Is there Causal Association between Exchange Rate and Inflation in Africa? A Panel Granger Causality Analysis Mamo Girma   African Economic Conference 2017 United Nations Conference Center, AA, Ethiopia December 4-6, 2017

Outline of the Presentation Background: Purpose & Objectives Data and Methodology Results: Descriptive/exploratory analysis Estimation result Conclusion and policy insights

Background Following the end of the Breton Woods system around 1973, many developing countries have increasingly opted for more flexible exchange rate regime. Africa is no exception Since then, the issue of exchange rate fluctuation has become very important in macroeconomic policy analysis especially in developing countries. High exchange rate volatility in the post-Breton Woods period has roused concerns among economists that it might have led to inflationary pressure in many developing countries. Recently, flexible regime has emerged as common practice in Africa, with 20/54 countries (37%) adopted it in 2014.

Background Cont’d Increasing trends towards inflation targeting…. A robust analysis of the interaction between exchange rate and inflation is believed to be very supportive for prudent monetary policy formulation in Africa. While the positive relationship between exchange rate and inflation is well documented, little is known regarding the causation between them in Africa (Nsiah, 2016). Thus, the purpose of this paper is to empirically investigate whether there exists causality between inflation and exchange rate and in what directions How exchange rate moves in relation to inflation? Is there causal r/p b/n them and in what direction?

Data and Methodology Data: A panel data on annual inflation and exchange rate is obtained from WDI online database. Model specification: A PVAR model under gmm is used to investigate the causation The PVAR model (Abrigo and Love, 2015): is a (1xk) vector of dependent variables- EXRT and INFL is panel specific fixed effect- capture heterogeneity error term, €it ~ iid(0; δ2)

Methodology_cont’d Why PVAR model? Unlike individual VARs, permits modeling both the endogenous and exogenous shocks captures country-level heterogeneity gain degrees of freedom by analyzing a panel of countries (Abrigo and Love, 2015): in the presence of lagged dependent variables, GMM estimator is said to be consistent to do panel Granger Causality Test Contribution of this paper: extend causality analysis in panel data setting in Africa adopts the latest PVAR model

Results Descriptive/Exploratory Analysis: exchange rate and inflation are moving together in a positive relationship. Bivariate correlation reveals 1% level of significance In line with other studies, exchange rate depreciation causes inflationary pressures in many African countries Lower exchange rate seems to be associated with low inflation

Descriptive-cont’d On average, degree of fluctuation moves in the same direction and vary across exchange rate regimes As expected, fixed regime exhibits lower volatility of inflation (3.5) and exchange rate depreciation (5.4) Exchange rate regime Rates of depreciation and inflationary pressure by regimes Overall volatility level by regimes Exchange rate Inflation Fixed 5.37 4.27 -2.54 3.5 Intermediate 9.93 6.46 2.44 6.09 Floating 9.86 9.38 5.07 9.05

Estimation Results Unit root and Co-integration tests: Panel unit root tests- LLC and IPS Both EXRT and INF are stationary at 1% level of significance Westerlund (2007) panel co-integration tests Presence of long-run relationship doesn’t tell us anything about the directions and magnitudes of causation between the two variables. This needs test for panel granger causality to determine the directions of the association. The pvar model is estimated using ‘pvargranger’ stata command as noted in Abrigo and Love (2015).

Estimation_cont’d The causality tests confirm bidirectional causal relationships between exchange rate and inflation in sampled countries the result is consistent with recent study by Nsiah (2016) in African context.

Concluding remarks and some policy implications Based on balanced panel data, this study empirically examine whether there exists causality between inflation and exchange rate in 26 African countries, 2001-13. The panel Granger causality test was performed in a panel VAR model within a GMM estimation technique, as proposed in Abrigo and Love (2015). Descriptive results demonstrate that: There exists strong positive correlation between them. Exchange rate depreciation causes inflationary pressure Empirical evidence reveals a bi-directional causation between inflation and exchange rate among selected countries in Africa.

Concluding remarks and some policy recommendations Cont’d Following are emanating policy insights: African policy makers needs to take note of such feedback effects between exchange rate and inflation and try to address them simultaneously while designing monetary policy. Causation from EXRT- INF: keeping exchange rate at a competitive level highly requires keeping domestic inflation low. Causation from INF- EXRT: maintaining price stability strongly demands maintaining exchange rate at low level.

Thank you very much for your kind attention