The Monetary Approach to Exchange Rates Putting Everything Together.
OF EXCHANGE · Flexible Price Monetary Approach ... IMF/World Bank formula chiefly in the areas of...
Transcript of OF EXCHANGE · Flexible Price Monetary Approach ... IMF/World Bank formula chiefly in the areas of...
A LONG-RUN MONETARY MODEL OF EXCHANGE RATE DETERMINATION FOR GHANA
Justin Tevie
Submitted in partial fulfillment of the requkements for the degree of Master of Development Economics
Dalhousie University HaMax, Nova Scotia
December, 1996
O Copyright by Justin Tevie, 1996
Nauonai uurïry of Canada
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Dedication
To my parents
Table of Contents
Dedication List of Figures List of Tables Abstract Acknow1edgment
Chapters
1.0 Introduction
2.0 Adjustment Programmes and the Ghanaian Economy
2.1 Economic Adjustment Programmes Economic Recovery Programme Exchange Rate Policies
2.2 Financial Structure 23 Economic Review (1983 - 1994)
Monetary hdicators Exchange Rate Gross Domestic Product Balance of Payment, hports and Exports
2.4 Conclusion
3.0 Monetary Theory of Exchange Rate Determination
3.1 Theories of Exchange Rate Determination 3.2 Monetary Models of Exchange Rate Detemination
Flexible Price Monetary Approach Sticky Price Monetary Approach
3 3 The Sticw Price Mode1 and Ghana's Long-Run Exchange Rate Uncovered Interest Rate Parity Purchashg Power Parity Money Demand Fmction
3.4 Conclusions
4.0 Data and Mode1 Estimation
4.1 Data Description 4.2 Order of Integration of Ghaua-US Series 4.3 Engle-Granger Two-Stage Procedure 4.4 Johamen Procedure
5.0 Conclusion
Bibliography
List of Figures
3.1 Sequentiai Chow Test for Money Dernand Function
3.2 Forward Recursion CUSUMSQ for Money Demand Fmction
4.1 Logarithmic Dineremes of Levels of Macroeconornic Senes
4.2 Sequentiai Chow Test for ECM
4.3 Forward Recursion CUSUMSQ for ECM
List of Tables
Monetary Indicaton
Exchange Rate and Real GDP Growth
Balance of Payment, Exports and Imports
Uncovered Interest and Real Interest Dif5erential:Ghana-US
Augmented Dickey-Fuller Unit Root Test Results
PhiUips-Perron Unit Root Test Resuits
Engle-Granger Test for Cointegration
Asymptotic Critical Values for Cointegration Tests
Error Correction Mode1 Estimates
Johansen's Likeiihood Ratio Test
Abstract
The Iong-nui relationships between the Ghana-US bilateral exchange rate and relative money
supplies, real incornes, and interest rates are exmineci for the penod 1983-1 994 based on the
sticky pnce monetary model of exchange rate determination. The Engle and Granger, and
Johansen cointegration methodologies are employed. As a coroliary of the former
methodology, the cointegrated system is reduced to a simple error correction model (ECM).
The ECM is subjected to a battery of diagnostic tests such as stability, parameter constancy,
heteroskedasticity, and autocorrelation, and pefioms reasonably well. The ECM M e r
shows that money supply and interest rates are unimportant in the short-run, but the Bank
of Ghana should account for them when fomulating Long-nui exchange rate policies. The
finding of one cointegrating vector is evidence that the model is a representation of long-nui
equilibnum between the exchange rate and the monetary variables in Ghana.
Acknowledgement
1 am grateful to Professors Kuan Xu, Taian Iscan and U.L.Gouranga Rao for helpful comrnents and suggestions. 1 wodd also like to thank Mr. Dennis Canterbury for his insights and advice. AU errors are entirely my responsibility.
Chapter 1
Introduction
The Ghanaian economy experienced severe crisis during the 1970s and early 1980s. The
main contributory factors for the crisis emanated fiom: a fixed and highiy over-valued
exchange rate; large deficits in the Governments budget; and inappropriate monetary
expansion which resulted into inflationary pressures, and imposition of price controls over
a wide range of goods. A prominent feature of the economic crisis was the inappropriate
policy measures with respect to the exchange rate. The government of Ghana pursueci a k e d
exchange rate policy in the 1 WOs, which in part caused the over-valuation of the Ghanaian
currency, and thereby a dramatic decline in exports. The fa11 in exports which resulted in a
decline in foreign exchange earnings had significant eEects on the entire Ghanaian economy.
This policy was also partly responsible for lower levels of production and productivity,
increased poverty, and excessive govemment intervention in the economy.
In 1983 the Ghanaian government was left with Little choice but to hplement a
structural adjutment and economic recovery programme, under the guidance of the
IMF/World Bank formula chiefly in the areas of exchange rate adjustments, and reduction
of public sector deficits. The exchange rate policy of the adjustment and recovery
programmes dowed for the value of the Ghanaian currency to be detemiined by market
forces. But ever since the floating exchange rate policy was implemented in 1983, as s h o w
2
by the economic statistics, output, and balance of payments have experienced wide
fluctuations, and inflation has been consistently high.
The problem is that there was an apparent absence of a valid fbrnework for analyzing
exchange rate movements in Ghana This problem was refiected and reinforced by the
Ghanaian monetary authorities use of what could be termed an ad hoc approach to
formulating exchange rate policy. An ad hoc exchange rate approach is denned as one which
draws on several aspects of exchange rate theories without an explicit reliance on any
pxticular theoreticd mode1 appropriate to Ghana's economic conditions. This means that
exchange rate policy in Ghana is formulated on an eciectic basis by drawing on different
aspects of the variety of exchange rate theories identifïed in the literature. For example, in
order to improve Ghana's extemal accomt, the government devalued the Cedi in 1983. This
was essentially a balance of payment (BOP) measure. The use of this approach was
discontinued by 1986 because the initial over-vaiuation of the Ghanaian currency was
rectifed. In the p s t 4 986 period, the government employed a somewhat monetax-y approach
through the use of interest rates and innuencing the money supply. The objective was
essentidy to stabilize the value of the currency. But it is possible for both devaluation and
interest rate increases to have opposite effects on the value of the currency, i.e., while
devaluation increases the home currency price of foreign currency, interest rate increases
may cause it to fd. Accordingly, it is imperative that the authorities select a fhmework most
appropriate to Ghana's economic environment because this will enable them to better plan
for the future, and also to maintain some stability in the value of the Ghanaian currency.
Clearly, there is no single exchange rate mode1 which wili provide a panacea for al1
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the problerns of long-run exchange rate determination in Ghana It can be argued that in
mderdeveloped economies like Ghana, the monetary authorities need to select a model of
Iong-nin exchange rate determination which is suitable to their economic conditioos. The
sticky price monetary model is a likely candidate. The ad hoc approach of the Bank of Ghana
was not very helpful for solving or alleviahg the country's pressing problems of exchange
rate management because the Bank's approach did not allow policymakers to search for a
model suitable to Ghana's economic environment. It wiii be shown below that such a
situation had devastating consequences for the Ghanaian economy. For instance, after more
than a decade of the ad hoc approach, the exchange rate, and pnces have both increased by
more than 1000%.
The objective of this thesis is to axertain whether the sticky price monetary model
can uncover any meaningful long-nui relationships between the Ghana-US bilateral
exchange rate, and relative money supplies, interest rates, and real incornes. Specincally, the
thesis examines the sticlq price monetary model for the Ghana-United States exchange rate
determination, c o v e ~ g the period 1983-1994. This model is proposed as one possible
approach that the monetary authorities in Ghana can use to formulate long-run exchange rate
policy. The thesis proposes that the use of this model will not ody address the problem of
"ad hocegt1 in inhanaïan exchange rate management, but will also provide policymakers with
a more appropriate fkmework for policymakhg purposes.
