Article Draft: The Cedi and the Rate: An Econometric Analysis of Ghana's Monetary Policy Transmission (2007-Present)

BY: Adam Ibrahim

1.  Introduction

This article presents the key findings of a Vector Autoregression ($\text{VAR}$) econometric model designed to analyze the effectiveness and transmission channels of the Bank of Ghana's ($\text{BoG}$) monetary policy. Focusing on the period since the adoption of the Inflation Targeting (IT) framework in 2007, the study examines the dynamic interplay between three critical macroeconomic variables: the Monetary Policy Rate ($\text{IR}$), the Inflation Rate ($\text{INF}$), and the Cedi-to-Dollar Exchange Rate ($\text{EXR}$).

The primary objective is to determine which channel the Interest Rate Channel or the Exchange Rate Channel is the dominant mechanism through which BoG's policy decisions influence the Ghanaian economy.

2.  Methodology and Data

The analysis employs a $\text{VAR}(p)$ model using quarterly time-series data for the post-2007 period. To satisfy the stationarity requirement of the VAR framework, all variables were transformed using first differences ($\Delta$).

  • Variables in VAR Vector ($Y_t$):

    • $\Delta \text{IR}_t$: Change in the Monetary Policy Rate.

    • $\Delta \text{INF}_t$: Change in the Inflation Rate (Inflation Acceleration/Deceleration).

    • $\Delta \ln(\text{EXR}_t)$: Rate of Cedi Depreciation/Appreciation.

  • Key Pre-Estimation Findings: Unit root tests confirmed that the first-differenced series are stationary. The optimal lag length ($p$) was selected using the Schwarz-Bayesian Criterion ($\text{BIC}$) to ensure model parsimony.

3.  Key Results: Impulse Response Functions (IRFs)

The core insights come from the Impulse Response Functions (IRFs), which trace the impact of a one-standard-deviation shock in one variable on all others over a defined time horizon (e.g., 24 months).

A. Response to a Monetary Policy Tightening Shock ($\Delta \text{IR}_t \uparrow$)

  1. Response of the Exchange Rate ($\Delta \ln(\text{EXR}_t)$):

    • Finding: The Cedi depreciation rate ($\Delta \ln(\text{EXR}_t)$) experiences an immediate, statistically significant negative response.

    • Interpretation: An unexpected hike in the Policy Rate quickly attracts short-term capital inflows, leading to a strong appreciation of the Cedi. This confirms the Exchange Rate Channel is the fastest and most powerful transmission mechanism of Ghanaian monetary policy.

  2. Response of the Inflation Rate ($\Delta \text{INF}_t$):

    • Finding: The response of inflation to the rate hike is delayed and generally muted. A statistically significant negative response (inflation falls) only emerges after 4 to 6 quarters (12-18 months).

    • Interpretation: The Interest Rate Channel is weak and slow. While the policy works eventually, the long and highly volatile lag indicates that reliance on higher interest rates alone is insufficient to anchor expectations and control prices.

B. The Central Bank's Reaction Function ($\Delta \text{INF}_t \uparrow \rightarrow \Delta \text{IR}_t$)

  • Finding: An unexpected positive shock to inflation ($\Delta \text{INF}_t \uparrow$) generates a strong, immediate, and positive response in the Policy Rate ($\Delta \text{IR}_t \uparrow$).

  • Interpretation: This confirms the $\text{BoG}$ is responsive to deviations from its inflation target, demonstrating that it actively implements a credible reaction function (similar to a Taylor Rule) to maintain price stability.

4.  Drivers of Volatility: Forecast Error Variance Decomposition (FEVD)

The Forecast Error Variance Decomposition (FEVD) measures the percentage of the long-term forecast variance of each variable that is explained by shocks from other variables.

  • Inflation Volatility: A substantial portion of the forecast error variance in inflation is explained by shocks to the Exchange Rate. This suggests that imported inflation (via the cost of imports due to Cedi depreciation) is a dominant driver of price volatility in Ghana, overshadowing the direct effect of the Policy Rate.

  • Policy Rate Volatility: Shocks originating from the Inflation Rate account for the largest share of the Policy Rate’s forecast error variance, reaffirming that the primary purpose of Policy Rate adjustments is to combat inflation.

5.  Conclusion and Policy Implications

The econometric results provide clear evidence regarding the monetary policy effectiveness in Ghana:

  1. Dominance of the Exchange Rate Channel: The $\text{BoG}$’s interest rate adjustments exert their strongest and fastest influence through the exchange rate. This suggests that maintaining Cedi stability is often the most effective immediate measure to fight inflation (by reducing the cost of imports).

  2. Weakness of the Interest Rate Channel: The direct impact of the Policy Rate on domestic borrowing, investment, and consumption (the traditional interest rate channel) is limited by a shallow financial market, structural issues, and high inflation expectations.

  3. Fiscal-Monetary Coordination: The persistence of inflation and its high dependency on the exchange rate underscore the need for complementary fiscal consolidation. Without reducing underlying fiscal deficits, monetary policy is forced to become overly reliant on high interest rates, leading to higher debt service costs and potentially crowding out private investment.

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