Is monetary policy effective in dampening fiscally induced exchange market pressures? Evidence from Ghana

Abstract

Episodes of currency crises in Ghana over the recent past were examined. We also address two fundamental questions using VAR framework. First, how does fiscal policy relate to exchange market pressures (EMPs) in Ghana? Second, whether persistent fiscal slippages hinder the effective use of interest rate as monetary policy tool to influence undesirable exchange rate fluctuations? We found sterilization interventions to be more effective than interest rate as a monetary policy tool in moderating tensions in foreign exchange market. Higher recurrent expenditure was generally associated with higher EMP, while capital expenditures tend to assuage EMP. We recommend strong policy coordination between the fiscal and monetary authorities to ensure macroeconomic stability.

Keywords:

• fiscal policy
• exchange market pressure
• monetary policy
• sterilization intervention
• currency crisis

JEL classification:

• E4
• E5
• F3
• G01
• H6

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. For example, using the traditional monetary approach to the balance of payment, Frenkel and Johnson (1976) argued that if the increase of the domestic credit portion of the monetary base outweighs that of base money demand, foreign exchange reserves will be depleted and the exchange rate regime will collapse.

2. This was addressed by Corsetti, Pesenti, and Roubini (1998); Krugman (1998); and tested by Goldfajn and Gupta (1999).

3. Papers that have presented models of EMP include Connolly and Da Silveira (1979) for Brazil, Weymark (1995) for Canada, Wohar and Lee (1992) for Korea and Burkett and Richards (1993) for Paraguay; Ahluwalia (2000) constructed a variant of EMP for several countries. More recently, several papers (including Eichengreen, Rose, and Wyplosz 1996; Kaminsky, Lizondo, and Reinhart 1998) have used EMP indirectly to construct a discreet crisis indicator, while others such as Hausmann, Panizza and Stein (2001) and Tanner (2001) estimated EMP directly to examine exchange rate management policy and the behaviour of EMP in emerging markets of Asia and Latin America, respectively.

4. See for example Drazen (1999), Kraay (2003) and Lahiri and Vegh (2000).

5. KLR approach is similar to that of Eichengreen, Rose, and Wyplosz (1996) but the former augments the volatility smoothing weights of the latter by multiplying the right hand side variables with a standard deviation of changes in exchange rate ‘’.

6. Several papers (including Calvo and Mendoza 1996; Flood, Garber, and Kramer 1996) have discussed such sequence of event in the context of balance of payment crises and speculative attacks.

7. For robustness, we also assumed a three-variable VAR using the ordering to further investigate the effectiveness of monetary policy tools in moderating EMP, barring any influence from fiscal policy.

8. The Fisher effect states that, in response to a change in money supply, the nominal interest rate changes in tandem with changes in the inflation rate in the long run. In addition, the quantity theory of money states that changes in money supply result in corresponding amount of inflation in the long run. Therefore, changes in the money supply should not have an effect on real interest rate in the long run.

Additional information

Notes on contributors

Nana Kwame Akosah

Nana K. Akosah is currently an Economist at the Research Department of the Bank of Ghana. He received his MSc in Economic and Financial Forecasting from London Metropolitan University, England. His research interests are in the area of Macroeconomics with special attention to monetary and fiscal policies in emerging/developing countries. He has published articles in journals including Journal of Economic Studies, West African Economic Review and Journal of Sustainable and Economic Development.

Julius Berry Dasah

Julius B. Dasah, PhD is currently a Resident Facilitator at the Centre for Training & Professional Development, Bank of Ghana. He received his PhD in Statistics from North Carolina State University, USA. His research interests include the applications of statistical methodologies in finance, economics and marketing. He has published articles in journals such as International Journal of Bank Marketing and International Business Economics.