Dynamics Of The Depreciating Cedi And Inflation Rate In Ghana

During the past few months from January 2014, the rate of inflation has risen from 13.5 to 15 percent in June 2014 with an expectation of it even jumping to 15.4% by the close of this month. Interestingly, this is the tenth consecutive time the inflation has accelerated. The Consumer Prices has also increased 1.6 percent in June of 2014, from 0.9 percent in the previous month (Ghana Statistical Service, 2014).

Though this rate of price increase is normal to the double-digit inflation regimes, I must say it is high enough to cause concern among economic analysts, financial market participants, Policymakers and the ordinary Ghanaian like you and I.

Among the various explanations for the recent acceleration in inflation is the sharp decline in the foreign exchange value of the Ghanaian cedi.

According to this view by the managers of the economy, the decline in the value of the Ghanaian cedi raises the Ghana cedi price of imported goods and, therefore, the prices paid by the ordinary Ghanaian citizens.

In this writing, I will build a framework to evaluate the claim that a decline in the Ghanaian cedi foreign exchange value raises the rate of inflation in Ghana.

The Relation Between Exchange Rate And Inflation

The foreign exchange rate simply is the price of a unit of one currency in terms of another. Why would one want to purchase another currency? There are several reasons. One is the need of foreign currency to purchase foreign goods by our businessmen and women.

Another is the need of foreign currency to trade in other countries' financial assets. Purchases of financial assets, like stocks or bonds, in another country can only be completed if one exchanges the Ghanaian cedi for the foreign currency like the United States Dollars, British Pounds or the Euro etc.

One reason that the recent Ghana cedi depreciation has aroused inflation fears stems from the casual observation that the exchange rate and domestic inflation tend to move in opposite directions. To further explain this negative correlation, includes the three commonly used measures of inflation: the Consumer Price Index (CPI), the Producer Price Index (PPI) and the GDP deflator.

These three differ in that they measure price changes at different levels of aggregation (the GDP deflator being the broadest measure) and for different baskets of goods and services.

Why Should Depreciation Raise The Inflation Rate

When the Ghanaian cedi depreciates relative to other currencies, the Ghanaian cedi prices of foreign goods increase relative to domestically produced goods, other things equal, making imports more expensive. A case in point is the rising cost of petroleum products that are imported to the country which eventually reflects in fuel price hikes. Since imports make up part of the basket of goods purchased by consumers, measures of inflation based on that basket also will rise.

The Direct Effect

It often is argued that foreign exporters, facing higher Ghana Cedi prices for their goods sold in Ghana, will simply pass on some or all of the depreciation-induced price increase to their Ghanaian customers. This is referred to as the 'pass through' effect.

To get a rough idea of how much a change in the exchange rate can directly impact inflation, the percentage of total consumer expenditures accounted for by imports can be used to derive a crude measure of the direct effect of a change in the cedi's value on the domestic inflation rate.

This effect is measured as the product of the percentage change in the exchange rate and the ratio of expenditures on imported consumer goods to total personal consumption expenditures. The impact on inflation can then be found by subtracting this direct effect from the reported rate of inflation. In other words, the falling value of the Ghana cedi accounted for much of the observed inflation.

The Effect On Foreign Exporters

There is another channel through which a fall in the Ghanaian cedi can affect the prices of Ghanaian imports and, hence, the domestic inflation rate. Consider a foreign manufacturer who exports to Ghana. If we assume that the manufacturer is a price-taker in the Ghanaian market that is, the individual producer does not influence the market price of the good the decision on how much to produce and export to Ghana will be determined by the given price and the cost of production.

As the upper panel of fig a shows, this representative manufacturer has the usual upward-sloping marginal cost curve. Since he is a price-taker in the Ghanaian market, the price in terms of the manufacturer's home currency is set at Pₒ. Given the position of the marginal cost curve, the quantity produced is given by the intersection of price and marginal cost, or at Qₒ.

Now assume that the foreign exchange value of the Ghana cedi falls. This means that, other things equal, the Ghana price received by the manufacturer in terms of his own currency falls to P - If the manufacturer's costs of production have not changed, this fall in price means that the quantity produced for the Ghanaian market falls to where marginal cost is equal to the new price. The Cedi's depreciation thus has reduced the supply of goods sent by this representative foreign manufacturer to Ghana.

