ABSTRACT
The study examines the antecedence of inflation, most
especially the effect of money supply growth, interest rate and real
depreciation of the cedi on inflation in Ghana using annual time series data
from 1990 to 2016. An Autoregressive Distributed Lag model was adopted as the
estimation technique to examine the long-run and short-run dynamics among the
variables used. In the long run, the regression estimates indicated that there
is an insignificant positive effect between money supply growth and inflation.
However, interest rate in the long run was observed to have a positive
significant effect on inflation in Ghana. Real depreciation of the cedi was also
seen to have a negative insignificant effect on inflation. The short run
results indicated that money supply growth had a positive insignificant effect
on inflation; interest rate and real depreciation of the cedi were equally
observed to have a positive significant effect on inflation in Ghana. From the
results obtained money supply is not an integral part in the fight against
inflation in Ghana. This confirms why the Bank of Ghana has shifted for
monetary targeting to inflation targeting monetary policy. Therefore, to reduce
inflation in the economy, immediate measures need to be adopted by the Central
Bank to strengthen the effectiveness of inflation targeting as a monetary
policy. A recommendation is made that the Bank of Ghana should continue to use interest
rate as the major instrument in the conduct of monetary policy in Ghana. It is
also recommended that measures should be implemented to reduce the depreciation
of the cedi, through the reduction of budget deficit financing and reduction in
external borrowing.
CHAPTER ONE
INTRODUCTION
Ghana formally implemented inflation targeting in 2007 making
it one of the first group of emerging market economies and as at the time one
of the first low income countries to do so. A 5% inflation rate was set as the
medium targeted by the Bank of Ghana. This objective was however affected by
negative shocks which made it difficult to achieve the target. Such problems
are common in the inflation reduction phase of inflation targeting countries
and do not necessary imply policy failure. It however means that there is the
need for flexibility in the implementation of inflation targeting. Challenges
in the implementation of inflation targeting policies are expected in the
economy since it is vulnerable to shocks and has a history of high and variable
inflation. Inflation rates came down significantly to as low as 10.7 percent in
2010, 8.7 percent in 2011 and 9.2 percent 2012. It has however returned to
double digits, thus, 11.6, 15.4, 17.1 and 17.5 percent as at the end of 2013,
2014, 2014, 2015 and 2016 respectively.
In several instances, monetary policy authorities have
reacted vigorously to short-run deviations from targets, in an attempt to
maintain credibility. This had a destabilizing impact on the economy.
Attempting to hit inflation targets for every year is not desirable and might
not be feasible. The challenge should rather be to maintain the credibility of
the ultimate target, in the face of variations in the path of inflation. This
can be done by not just focusing on annual inflation targets but also being
mindful of short-run trade-offs against output and employment (Ekholm, 2010).
Background to the Study
Inflation is a key macroeconomic variable that exerts
important influence on macroeconomic stability and is a focal point of
macroeconomic policy aimed at achieving sustainable rates of economic growth
and development in many countries. Inflation is defined as a persistent
increased in the general price level of goods and services in an economy over
time. In an inflationary economy, it is difficult for money to act as a medium
of exchange and store of value, with adverse effect on output, employment and real
income. There is, however, no consensus both in theoretical and empirical
literature regarding the factors that drive the inflationary process of many
economies, especially in the developing world. While in the monetarist theory
aggregate excess demand resulting from excess supply of money is regarded as
the only cause of inflation, the structurelist theory accredits inflation to
the composition of demand for products and services accompanied by
inflexibilities in the productive structure (Fisher & Mayer, 1980).
One of the key culprits of money growth, especially in the
developing world, is the monetization of deficits. The monetization of deficits
leads to increases in the monetary base in an economy, which implies increases
in the money supply, which in turn stimulate aggregate demand and expectations
of higher inflation, pushing the authorities to accommodate the resulting price
increases.
Friedman (1963) arguing that, high rate of inflation in any
economy is due to monetary expansion, some researchers and policy makers argued
that government budget deficits are also inflationary. These arguments (Sergent
& Wallace, 1981; Leeper &Walker 2012) stem from the method
by which government finance their deficits. That is, either by borrowing from
domestic or foreign sources or by printing money. This is because, deficits
financed by monetization would directly expand the money supply whiles
borrowing (particularly from domestic sources) tend to crowd out investment of
the private sector and cut down economic growth and aggregate supply, which
also has inflationary effect on the economy. Historically, high inflationary
economies, especially those in the developing world, also tend to have wide
fiscal deficits; suggesting a line between fiscal deficits and inflation.
