On the Causes and Effects of Exchange Rate Volatility on Economic Growth: Evidence from Ghana

ABSTRACT

What drives exchange rate volatility, and what are the effects of fluctuations in the exchange rate on economic growth in Ghana? These questions are the subject matter of this study. The results showed that while shocks to the exchange rate are mean reverting, misalignments tend to correct very sluggishly, with painful consequences in the short run as economic agents recalibrate their consumption and investment choices. About three quarters of shocks to the real exchange rate are self-driven, and the remaining one quarter or so is attributed to factors such as government expenditure and money supply growth, terms of trade and output shocks. Excessive volatility is found to be detrimental to economic growth; however, this is only up to a point as growth-enhancing effect can also emanate from innovation, and more efficient resource allocation.

KEYWORDS:

• Volatility
• GDP growth
• Exchange Rates
• GARCH
• GMM
• Ghana

JEL CLASSIFICATION:

• F4
• F31
• F32
• C1

Notes

1. There have also been excellent discussions on carry trade–exchange rate volatility nexus (see Menkhoff et al., 2012; Cenedese, Sarno, & Tsiakas, 2014).

2. For brevity, we do not report the unit roots results but these are available upon request.

3. Under a fixed regime, the domestic authorities could potentially respond to stem the tide of loss international reserves to forestall devaluation. Optimizing agents foresee that the authorities would take these actions to stabilize the exchange rate. This may either lead to a self-fulfilling crisis whether the expectation of further depreciation leads to speculative attacks and abandonment of the peg, or on the positive side, the expectation of the authorities’ intervention stabilizes the exchange rate at its current equilibrium level.

4. Mpundu Chipili (2014) also assesses the impact of central bank of Zambia’s intervention on the volatility of the exchange rate and found a statistically weak negative impact of intervention on exchange rate volatility, suggesting that other important policy instruments are required to augment foreign exchange interventions in taming exchange rate volatility.

Additional information

Funding

This study was funded by the International Growth Centre (IGC), London School of Economics and Political Science (LSE). The authors fully acknowledge their financial support.