The thesis suggests that the sticky pnce monetary model offers a better explanalion
of the long-m relationships between the exchange rate, and the monetary variables, than
does the current ad hoc approach employed by the Bank of Ghana The sticky price monetary
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mode1 for Ghana is proposed and appiied Understanding the overd behaviour of the
monetary variables is crucial to long-run exchange rate management. This wili ultimately
lead to the formulation of policies that wiii stimulate economic growth. This study is
conducted within a monetary fiamework An empirical methodology is employed based on
data obtained through archivai and Library searches, and officiai poiicy documents supplied
by the Government of Ghana
The organktion of the remainder of this thesis is as follows. To underscore the
economic decline associated with the ad hoc approach used by the Ghanaian Central Bank,
a description of the Ghanaian economy is provided in chapter 2. In chapter 3, the relevant
literature on the monetary models of exchange rate determination is reviewed, and the
relative strengths and wealmesses of the monetary models are examined within the context
ofthe Ghanaian econorny. The statistical properties of the data, the estimation of the sticlq
price monetary mode1 for Ghana, and the empirical evidence are presented in chapter 4. In
the £inal chapter, the conclusions are summeed.
Chapter 2
Adjustment Programmes and the Ghanaian Economy
Since independence in 1957, and particdarly during the 1960s, the economy of Ghana
witnessed relative prosperity mainly due to high export prices for cocoa, gold, and tirnber,
and a fairly stable political and macroeconomic environment mstry of Finance &
Ewnomic Planning (MFEP) 199 11. Real GDP increased by an average of 3.4% per annum
in the period of 1957-73 (ibid.1991). With a population growth of 2.2% per annum in the
same penod, the annual average growt. of real GDP per capita was 1.2% (ibid.1991).
Merchandise exports increased by 3.5%, while imports decreased by 3 -3 % (ibid. 1 99 1). For
the same period, the Consumer Price Index (CPI) inflation rate averaged 6.3% per annum
(ibid.1991). But fiom 1974 to 1982 however, the Ghanaian economy witnessed an
unprecedented decline. This decline was ascribed to an interplay of several wrongful
policies, namely a fked exchange rate policy which resulted in a highly over-valued
exchange rate that discouraged exports, expansionary fiscal policies that led to large
budgetary deficits, and expansionary monetary policies which resulted in idationary
pressures.
During the decade immediately preceding 1983 when economic adjustrnent was
introduced, the Ghaoaian economy was characterized inter alia, by budgetary deficits, a high
rate of monetary expansion and inflation, declining GDP and export levels, an over-valued
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exchange rate, and an isolated domestic money and capital market (Kapur 199 1). Ail of these
characteristics persisted dirring the eni of economic adjustment, with the exception of an
overvalued exchange rate (ibid1991). The government financed its huge deficit principally
through h ~ ~ w i n g h m the local financial houses, especiaily the commercial banks, and by
printing more Cedis (ibid. 1 99 1).
The ensuing overview suggests that Ghana's economic decay happened in a penod
in which there was no explicit exchange rate policy. The absence of such a poiicy is partly
responsible for the economic deche in Ghana. Expansionary fiscal and rnonetary policies,
and iIl-planned agricultural, and industrial policies were other explanatory factors.
2.1 Economic Adjustment Programmes
The structural adjustment and economic recovery programmes in Ghana have their
theoretical origins in the classical idea of the k e market as the most efficient ailocator of
scarce resources. In essence, the policy prescriptions of these programmes are based on the
neo-classical theory of supply and demand management. The main goal of demand
management is to r e h c t the level of effective demand by suppressing the wage rate,
lowering the money supply, and restricting credit by adjusting the interest rate (ibid. 199 1).
Supply management is designed to stimulate output by lowering production costs
(ibid.1991). The following discussion enurnerates the salient features of the adjustment
programme and the exchange rate policies contained therein.
Economic Recovery Programme
Ghana's economic recovery programme has been undeltaken in a number of phases. These
phases are: Phase 1,1983-84; Phase II, 1987-88; Phase III, 1989-90; Phase IV, 199 1-3; and
Phase V, fiom 1994 to present. Ghana's Economic Recovery Programme (ERP) was
conceived of as an on-going process to place:
The Ghanaian economy on a sound recovery fiom three essential structural bottlenecks/rigidities, namely (1) colonial economic structure, (2) monocultural export structure and (3) weak moral, social, and physical hfkstmcture (MFEP 1991).
The broad objectives of the ERP were to:
(1) shift relative pnces in favour of production, particdarly for exports; (2) restore fiscal and monetary discipline; (3) initiate rehabilitation of the country's productive base and its economic and
social infrsistnicture; and (4) restore incentives for pnvate savings and investment (ibid. 1991).
According to MFEP (1991), the following specific objectives were forrnulated:
1. To reform the exchange rate system and render it more flexible; . . il. To refom the customs t a f i system in order to simpli& the rates to a more
... d o r m structure; m. To establish realistic relative prices and incomes in the context of the large
achievements in the exchange rate; iv. To restore fiscal discipline; v. To phase out the reduction of the extemal payment arrears which stood at
USS6Ol million at the end of 1983, in order to re-establish the country's credit worthuiess; and
vi. To formulate programmes and projects with a view to rehabilitating the key sectors of the economy including cocoa, gold, timber and mining as part of the 1984-86 ERP. These programmes included sector specific measures designed to restore incentives, improve management, ensure adequate inputs and replace capital.
Since the ERP was implemented in 1983, a number of goals were achieved. F i a the
depreciation of the exchange rate resulted in a doubling of the producer pnce of cocoa
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Second, administered pices fidly adjusted to the devaluation. Finally, there was a decline
in inflation and positive real interest rates were attained in 1984 (ibid. 1 99 1).
Exchange Rate Policies
As was mentioned above a key gain of the ERP is the liberalkation of the exchange rate. The
specinc measures employed to achieve that goal were: a devaluation of the Cedi; the
introduction of a foreign exchange auction at the Centrai Bank in which individual exporters
made bids; the unification of the black market and official exchange rates by the introduction
of Foreign Exchange Bureaus which were allowed to operate at market prices; and the
unification of the auction and the inter-bank markets by allowing commercial and
development banks to hold auctions as weU.
2.2 Financial Structure
Ghana's financial system comprises a number of banking and non-bank financial
intermediaries. The Bank of Ghana (BOG) is the monetary authority, which in conjunction
with the Mini- of Finance and Economic Planning regulates the behaviou. of the entire
banking and non-bank £inancial sectors. MFEP has the broad fiuiction of fïnancially
administering the country. This inter alia, entails the prudentid management of the Ghana's
finances with a view to ensuring its soundness. As a consequence, it formulates fiscal and
monetary poiicies in the discharge of its duties. In addition, it is also the oniy agency
authorized to contract loans on behaifof the Government of Ghana The Bank of Ghana is
9
empowered by the Bank of Ghana Act to implement fiscal and monetary policies formulated
by MFEP. It perfonns several fiinctions in the execution of its duties. It is responsible for
printing Ghanaian currency (notes and coins). The Bank also has regdatory oversight over
the entire banking and non-banking sectors. It also s u p e ~ s e s banks, by seaing uniform
accounting and auditing standards. The Bank also manages Ghana's foreign exchange
reserves, and in addition is accountable for maintahhg stability in the value of the Ghanaian
currency. In this regard, it buys and sells foreign currency. The banking and non-banking
sectors are also regulated by statutes, namely the Bankùig Law 225 and the Securities
Industry Law. The Banking Law provides a sound and prudentid legal framework for
Ghana's banking sector. It requires banks to maintain a minimum risk-adjusted capital base
equivalent to 6% of net assets. In addition, it sets equable accounting standards and places
restrictions on rkk exposure to single sectors and customers. The Secunties Ind~stry Law
stipulates the establishment of a S e c d e s Commission to regulate the activities of players
in the securities indusûy. These include the stock exchange, investment dealers, and stock
brokea. The Law m e r empowers the Commission to ensure that dealings in securities are
fair, orderly and transparent.
