Exchange rate impact on output and inflation: A historical perspective from Zimbabwe

Abstract

This research looks at the inflationary effect of currency devaluation and its contractionary effect on real output growth in Zimbabwe. The study uses quarterly data from 1990 to 2006 and utilizes the Johansen co-integration regression test and vector error correction method (VECM); and examines the short run and long run relationship between exchange rate, inflation and real output. The study finds that firstly, in both the short run and long run, fluctuations in the real exchange rate are significant on real output growth and expansionary in both periods. Secondly, the findings of the study suggest that exchange rate fluctuations are neither inflationary nor deflationary in Zimbabwe in the short run. Lastly, the result of the long run supports our hypothesis that devaluation of real exchange rate is inflationary. It implies that the weakening of domestic currency as part of the exchange rate liberalization policy is an incentive to Zimbabwean exporters and has potential economic growth gains though, in the long run, it has inflationary effects.

Keywords:

• inflationary effect
• currency devaluation
• exchange rate
• co-integration test
• Zimbabwe

JEL Classification:

• F30
• F31
• F40

Notes

1 Contractionary effect means devaluation of currency has a negative effect on Real Gross Domestic Product.

2 Expansionary effect means devaluation of currency has positive effect on Real Gross Domestic Product (Vaithilingam, Guru, and Shanmugam 2003).

3 Devaluation is the weakening of domestic currency against another country's currency. In this study we use it interchangeably with depreciation of exchange rate.

4 Data source for this section is Zimbabwe Statistics (ZIMSTATS) (1992; 1995, 2006) Statistical Yearbook and the Reserve Bank of Zimbabwe (2006).