The Ghanaian economy for more than centuries has experienced
high and continuous inflation and a lot of policies and programs like the
Economic Recovery Program (1983), the Structural Adjustment Program (1986) that
was aimed at solving it proved to be futile. Sowa and Kwakye (1993),
Atta-Mensah and Bawumia (2003), Ocran (2007), Adu and Marbuah (2011) among
other empirical studies on the causes of inflationary process in the Ghanaian
economy have arguably pointed out that, the high and persistent increases in
the price of goods and services since the late 1970s has been “nurtured” by
monetization of the fiscal deficits, monetary expansion, depreciation of the
Ghanaian currency, cyclical food deficits among others.
After Ghana gained independence in 1957, the country
encountered relative price stability as the inflation rate floated to a single
digit. However, the 1970s and beginning of 1980, saw very high inflationary
episode been recorded. The yearly inflation rate recorded, assuaged 100% on
four occasions between July 1977 and March 1983. The 1970s in particular was
characterized by an increased trend in inflation. Inflation levels remained
generally high from 1972 with rates ranging between 10% in 1972 and 123% in
1983, with growth in money supply being 41% and 40% respectively in both years;
while the figures for fiscal deficits in that period were 5.7% in 1972 and 2.7%
in 1983. The surges in inflation during this period were (1972-1983) could be
as a result of the excess growth in money supply due to the monetization of the
fiscal deficits. The inflation rate then came down in 1984 to 39% while growth
in money supply was 53% and a deficit-GDP ratio of 1.8%. After moderating
somewhat during the latter parts of the 1980s; government expenditure goes up
in 1992 which was an election year contributed massively to inflation rates
surging from 10.1% in 1992 to 24.81% in 1993 and 59.9% by the end of 1995.
In recent times, the inflation rate has been of relatively
low when compared with the 1970s and 1980s. In 2000s, the rate has been between
11% and 34% with 2001 and 2011 having the highest and the lowest figures of
32.9% and 8.7% respectively. During this same period fiscal deficit as a
percentage of GDP was 7.7% (2001) and 4.2% (2011) while growth in money supply
was 56.53% for 2001 and 34.04% for 2011.
Statement of the Problem
The significance of stable prices in achieving macroeconomic
stability and providing the congenial environment for attaining sustainable
growth in employment and output cannot be overemphasized. As such ensuring
price stability in the form of low inflation, so as to anchor governments
objectives of attaining higher rates of employment and economic growth
remains the focal point and the cornerstone of Bank of Ghana’s monetary policy.
For the past three decades, Ghana has succeeded in lowering inflation rates
from historically high levels to a single digit, of 8.80 percent in January
2013 (Ghana statistical Service, Quarterly Statistical Bulleting). However,
over the four (4) years, the country seems to appear vanquished in the battle
against inflation as the general price level has steadily edged up to 13.3
percent in January, 2017. The economy is showing signs of deterioration and the
stability of the macroeconomic environment is being threatened as the cedi is
losing its external value against major currencies (i.e. depreciating by 6.2
percent against US dollars), with public debt to GDP ratio reaching 74 percent
all in 2016 (Ghana Statistic Service report 2016). Furthermore, whereas, ardent
monetary growth in recent years (i.e. dropping from 20.4 percent in 2013 to 3.6
percent in 2016), the country continues to experience increasing fiscal deficit
and current account deficits (reaching 9.0 percent and 7.8 percent in 2016
respectively) with detrimental effects on the price stability, economic
activities and economic growth in general. Whereas government is consolidating
its fiscal stance by cutting down taxes’ on some goods and reducing fuel prices
and utility subsidies in order to stabilize the price level and economy as a
whole, the question remains whether we can rely on fiscal prudence alone to solve
the inflationary pressures in the economy.
Again, how is price level influenced by expansion in
aggregate money supply? Is there causal link between money growth and inflation
rate in Ghana? Does interest rate and exchange rate affect inflation in Ghana?
Finding empirical answers to these questions is what this dissertation set out
to achieve. This study differs from existing studies by looking at the extent
to which both fiscal and monetary policy interacts to influence the price level
in Ghana.
As Ghana continues to combat inflation through the framework
of inflation targeting and also attaining its objective in meeting the
requirement of joining the West Africa Monetary Zone (i.e. Single-digit
inflation), understanding of the forces that actually explain the antecedence
of inflation cannot be overstressed.
This research therefore explores the relationship between
money growth, interest rate, exchange rate and inflation in Ghana.
Specifically, it aimed at finding a possible two-way relationship between money
supply growth and inflation in Ghana, the effect of interest rate and exchange
rate on inflation in Ghana.
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