The effect of this reduction in imported goods is shown in the lower panel of fig a. Here the supply and demand curves for the Ghanaian market in which the foreign manufacturer sells is shown. The market supply curve drawn is the sum of the domestic and foreign producers' individual curve. Other things the same, a reduction in the amount exported to the Ghanaian market results in a leftward shift in the supply curve.

The effect on the Ghanaian prices? Given the demand for the goods, the price paid by Ghanaian citizen increases from Pₒ to Pᵢ. In other words, a depreciation of the Ghanaian cedi increases the prices paid by the ordinary Ghanaian citizens for this good. Such an increase will result in a higher price level and, hence, at least a temporary increase in the rate of inflation.

Depreciation Of The Cedi Does NOT Always Cause Inflation

The discussion thus far suggests that there is a direct relationship between depreciation in the Ghana cedi and higher domestic inflation. Thus, if the prices of imports rise because of a fall in the value of the cedi, it is just arithmetic to show that the Ghanaian inflation must increase. Unfortunately, while the simplicity of such a view is seductive, it is not correct. The reasons why are discussed in the remainder of this article.

An observed exchange rate is determined by the demand for and the supply of a currency in international exchange. Movements in the exchange rate reflect relative economic conditions between countries that, in turn, influence the demand and supply of the currencies. Moreover, because exchange rates are forward-looking, their adjustments reflect changes in expectations about future economic conditions.

Consequently, it may be incorrect to impart a causal role to exchange rate movements in explaining domestic economic activity when the exchange rate merely reflects the underlying economic conditions, actual and expected, in different countries.

Over long periods of time, one key factor that influences the level of the exchange rate between two countries is their relative price levels. When one price level changes, the exchange rate will adjust accordingly to equate prices. This notion, referred to as purchasing power parity, means that similar bundles of goods have a common price across international boundaries.

If prices increase in only one country, the exchange rate between that country's currency and all other currencies will fall, ceteris paribus. Since in the absence of exchange rate changes the same basket of goods can be purchased elsewhere for a lower price, the demand for the country's goods and for its currency declines. In unfettered foreign exchange markets, changes in the exchange rate may simply reflect changes in the countries' price levels.

Exchange rate movements also may reflect differences in countries' economic activity. Because increased demand for imported goods is often associated with an increased level of economic activity, those countries experiencing faster growth may also find that their currency is depreciating in foreign exchange markets. Recall that one use of foreign currency is to purchase foreign goods and services.

Assuming Our Country Is Growing

faster than other countries, and its demand for imports is likewise increasing, then the demand by the Ghanaian citizens for foreign currency also is increasing. Consequently, there is relatively more demand for other currencies and their value appreciates relative to the cedi. Thus, movements in the exchange rate also may reflect differences in the relative economic conditions of two countries.

Movements in the exchange rate also reflect differences in interest rates across countries, a channel of influence thought to be most important in explaining exchange rate movements over short time spans. For example, suppose that from an initial point of equality, interest rates on identical financial instruments, say bonds, in the United States rise 3 percent while those in the Ghana are unchanged.

Other things the same, investors prefer the U.S. bond's rate of return to the Ghanaian bond. The U.S. dollars, therefore, will be in increased demand in order to purchase the U.S. bond, and the result is a depreciation of the Ghanaian cedi relative to the U.S. dollar.

This discussion points out that movements of the exchange rate can reflect changes in either key economic factors between two countries or people's expectations. In a very direct way, these factors are related to changes in money growth and the process by which such changes are transmitted to the economy. For example, consider the effects of an increase in the growth of the money supply.

If we assume that prices react somewhat slowly at first to this change, the brunt of the faster money growth will be evidenced in faster economic growth and in lower nominal interest rates. As noted earlier, faster economic growth in Ghana relative to other countries leads to a fall in the value of the
cedi. The decline in interest rates here relative to abroad also reduces the relative demand
for cedi-denominated financial assets and, hence, the cedi's value falls.

But, as economic theory predicts and much empirical research shows, an increase in the growth rate of the money supply ultimately leads to an increase in the inflation rate. This movement to a higher rate of inflation reflects the increase in money growth, but also will occur at the same time that the cedi's value is falling in foreign exchange markets. In other words, the decline in the value of the cedi and the increase in inflation are both manifestations of the same thing, namely, the increase in the growth rate of the money stock.

Hence, it is incorrect to assign exchange rate changes an independent role in determining permanent changes in inflation once the effects of changes in money growth have been taken into account.

Maxmillian Kwarteng

[email protected]

0249294482

2014-07-27 003017

2014-07-27 003029