The Central Bank employs interest rates and money supply as instruments of
rnonetary policy. Historically, the Bank of Ghana centred its attention on influencing the
money supply growth and directed monetary policy to that purpose. Its primary tool was its
open market operatiom. If the Bank thought the money supply was too low, it would
purchase bonds and treasury bills util the money supply rose up to the target range. If it
thought the money supply was to hi&, it would sel1 bonds and treasury bills to the general
10
public and fimuciai institutions. The use of required reserves as an instrument of control is
less popular. This is simply because it is solely directed towards h c i a l institutions
(maidy banks), and as such excludes the general public. The Bank therefore sees open
market operations as an effective tool for controlling money supply growth. The Bank of
Ghana since 1983 mostiy focused monetw poiicy on quantitative credit controls. This took
the form of credit ceilings to both the public and private sectors. This policy was gradually
abandoned because the government had initiated a process of h c i a l deregdation in 1986.
Consequently, a market-oriented system of monetary control was initiated by 1987 tbrough
the use of market-detemiined interest rates. In 1989 when inflation had reached very high
levels by Ghanaian standards, the Bank of Ghana changed it policy and switched its target
fiom interest rates to the rate of monetary growth. As a result, monetary policy concentrated
primarily on targeting the money supply and influencing its transmissions throughout the
economy (Kapur 199 1). Nevertheless, these policies did not prove f U y supportive of the
exchange rate poiicy because the rate of rnonetary expansion still remained high and real
interest rates failed to reach satisfactory levels (ibid. 1991). Monetary policy in the post-1989
era has continued to focus on controliing money supply growth principally through open
market operations.
There are three large commercial banks in operation in Ghana - the Ghana
Commercial Bank, the Standard Chartered Bank of Ghana, and the Barclays Bank of Ghana.
The Ghana Commercial Bank is a public enterprise, while the latter two banks are branches
of multi-nationals. The commercial banks in addition to taking deposits and making loans,
undertake money market and foreign exchange activities (buying governrnent securities,
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issuing certificates of deposits, and buying and s e h g foreign exchange). Further, there are
seven secondary or deveiopment banks in operation in Ghana. These banks are the Social
Security Bank, the Bank for Housing and Construction, the National SaWigs and Credit
Bank, the Agricul- Development Bank, the National Investment Bank, the Merchant
Bank, and the Bank for Credit and Commerce. AU of these banks, with the exception of the
Bank for Credit and Commerce, are public enterprises. These development banks are mainly
involved in commercial banking, although they are supposed to perform a developmental
function, i.e., making project loans to the various sectors. In addition, they also engage in
money market activities (mainly by investing in govemment securities), and buy and seii
foreign exchange. These institutions are required by regulation to hold a certain amount of
required reserves as determined by BOG. The Bank of Ghana, for example may increase the
reserve requirement and aIlow the commercial banks to hold part of their reserves in treasirry
secuities. These banks by complying with this directive play a crucial role in making
monetary policy successful. Also by v h e of the fact that they engage in money market
activities means that the effectiveness of the open market operations depends to a large
extent on their participation. There are three merchant banks in the financial system. These
banks are Ecobank Ghana, Continental Acceptances, and Meridian Bank. These banks are
joint-ventures between the govemment of Ghana, and local and foreign shareholders. They
concentrate on corporate finance, advisory services, and money and capital markets activities
(underwriting, stock broking and investing in govenunent securities). Featuring among the
merchant banks as well is a small CO-operative bank, and over 100 small rural banks
established to mobilize resources in the rurai areas (Kapur 1991). Like commercial and
12
development banks? these merchant banks are required to hold a certain amount of reserves.
They also invest in government securities. Thus, it is an undeniable fact that they play a very
signincant role in ensuring the success of monetary policy.
The non-bank financial sector comprises inter dia, two discount houses, Le., the
Consolidated Discount House, and Securities Discount Company, the Social Security and
National Insurance Trust (SSNIT), the Ghana Stock Exchange, the Home Finance Company
WC), the Export Finance Corporation (EFC), and about 20 insurance companies, including
the State Insurance Corporation, which is the largest. The discount houses were established
in 1988 and 1991 to enable banks better manage their liquidity position. They mainly accept
short-term deposits fiorn banks and other financial institutions, and also invest in shoa and
medium term govemment securities. They are required to hold a large chunk of their assets
(about 70%) in short-term securities. The SSNIT is a public institution mandated to collect
social sec- contributions and pay social s e c m contributions to participants upon
retirement. It is also dowed to invest up to 6% of its assets in govemment securities. The
HFC and EFC specialize in mortgage b c i n g and export b c i n g respectively. These
non-bank financiai institutions by engaging in the purchase of govemment securities, also
play an important role in the centrai bank's open market operations directed at them. The
discount houes and the banks are key players in the foreign exchange market. Less
important players are the insurance companies. It is worth remarking that the npid
depreciation in the value of the Ghanaian currency in the post-1983 era affected the entire
financial sector, mostly banks, adversely. For example, the external iiabilities of most banks
escalated excessively making them fïmmcially worse off.
2.3 Economic Review (1983 -1994)
The ensuing economic review discusses monetary indicators, exchange rates, gross domestic
product, and balance of payments, imports and exports.
Monetary Indicritors
A w e y of the monetary indicators shows that growth in the money supply is considerably
high despite the fact that it has sloweddown since 1 983 (Table 2.1). The high rate of growth
in the money supply was due to excessive govemment borrowing in the domestic capital
market to hance its non-productive activities, such as the payment of wages to civil
servants, which was about 65% of govemment revenue in 1992/93. Further, the high rate of
growth in the money supply c m also be athibuted to goveniments printing of excessive
amounts of Cedis to pay its bills (World Bank 1989). In the period of 1983-1994 govemment
borrowing increased by 1 100%.
The slow-down in the rate of growth in the money supply fiorn 1989-1990 was due
m a d y to contractionary monetary policies. The average rate of inflation fiom 1983-1988
was considerably high (Table 2.1). This was due maialy to excess demand created by the
increase in the money supply which went to pay public sector wages (ibid. 1989). However,
the rate of inflation declined sharply fiom 37.1% in 1989 to 18% in 1990. This rate fell
M e r to 10% in 199 1. The welcomed fdl in the rate of inflation was short-lived, because
agricultural production declined and money growth rose. From 1992 to 1994 the average rate
Table 2.1 Monetary Incikators
Inflation Money (Ml)
1983 40.0% 60.5%
Year
Source: Computed from International Financial Statistics Yearbook, 1995 gines 64,34 and 60c)
of inflation soared upwards to 24.8%. The initial fd in the da t ion rate could be attributed
to an increase in food production associated with the agriculturai policies of the economic
adjustment prognimme (MFEP 199 1, and Berry 1995). Also, the more recent inflationary
CPI1
Of the itemized composition of the Consumer Price Index, local foodstuffs account for approximately 49%. The reminder is accoimted for by items such as transportation, dothhg and rent (Kapur 1991).
