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

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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 2 3 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 4.2 4.3 4.4

5.0

Data Description Order of Integration of Ghaua-US Series Engle-Granger Two-Stage Procedure Johamen Procedure

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 1983-1994 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-nuiexchange 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. 1wodd 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 1WOs, 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

3

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 ~ gthe 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 "adhocegt1in 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

4

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 £inalchapter, 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 m s r t y of Finance & Ewnomic Planning (MFEP) 19911. 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. 199 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

6 exchange rate, and an isolated domestic money and capital market (Kapur 1991). 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 hn m g the local financial houses, especiaily the commercial banks, and by

printing more Cedis (ibid. 199 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 d e c h e 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. 1991). 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, 1991-3; 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) (2) (3) (4)

shift relative pnces in favour of production, particdarly for exports; restore fiscal and monetary discipline; initiate rehabilitation of the country's productive base and its economic and social infrsistnicture; and restore incentives for pnvate savings and investment (ibid. 1991).

According to MFEP (1991), the following specific objectives were forrnulated: 1.

.. il. ...

m. iv. v.

vi.

To reform the exchange rate system and render it more flexible; To refom the customs t a f i system in order to simpli& the rates to a more d o r m structure; To establish realistic relative prices and incomes in the context of the large achievements in the exchange rate; To restore fiscal discipline; 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 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

8 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. 1991).

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 by seaing uniform the entire banking and non-banking sectors. It also s u p e ~ s e banks, s

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~stryLaw 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 1991). 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 ofGhana,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,

11

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-operativebank, 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 1983 (Table 2.1). The high rate of growth in the money supply was due to excessive govemment borrowing in the domestic capital market to h a n c e 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 1100%. 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 1991. The welcomed fdl in the rate of inflation was short-lived, because agricultural production declined and money growth rose. From 1992 to 1994the average rate

Table 2.1 Monetary Incikators

Year

CPI1 Inflation

Growth of Money (Ml)

1983

40.0%

60.5%

Source:

Interest

Computed from International Financial Statistics Yearbook, 1995 gines 64,34 and 60c)

of inflation soared upwards to 24.8%. The initial f d in the d a t i o n rate could be attributed to an increase in food production associated with the agriculturai policies of the economic adjustment prognimme (MFEP 1991, and Berry 1995). Also, the more recent inflationary

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.

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 f d 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 21.7% in 1987.However,

in 1988 and 1989 the interest rate fell slightly to about 20.0%¶ but resumed its upward trend in 1991 and 1992. It peaked in 1993 at about 3 1 % compared with 13.O% in 1983.The expost 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$)

Source:

Real GDP Growth

Computed fkom International Financial Statistics Yearbook, 19 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. 1994). 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 ofUS Dollars)

Year

"

Balance of Payments

Exports

Export Prices

hports

(Cocoa)

1983

-180.9

439.1

1984

35.6

565.9

18.7

533.0

1985

14.1

632.4

24.3%

668.7

1986

-60.8

773-4

43 .O%

712.5

1987

140.1

826.8

81.7%

951.5

1988

181.1

88 1.O

93.9%

993.4

1989

155.6

807.2

92.0%

1002.2

1990

f 05.3

890.6

100.0%

1198.9

1991

109.2

997.6

115.7%

13 18.7

1992

-56.2

986.4

117.3%

1456.7

1993

-232.5

1064.0

140.0%

1728.0

1994

142.6

1227.0

248.0%

1580.0

Source:

8.1%

499.7

Computed fkom International Financial Statistics Yearbook, 1995 (Iines 78cbd, 78aad, 78abd, and 74r)

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 1991 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 1984-1985, and 1987-1991 was attributable mainly to the increase in

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 " 1991). 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 and n regulatory fiamework contributed significantiy to the demise of the banking sector in the pst-1983 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. 1991). In addition, the inadequate bank s u p e ~ s i o nand 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. 1991).

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. F h t , 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 e d 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

24 (Meese 1986; Boothe and Glassman 1987; and McNown and Wailace 1989). One explanation for these dismal 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 (1994); and Van Der Berg and Jayaneai (1993) have demonstratedthat 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 (199 1), who found some evidence favourablleto 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 metare the logarithms of the domestic and foreign money supplies respectively; y, and yetare 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 (1994) 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 ami foreign corntries respectively.

Assuming that equilibrium values are given by their current Levels, replacing equation (3.3) by (3.5) and then substituthg for pt and pt9fiom equations (3.1) and (3.2), i.e. the monetary equilibrium conditions and adding a disturbance term, we obtain the reduced-form SPMA

equation:

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,