one Obadan in 2007, who further explained that choosing the suitable exchange rate regime that would favour positive exchange rate levels is always a crucial decision for open economies because of effects like the standard of living, income distribution, balance of payments and others (Obadan, 2007). In 1976, Dornbusch stipulated that when exchange rate is defined as the rate of change between the currencies of two countries, an increase in exchange rate will lead to a rise in general price levels, and when the exchange rate falls, specifically the home country’s currency appreciates, then price levels are expected to decline as well (Dornbusch, 1976). In developing countries, the inflation rate has been double that of advanced countries since 1980 (Obiekwe & Osabuohien, 2016), emphasizing the need to implement real exchange rate policies that would take inflation into account. (WHY HOW).