The interest rate is the rate on the 9 May Government of Ghana Treasury bills.
Growth of Interest
15
trend was due to a decline in agricuihiral output (ibid- 1999, and to the rapid depreciation of
the exchange rate resulting fiom the hi& rate of monetary expansion (Economist Intelligence
Unit (EIU) 1995). Since imports account for a signiscant proportion of the inputs used in
domestic agriculture, the depreciated exchange rate waich resulted fkorn the policy to "fioat"
the Cedi, increased the production costs of small fhmers. The result was a fd in agricuitural
production.
Nominal interest rates were volatile during the period under consideration (Table
2.1). The interest rates increased respectively, fiom 13% in 1983 to 2 1.7% in 1987. However,
in 1988 and 1989 the interest rate fell slightly to about 20.0%¶ but resumed its upward trend
in 199 1 and 1992. It peaked in 1993 at about 3 1 % compared with 13 .O% in 1983. The ex-
post real interest rate was negative for most of the period.
Exchange Rate
The data reveal a dramatic depreciation in the exchange rate between 1983 and 1994 (Table
2.2). Following the introduction of the floating exchange rate in 1983, there was a 990%
devaluation in the Cedis-US$ exchange rate from its h e d value of 2.75 Cedis=lUS$ in 1978
(World Bank 1989). In 1983,3O.O Cedis was equal to one US dollar. By 1987 the rate was
176 Cedis=IUS$, and by the end of 1994 it was 1300 Cedis=lUS% (Table 2.2). The
instability in the value of the Ghanaia. currency has been attnbuted to the relatively high
monetary growth and innationary pressures which prevailed during the period (EIU 1996).
Gross Domestic Product
The components and breakdown of GDP are as foilows: Agriculture, Forestry and Fishing,
47.6%; Mining and IndUStfy, 16%; Manufacturing, 8.5%; and Services, 36.4% (MFEP 1991
and World Bank 1995). Apart from cocoa, the major agricdtural crops produced in Ghana
fall into either of two categories, namely cereals, and starchy staples. The former includes
maize, nce, millet, and guinea corn. The latter comprises food items such as cassava, yam,
Table 2.2 Exchange Rate and Real GDP Growth
Exchange Rate (CedisRIS$)
Real GDP Growth
Source: Computed fkom International Financial Statistics Yearboo k, 1 9 9 5 e e s ae and 99b.p)
17
cocoyam, and plantain- The services sector consists principdy of hotel, restaurant, and
banking operatiom. Manufàcturing can be classified into textiles, wood processing, vehicle
assembly, and food processing. The mining and industry sector consists mainly of mining
activities. Ghana's economy grew at an appreciable average annual rate of 4.55% during the
period under review (Table 2.2). The highest growth rate was recorded in 1987 (5.6%), while
the lowest occurred in 1983 (2.6%). The positive growth rate throughout the entire period
was attributable to increases in the agricultural and seMces sectors (ibid.199 1 and EIU
1996).
Balance of Payment, Imports and Exports
Ghana's irnports consists mainly of capital goods, intemediate goods, fuel, and consumer
goods (ibid. 1996). Exports on the other hand, consists chiefîy of gold, cocoa, and timber
(ibid.1996). Its major principal trading partuers are United States, United Kingdom,
Germany, and Togo. Together they account for approximately 54% of all exports
(ibid.1996). The remaining 46% is accounted for by about 46 countries, such as Japan,
SwitzerIand, Netherlands, and France (United Nations 1994). On the imports side, Nigeria,
United Kingdom, Italy, Japan, and the United States account for approximately 60% of ail
imports. The remaining 40% originates from countries such as Belgium, France, Canada,
Korea, and China, and some 40 other countries, the principal ones being Ivory Coast, and
Togo (ibid. 1 994).
The data on the value of imports and exports show that in general the former grew
at a much faster rate than the latter during the period under review (Table 2.3). Imports
Table 23 Balance of Payment, Esports and Imports (millions of US Dollars)
Source: Computed fkom International Financial Statistics Yearbook, 1995 (Iines 78cbd, 78aad, 78abd, and 74r)
Year
1983
1984 "
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
exceeded exports in every year with the exception of 1984 and 1986. But, although expoa
eamings were greater than the value of imports in 1983 the overall balance of payment was
negative. However, in 1985, and between 1987 and 199 1 although imports exceeded exports
the overall BOP was positive. Further, in 1983, and between 1992 and 1994 the value of
imports was greater than export receipts, and the overall BOP was negative (Table 2.3). The
BOP surplus between 1984-1 985, and 1987-1991 was attributable mainly to the increase in
Balance of Payments
-1 80.9
35.6
14.1
-60.8
140.1
181.1
155.6
f 05.3
109.2
-56.2
-232.5
142.6
Exports
439.1
565.9
632.4
773 -4
826.8
88 1 .O
807.2
890.6
997.6
986.4
1064.0
1227.0
Export Prices (Cocoa)
8.1%
18.7
24.3%
43 .O%
8 1.7%
93.9%
92.0%
100.0%
1 15.7%
1 17.3%
140.0%
248.0%
hports
499.7
533.0
668.7
7 12.5
951.5
993.4
1002.2
1 198.9
13 18.7
1456.7
1728.0
1580.0
19
exports (Table 2.3), and improved export pnces (Table 2.3). The flexible exchange rate
strategy p m e d by the Govemment since 1983 was aiso partiy an explanation for this trend
(Kapur 1991).
2.4 Conclusion
Several observations may be made from this brief description of Ghana's financial system,
and review of its economy. The feature of the hancial system is that it is dominated
by public enterprises. It appears that the state sector has "crowded-out" the pnvate sector in
the financial system. Also, the financial system appears to have suffered f?om "weak bank
supervision and regdatory ~ e w o r k " (Kapur 199 1). The Government has agreed under the
Financial Sector Reforms to implement more appropriate regdatory masures of the sector.
Another worthwhile observation is that the depreciation of the Ghanaian currency affected
the financial sector (especially banks) davourably.
The £kst two features, namely a predominant public sector, and a weak bank
s u p e ~ s i o n and regulatory fiamework contributed significantiy to the demise of the banking
sector in the pst-1 983 penod. The predicament of the sector was M e r aggravated by the
rapid depreciation of the Ghanaian currency. To be precise, the hanciai heaith of domestic
banks detenorated either because, the exchange rate adjustments soared their extemal
liabilities or rendered some of their customers (mainly public enterpnses) financiaüy
distressed (ibid. 199 1). In addition, the inadequate bank supe~s ion and regulatory regime
worsened the problems of the banking sector, because of the absence inter dia of, W o r m
20
and appropnate accounting standards (ibid. 199 1).
The economic review also reveals severai important features of the Ghanaian
economy. F w the monetary indicators reveal that money growth, and inflation continue to
be relatively high and variable. As a consequence, exchange rate depreciation is rapid, p d y
accomting for the misfortunes of the banking sector. Second, although imports exceed
exports in a number of years, the BOP remained positive. Third, the economy recorded a
positive cyclical growth pattern through out the entire period under study. Finally, interest
rates have been volatile for majority of the period under review. The resdts of the economic
sunrey suggest that there is a need for a theoretical h e w o r k to assist policymakers to
account for the behaviour of the exchange rate in Ghana.
Chapter 3
Monetary Theory of Exchange Rate Determination
In this chapter the literahue on the monetary models of exchange rate determination is
reviewed. The discussion is organized into four sections. Fht , the theories of exchange rate
determination are examined. Second, the monetary model of exchange rate d e t e k a t i o n is
analyzed. Particular emphasis is placed on the flexible, and sticky price monetary
approaches. Third, the applicability of the sticky price monetary model to the Ghanaian
economy is discussed with reference to the uncovered interest rate parïty condition,
pinchashg power parity condition, and the money demand fhction. It is concluded that the
sticky price monetary model is appropnate for the evaluation of the long-mu exchange rate
in Ghana.
3.1 Theories of Exchange Rate Determination
The theories about the exchange rate detemination foliows two distinct traditions: namely
the balance ofpayments (BOP) approach; and the asset approach (McDonald and Hallwood
1994). The asset approach advocates the monetary, and portfolio balance models. The two
major versions of the monetary approach are the flexible, and sticky price rnodels.
The BOP approach to the exchange rate detennination focuses on some major factors
of the balance of payments. According to the BOP approach, the exchange rate is
determined by the flow of currency through the foreign exchange market (Solnik 1996). This
view is Iimited because its main focus is on the trade account due to the historid restriction
on capital flows at the t h e the theory was fomdated. Capital flows are treated as
exogenous shocks rather than being endogenous to the mode1 (McDondd and Hallwood
1994). According to the balance of payments approach, a trade deficit wotdd lead to a
reduction in the country's foreign reserves, and lead dtimately to a depreciation of the home
currency (Solnik 1996). In turn this depreciation would improve the terms of trade
(ibid. 1996).
The BOP approach contrasts sharply with the asset view of the exchange rate
determination (ibid. W4). As was mentioned above, this latter approach is sub-divided into
the monetary, and portfolio balance approaches. In both cases the exchange rate is treated
as the pnce of an asset, Le., the relative price of two monies (ibid. 1994). Mussa (1 982) for
instance argues that:
In analyzing the determination of the exchange rate, one should use the tools which are normally used for the determination of other asset prices, such as bonds and share prices.
In both flexible, and sticky price monetary models, non-money assets are assumed to be
pertèct substitutes, and the exchange rate is determined by relative excess money supplies.
The portfolio balance models advocate that non-money assets are imperfect substitutes, and
play a crucial role in the determination of the exchange rate.
3.2 The Monetary Models of Exchange Rate Determination
Before a detailed examination of the flexible, and sticky price models is undertaken in this
23
section, a brief description of monetary approach is presented Exchange rates have been
charactexized by extreme volatility ever since the advent of the "float" in 1973 (Mosa 1994).
This has engendered a great deal of interest and research in exchauge rate detemination. The
flexible, and sticky price monetary approaches, have emerged as important tools for
exchange rate analysis. They derive their name fiom their assumptions which are associated
with the monetary approach to balance of payments (Johnson 1973). Their assumptions are
that there exists a stable money demand function, uncovered interest parity condition, and
purchasing power parity condition; and that the fluctuations of the exchange rates, and
interest rates fluctuations are the main sources of monetary disturbances (Baxter 1994).
However, they m e r on the mechanisms by which they influence the exchange rates, and
interest rates. Monetary theorists dso suggest that in the absence of substantial transaction
costs, the law of one pnce, i.e., purchasing power parity and interest rate parity, will hold in
international markets @ilson 1978). In addition, ail versions of the monetary models assume
that there are no transaction costs in capital markets, and that there are no obstacles to capital
mobility.
Although, the monetary are used extensively in existing empirical work (McDonald
and Taylor 1994), the empincal r ed t s are mixed (Sarantis 1994). Early tests of these models
by Bilson (1978), Hodrick (1978), and Frankel(1979) were supportive of the flexible price
monetary model. A number of research examined the monetary models for the post-1978
period, and indicate that the models did not perform weli (McDonald and Taylor, 1992).
Perhaps the most serious challenge to the monetary models is that they are not used to
represent a long-run equilibrium between the exchange rate and the monetary variables
(Meese 1986; Boothe and
explanation for these dismal
24
Glassman 1987; and McNown and Wailace 1989). One
results relates to the fact that the assumptions underlying the
monetary models - stable money demand fiinction, PPP and uncovered interest rate parity -
may not be valid in the real world. Goldstein et ai.(1980) and Aliber (1973) have suggested
that uncovered interest rate parity may not hold in the reality because of various country
risks, lack of market integration, failure of instantaneous PPP, errors in measuring expected
exchange rate depreciation, and rïsk premium. The assumption of a stable money demand
hction albeit appealing, does not lend support to the model in reaiity. The reason is simply
because the underlying economic structures of the two countries may undergo a variety of
changes thereby making the money demand functions unstable over time. Finally, the PPP
concept per se is controversial in the sense that there is not any agreed upon price index to
be used in computing the parity (Frenkel 1976). When the resdts of a theory seem to hinge
cruciaily on an assumption such as the PPP, then if the assumption is dubious, the resuIts are
suspect The debate in the Literature is whether the index shouid pertain to traded goods ody
or whether it should cover the broadest range of commodities.
These criticisms notwithstanding, McDonald and Taylor (1994); McNown and
Wallace (1 994); and Van Der Berg and Jayaneai (1 993) have demonstrated that the rnonetary
models do have some long-nui validity. The study by McNown and Wallace (1994), was
primarily motivated by the works of Abuaf and Jorion (1 !WO), and Choudhry, McNown and
Wailace (1 99 1 ), who found some evidence favourablle to long-run PPP. Of particular interest
is the approach adopted by McDonald and Taylor (1994). They tested for the long-nui
validity of the model using Johansen's cointegration procedure (Johansen 1988 and Johansen
et ai. 1990) and modelled the short-run dynamics via an Error Correction Mode1 (ECM).
33.1 Flexible Price Monetary Approach (FLMA)
The flexible price monetary approach is proposed by Frenkel(1976), Mussa (1976), and
Bilson (1978). It assumes that pnces are fUy flexible, and that purchasing power parity
(PPP) holds instantaneously. It also assumes the existence of a stable monetary equilibrium
between reai money demand and real money supply. Finally the rnoney supply and real
iocome variables are assurned to be exogenously detefinined. The mode1 embodies the
following equations:
m, 'Pt +byt -ai,
m; = p', + by; - aiet,
and
st = Pt - P.,
where m, and met are the logarithms of the domestic and foreign money supplies respectively;
y, and yet are the logarithms of domestic and foreign real incornes; it and i', are the domestic
and foreign interest rates, respectively; s, is the logarithrn of the spot exchange rate (home
price of foreign currency); p, and R* are the logarithms of the domestic and foreign pnce
levels, respectively; and a and b are parameters representing the interest rate and income
elasticities respectively across coutries.
Equations (3.1) and (3.2) are the money market equilibrium conditions for the home
26
and foreign countries respectively, and represent 1ogarit)unic versions of the typical Cagan
(Cagan 19%) demand for money function. Equation (3.3) is the purchashg power parity
hypothesis. Solving for p, and p; in equations (3.1) and (3.2), and substituting into equation
(3 3), and adding a disturbance te- yields the nnal reduced-fonn exchange rate equation:
where g, is the random error tem, and dl other variables are as previously defined. If the
FLMA is correct, it is expected that P,=l, P,4, P, >O.
McNown and Wailace (1 994) argue that:
According to the monetary approach, inmeases in home (foreign) money supply and interest rates, the latter by reducing the demand for money cause a depreciation (appreciation) of the domestic currency. Increases in home (foreign) real income, by increasing the demand for money, cause the domestic currency to appreciate (depreciate) (McNown and Wallace 1994).
The positive effect of changes in the domestic interest rate on the exchange rate, reflects the
fact that an increase in the latter reduces the dernand for rnoney, which in tum leads to a rise
in the domestic price level. In this way money market equilibrium is maintained. However,
given that PPP holds, the domestic price level can only rise if the exchange rate depreciates
(McDonald and Hdwood 1994). A rise in income increases the transactions demand for
money and, with a constant nominal money supply, money market equilibrium can oniy be
restored if the domestic pnce level f d s ; this in tum cm only occur given a strict PPP
assumption, if exchange rate changes (ibid. 1994).
27
3.2 Sticky Price Monetary Approach (SPMA)
This approach is attributed to Dombusch (1976) and Frankel(1979). AU of the assumptions
underlying the FLMA still hold, with the exception of instantaneous PPP. Both Dombusch
and Frankel argue that in the short-nui prices are more iikely to be sticlq, due to "menu
costs" and imperfect information, and as a consequence PPP does not hold instantaneously.
For example, Frankel assumes that the adjustment of the exchange rate to its equilibrium
level depends on the r d interest rate differential, such that PPP holds onIy in the long-run.
Thus, in an environment where PPP does not hold instantaneously, the current exchange will
deviate f?om its long-run Ievel such that the following relationship holds (Sarantis 1994),
where zt and x; are the Mation rates in the home am i foreign corntries respect ively .
Assuming that equilibrium values are given by their current Levels, replacing equation (3.3)
by (3.5) and then substituthg for pt and pt9 fiom equations (3.1) and (3.2), i.e. the monetary
equilibrium conditions and adding a disturbance term, we obtain the reduced-form SPMA
equatio n :
If the SPMA mode1 is correctly specifïed, the coefficients of the variables entering the
FLMA have the same interpretation. However, the fiutdamental distinguishing feature
28
separating the two models is the presence of home and foreign country inflation rates, the
impacts of which are expected to be negative (i.e.P,<O).
3.3 The Sticky Price Model and Ghana's Long-Run Exchange Rate
In this section an anaiysis of the sticlq price monetary mode1 is presented to determine its
suitability for the Ghanaian economy. In order to establish the relationship between the
SPMA and Ghana's economy, an empirical analysis of the uncovered interest, and purchasing
power parities, and the money demand function are undertaken.
3.3.1 Uncovered Interest Rate Parity
The uncovered interest rate parity (UIP) assumes that an investor is indifferent between
investing one doilar in home or foreign treasury bills, or some other financial asset such as
a bank account, without covering the risks of foreign exchange rates changes in the fomard
market, when the expected rates of retum on them are equal and nsk fiee (McDonald and
Haüwood 1994). in other words, the foilowing condition holds:
where gt and ,q* denote the nominal yields to rnaturity on k period domestic and foreign
bonds in period t, respectively; s, denotes the logarithm of the exchange rate, definecl as wits
of foreign currency per unit domestic currency; and E&,, - sJ denotes the expected change
in the log of exchange rate between periods t and t+k (ibid. 1994).
The uncovered interest rate differentiais (UTD) is defhed as the rate on the three
month US treasury bill minus the rate on three month Ghana treasury bill denominated in
Ghanaian c~rrency.~ The UIDs for Ghana-US currencies deviate sipnincantiy fkom zero
(Table 3.1). It may be speculated that the deviation of the UIDs from zero, in the case of
Ghana, reflects a possible level of uncertainty about country risk, i.e. imposition of capital
controls, taxes, or other country specinc restrictions on capital flows, and defauit risk,
especialiy on pnvate securities. This speculation is encourageci by Alibefs (1 973) argument
that political risk is one reason why UIP may not hold.
33.2 Purchasing Power Parity
There are two versions of PPP: the absolute and the relative. The former States that the
equilibrium exchange rate equals the ratio of domestic to foreign prices. The latter relates
changes in the exchange rate to changes in price ratios (Frenkel 1979). McNown and Wallace
(1994) observed that "the h t building block" of the monetary mode1 "assumes long-nin
(relative) PPP". This mode1 assumes that ex ante PPP wodd hold if prices were fully
flexible, i.e.,
See Goldstein, Mathieson, and Lane (1980) for a similar definition of ULD in their discussion of covered and uncovered interest rate differentiais between the US dollar
and the French, German, Japanese, and British currencies.
30
Ifprices are less than M y flexible, as in the SPMA, the= may be temporary deviatiom fiom
the ex ante PPP condition. PPP relations are nevertheless assurned to hold in the long-nin
when price level adjustments are complete. The relative PPP theory predicts that exchange
rates are determined by inflation differentials. This is closely related to the Fisher theory of
interest rates, i.e.
and
where rt is the real interest rate, and Ap;,, is the expected inflation rate over the maturity
horizon of the underlying bond, based on information available at t h e t and asterisks denote
corresponding foreign variables. The Fisher theory predicts that market interest rates change
in response to changes in inflation. The interest rate theory predicts that the disparity
between two courmies' interest rates will reflect the differential between their expected
inflation rates. Therefore the exchange rate of the high-inflation country would depreciate
enough to wipe out the advantage of its higher interest rate if these parities held exactly
(Spiro 1989).
The real interest rate differentials (RIDs) for Ghana-US are depicted in Table 3.1. The
real interest differential (RD) is defined as the difference between the real rate of interest
31
on 90-day treasury biils denominated in each cunency." The real interest rate in each country
is defined as the 90-day treasury bill adjusted for inflation, as measured by the Consumer
Price Index (Goldstein et al 1980). The data show that there are signincant depamires of RID
for Ghana and the United States between 1983 and 1993 (Table 3.1). It reduced cùasticdy
between 1983 and 1989, but increased sharply thereafter. Deviations of the RID fiom zero
Table 3.1 Uncovered Interest and Real Interest DîfEerentials: Ghana-US
year I IJID I RID
Source: Computed fkom International Financial Statistics Year Book 1995 @ne 60c)
See Goldstein, Mathieson, and Lane (1980) for a simila. definition of RID in their discussion of real interest rate differential between the US dollar and the French, German, Japanese, and British currencies.
can reflect the fdure of either UID or instantaneous PPP (ibid.1980).
3 3 3 Money Demand Fonction
The monetary models assume a stable money demand fiinction. Foilowing is an empiricai
test for the stability of the money demand h c t i o n in Ghana The mode1 which is tested
closely replicates equation (3.1):
where Bo, Pi and p2 are parameters and a i l other variables are as previously defined.
Two tests (Chow 1960, and Brown et al. 1975) are employed to determine the
stability of Ghana's money demand function. The former provides a means for determining
parameter constancy, whereas the latter is used in detecting a structurai break The Chow test
divides the sample into two parts. Part one is the baseline period, while the second comprises
the observations from the end point of the baseline period to the last observation used in the
recursive estimate (White 1993). The Chow Test is caiculated using the following formula:
where SSEl and SSE2 are the sum of squared errors fiom the first and second parts of the
split sample, N is the number of observations in the entire sample, K is the number of
33
estimatecl parameters, N, and N, are the observations in the fkst and second part of the split
sample respectively, and SSE is the residual sum of squares fkom the regression over the
entire sample. Brown et d(1975) suggested that in order to ascertain the extent of a
structurai break within a model, the cumulative sum of squared residuds defined as
needs to be computed, where vj and v, are the residuds fiom the regression and k is the
number of parameters. This test is widely known in the econometric Literature as
CUSUMSQ. The results of the Chow statistic is shown in Figure 3.1. Here the confidence
interval at 95% is provided in order to detect any depamires fiom constancy. There is strong
evidence of a break fiom parameter constancy in 1983 and 1988. Figure 3.2 shows the
recursive CUSUMSQ at the 5% level of signincance. Any deviation from the upper and
lower bounds is evidence of instability in the model. Note that there is a break fiom stability
over the entire sample. This instability can be associated with those periods during which
prices, money supply, GDP and interest rates experienced wide fluctuations (see Tables 2.1
and 2.2). Both the sequential Chow and CUSUMSQ tests reveal that the money demand
fiuiction is not stable across the penod under study (1983-1994). Put simply, these tests
suggest that the parameters of the model are not invariant over tirne.
34
3.4 Conclusion
The conclusion can be drawn fiom the results of the tests conducted in this chapter that the
sticky price monetary mode1 may explain long-run exchange rate behaviour in Ghana. The
empiricd evidence suggests that the money demand h c t i o n is not stable over tirne.
Furthemore, the evidence does indicate signincant departures fiom the parity conditions in
both directions. Clearly, the latter is in conformity with the view that pnces are seemingly
sticky, adjusting graduaily, such that PPP may hold in the long-nui. On this basis, it is
possible that the SPMA will be an approximation of long-run equilibrium towards which
the Ghanaian economy tends to adjust This leads one naturally to wonder whether the
SPMA is a better fit especially given the fact that a number of researchers have expressed
some scepticism about its validity. The question being addressed is whether the SPMA is
more useful in understanding actual exchange rate behaviour in Ghana. As it happens,
however, that question is very controversial, and not one that can be answered in a few
sentences. As mentioned before, the PPP assumption is crucial, Le., one on which the
conclusions depend sensitively. However, fiom the foregoing discussion, and ceteris paribus
the SPMA codd offer a better explmation of the long-nin exchange rate movement in
Ghana.
Chow Statistics
Chapter 4
Data and Mode1 Estimation
The data sources and the estimation redts are reporteci in this chapter. In section 4.1, a bnef
description of the data sources is presented. In section 4.2, testing for unit root are
considered. Sections 4.3 and 4.4 are devoted to the application of the EngIe and Granger two-
stage, and Johansen test procedures for cointegration respectively.
4.1 Data Description
The data of the Ghana-US exchange rate, and Ghana and US macroeconomic variables are
ail taken fiom the International Financial Statistics Year Books (IFSYB) from 1983-1994.
The exchange rate used is d e h e d as (Ghanaian currency per US dollar). The chosen
monetary aggregate is MI, while the real incorne measure is real GDP, and the short-term
nominal interest rate is the three-month treaniry bill rates. The Consumer Price Index is used
as a measure of the inflation rate. All domestic variables, except the short-terni nominal
interest rates and the Consumer Pice Index are measured in Ghanaiao currency. The US
variables, except the short-term nominal interest rates and Consumer Pnce Index are
measured in US dollars. Other sources are fiom the Economist Intelligence Unit (EW)
Country Reports on Ghana (1 992-95), the Ministry of Finance and Economic Planning,
Ghana, and Statisticai SeMce, Ghana.
38
4.2 Order of Integration of Ghana-US Series
Plots of the levels of ail the macroeconomic variables entering equation (3.6) are shown in
Figure 4.1. Apart h m s,, a visual inspection of the levels of &'t-y3, (i:-4). (m*t-rnJ and (xta-
xJ show that these do not display a clear-cut upward trend. In fact it is very difncdt to
visually decipher whether they are nomtationary or not The behaviour of (yvt-yJ, (ivriJ, (mat-
mJ and (z;-q) c m largely be attributed to volatility of interest rates, rapid growth of money
supply, high and variable inflation rates, and output fluctuations in Ghana during the period
under investigation (see chapter 2 for a detailed explanation).
In order to verify statistically if the variables have unit roots, the augmented Dickey-
Fuller (198 l), and Phillip-Perron (1988) tests are performed. Test results appear in Tables
4.1 and 4.2, respectively. In both tables, the results for considering constant trend and
constant no trend cases are shown. The null hypothesis of a unit root in the levels of all the
variables cannot be rejected at the 10% level of signincance? Both the Dickey-Fuller and
Phiilip-Perron tests confïnn the non-stationary nature of the data. Each of the variables
requires only one diEerencing in order to remove the nonstationarïty. This is evidence that
all the variables are integrated of order one [i.e.,I(l)].
Additional unit root tests performed on the first clifferences of each times series show that the null hypothesis that the first ciifferences of these series had a unit mot can be rejected. In other words, it is confirmed that the levels of al1 the original t h e series are I(1).
39
4.3 Engle-Granger Two-Stage Procedure
Because the presence of a unit root has been established in the variables that appear in the
model, the presence of cointegrathg vectors is tested. Both Engle and Granger (1 987) tests
and, Johansen and Juselius (1992) are used. The nuiI hypothesis being tested that is: There
is no cointegration in the case of the Engle-Granger two-step method. The Engle-Granger
method for testing for cointegration fïrst involves estimating by OLS, the foliowing
regression
A test for cointegration is given by a test for a unit root in the estimated error term et. This
is achieved by conducting an augmented Dickey Fuller test on the residuals fkom equation
(4.1) The results of this test are presented in Table 4.3. Since in absolute terms the test
statistic exceeds the criticai value, the null hypothesis of no cointegration among the
variables is rejected at the 10% level of significance. The conclusion would be that the
estimated e, is stationary, and hence the variables are cointegrated. Critical values for these
tests appear in Table 4.4. The second stage, which follows fiom the Engle and Granger
representation theorem, irnplies that any set of cointegrating variables which have an Auto-
Regressive Integrated Moving Average (ARMA) representation may be 7Nntten in the form
of an error correction model (ECM). Here, the parameters obtained fiom the regression in
the first stage, are used in an error correction fom. The simple ECM (Engle and Granger
1987) which captures the dynamics of the system can be WRtten as:
where A refers to the fïrst Merence, q-, is the one period lagged value of the r e s idd fiom
the original regression (4. l), the OLS estimate of the e m r te- and v, is the error term. The
original OLS error terni is construed as the equilibrium e m r and is used to link the short run
behaviour of s, to its long-run value. The essence of formulating an ECM is to correct for this
error.
In this regression, A(m',-mJ, A(& -X ), AG ), A($ -p ) capture the short-nui
variations in (met-@, (Y*~-YJ. (iet-it), (x0&, whereas the error correction term q, captures
the adjustment towards the long-run equilibrium. If the estimate of P, is statistically
signiscant, it indicates what percentage of deviation fiom the long-run equilibrium s, in one
period is corrected in the next penod. Table 4.5 reports the esfimated ECM, together with
Lagrange Multiplier test statistics pertaining to the residual serial correlation x2,; and a test
for heteroscedasticity x2, These results indicate that the short-m changes in (y*,-y,) have
a substantial positive impact on s, whereas short-run changes in (m*t-mJ, (iot-iJ, (x;-xJ have
insignificant negative effects on st. Specifically, the short-run effects reveal that a 1%
reduction in the relative money supply and inflation rates leads to a 0.659% and 0.3 16%
appreciation of the exchange rate respectively. On the other hand, a 1% improvement in real
incornes and interest rates results in 1.732% and 0.151% depreciation of the currency
respectively. Note that the coefficient estimates of the interest rate and inflation variables do
41
not have the expected sign(s). In addition, the evidence M e r shows that about 0.72% of
the discrepancy between the actual and the long-run, or equilibrium, value of s, is eliminated
or corrected each qwuter. Alternatively put, disequilibrium in the exchange rate is corrected
through a process in which the achial exchange rate gravitates towards equilibrium at a rate
of 0.72% per quarter. This represents a fairly high speed of adjustment.
The stability of the ECM was evaiuated by the Chow and CUSUMSQ tests. The
sequentiai Chow test at the 5% level of sigrScance for the ECM equation (4.2) is shown in
Figure 4.2. An inspection of the graph reveals that there is strong evidence of a structurai
break between 1984 and 1987. The period in which the break fiom constancy occur roughly
coïncides with an era characterized by volatile interest rates and marked fluctuations in
money supply, real outp* and high inflation rate. The results of the Chow test suggest that
the ECM does not displays stability over the entire data set The CUSUMSQ test (Figure 4.3)
reveals that there was a strikïng deparhue fiom constancy between 1985 and 199 1. The
results of both tests show that the ECM was relatively stable over the period under
investigation. The ECM was next evaluated for heteroscedasticity and autocorrelation. The
Lagrange Multiplier test accepted the nuil hypothesis of uncorrelated residuals. The test for
heteroscedasticity rejects the nul1 hypothesis of homoscedastic errors at the 10% level of
significance. Note that the standard errors are heteroskedasticity-consistent (White 1980).
4.4 The Johansen Procedure
Another procedure employed for testing for the presence of cointegration was that suggested
42
by Johansen (1988) and Johansen and Juselius (1990). This approach is useful for confirming
the Engle and Granger r e d t s of cointegration.
In order to implement this procedure, a lag length must be specined for the Vector
autoregression (VAR) and the orders of integration of the series entering the VAR must be
determined. The Akaike Information Critenon (AIC) is used for choosing the optimal lag
length of three. In Table 4.6, the values of the trace statistics obtained using Johansen's
multivariate maximum likelihood technique for estimating cointegration relationships are
reported. The trace statistic is used to test the nuil hypothesis that there are at most r
significant cointegrating vectors among a system of time series (Le., zero against r
cointegrating vectors). The maximum eigenvalue tests the nul1 hypothesis of r cointegrating
vectors qaiost the alternative of r+1 cointegrating vectors. These test statistics are also
referred to in the econometric literature as iikelihood ratio test statistics. On the basis of these
trace statistics, we may reject the null hypothesis that there are no cointegrating vectors. The
hdings suggest that there is one such relationship. The results also validate the Engle and
Granger finding of cointegration for the system.
Table 4.1 Augmented Dickey-Fulier Unit Root Test Results
Asymptotic Critical Values (Davidson & Mackinnon, 1991)
No Trend Trend Level of Significance
-2.57 -3.13 10%
Variables
S,
Table 4.2 Phiiiips-Perron Unit Root Test Results
Variables
ta(Constant No Trend)
-1 -8 162
Z(t'd(C0flsfant No Trend)
dConstant Trend)
-2.7088
( Z(t*.)(Co~l~fant Trend)
Asymptotic Critical Values (Davidson & Mackinnon)
No Trend -1 1.2
Trend Level of Significance -1 8.2 10%
CRDW represents the Cointegration Regression Durbin Watson
Table 4.3 Engle-Granger Cointegration Test Results
Table 4.4 Asymptotic Critical Values for Cointegration Tests
L
Critical Values
R2
CRDW
l
Test Statistic
dimension = 2 r,(No Trend) r.(Trend)
sa(C0nstant No Trend)
-5.40
-4.13
0.96
1.53
dimension = 3 r,(No Trend) trend)
r,(Çonstant Trend)
-5.70
-4.43
0.96
1.55
dimension = 4 r,(No Trend) trend)
dimension = 5 ra(No Trend) taprend
dimension = 6 se No Trend) ra(Trend
10% Level of Simiificance
Source (Davidson & Mackinnon, 199 1) Note: dimension refers to the number of variables in the mode1
Table 4.5 Error Correction Mode1 Estimates
Variable 1 Coefficients 1 S.E. 1 T-statistics
where R2 is the coefficient of determination, and S.E. refers to the standard errors obtained fiom the regression.
Table 4.6 Johansen's Likelihood Ratio Test
r represents the nurnber of cointegrating vecton. * indicates statistically signifïcant.
a criticai values are at 10% level of signincance and are taken nom Osterwald-Lenum, M. (1 992).
The LR test statistic is computed as follows, n
LR= T Z In(1-4) , where Aj are the canonid correlations between j=r+l
the lagged values of a time series and a change in its value, T is the number of observations, and n is the number of variables in the system.
Chow Statistic
Chapter 5
Conclusions
In this thesis, the Ghanaian economy is examined with respect to fiscal, monetary and
exchange rate poiicies to establish its basic characteristics. An in-depth review of the
theoretical underpinnings of the monetary models is presented in Chapter 3. Additionally,
the tenability of the assumptions of the monetary models for Ghana is evaluated. The
empirical evidence suggests that the use of the sticky price monetary mode1 is more
appropriate. This thesis reports the existence of cointegrating relationships among the
exchange rate, and the monetary variables in the case of Ghana.
Several important results emerged fiom this study. As a preliminary step for testing
for long-run relationships between the exchange rate and the monetary variables, the short-
nin dynamics of the exchange rate is modeiied using an ECM. The results of the ECM reveal
that real incomes impact significantly on the exchange rate a d j m e n t in the short-nui
whereas, relative money supplies, interest rates and inflation rates have less significant
effects on short-nui adjustments in the exchange rate. The coefficient of the error correction
term indicates a fairly hi& speed of adjustment of the actual to the equilibrium exchange
rate. Additionally, the sequential Chow and CUSUMSQ tests show that the ECM is
relatively stable for most of the t h e . The cointegration results provide concrete evidence
that there is one statistically signincant cointegrating vector between the exchange rate and
domestic and foreign money supplies, reai income, short-term interest rate, and the innation
49
50
rates in Ghana The research suggests that the sticky pnce monetary model can explain long-
nin reiationships behveen the exchange rate, and the monetary variables in Ghana The
hding of one cointegrating vector is consistent with the findings of other researchers
notably, McNown and Wallace (1994) who applied the model to Chile, Argentina and Israel,
and Hendrik and Jayanetti (1993) who tested the long-run validity of the model for India and
Sri Lanka.
The findings of this thesis suggest that: (1) the model provides a plausible description
of the long-nm equilibrium exchange rate; (2) the equilibrium exchange rate is not strongly
linked to the underlying instruments of monetary policy (money supply and interest rates)
in the short-run, but is directiy linked to them in the long-m. The sticky price monetary
model may therefore serve as a useful reference in the formulation of long-run exchange rate
policy for Ghana; and (3) non-monetary factors such as speculation may be important in
explainhg short-run exchange rate behaviour.
Dickey, Jansen and Thorton (199 1) have pointed out that the cointegrating vectors
illustrate reduced-form relationships. Consequently, we should exercise caution when
drawing conclusions fiom these relationships because the reduced-form coefficients are not
representative of the underlying structural model. In other words, equation (4.1) faiis to
capture all the action produced by the true underlying structural model.
In temm of friture research, the findings suggest three fhitful avenues. First, attempts
should be made to estimate a dynamic structural monetary model for Ghana to ver* the
nature of the true relationships among the variables. Second, the empirical results show that
51
monetary factors are less important in explaining short-run variations in the exchange rate
of the Ghanaian cunency and that non-monetary factors are more important. The next step
is to investigate this case M e r . Third, the use of alternative definitions of money in
cointegration modelling is worthy of investigation in Ghana.
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