Examining the 2007 Redenomination of the Ghanaian Cedi on The

37 KEYWORDS: international macroeconomics, monetary policy, inflation, Ghana, redenomination, VAR model Examining the 2007 Redenomination of the Ghanaian Cedi on the Disinflation Process Using the Chow Structural Break Test and VAR RIKI MATSUMOTO INTERNATIONAL AFFAIRS & ECONOMICS, ESIA ‘18, [email protected] ABSTRACT Ghana has experienced high and variable rates of inflation over the past 40 years. While this is no longer the case, inflation remains stubbornly elevated relative to economies of similar size (Magnus & Fosa, 2011). Conventional disinflation policies involve countercyclical monetary policies, reducing fiscal expenditure, and comprehensive economic and political reform. These policies in turn can be bolstered by a currency redenomination; when the nominal value of all prices is reduced. A number of countries such as, Turkey (in 2005), Romania (in 2005), Belarus (in 2006 and 2016) have pursued this strategy, including Ghana (in 2007). The question of whether currency redenomination is an effective qualitative tool in the disinflation process is important because of its potential as an important tool for countries struggling with high and variable rates of inflation. Unfortunately, existing literature has been deficient, and no appropriate techniques have been employed to examine this question. Thus, the goal of this paper is to examine the impact of the Ghanaian currency redenomination in 2007 on the disinflation process using appropriate statistical techniques; the Chow Test and Vector Autoregression (VAR), then evaluate whether it may be an effective policy option for monetary authorities. This paper employed monthly time series data from January 2000 to September 2017 provided by the Bank of Ghana. The results gathered in this paper showed that the Chow Test found a structural break before and after the date of redenomination. However, the bifurcated vector autoregression VAR(3) was inconclusive as to whether the policy itself directly affected the disinflation process. These results suggest that further research is needed to evaluate the potential of currency redenomination as a qualitative tool in the disinflation process. Originality/value – This paper is one of few studies which has investigated the impact of currency redenomination, especially in Africa and Ghana specifically. • INTRODUCTION other scenarios, disinflation policies may require a reduction in the monetization of government debt, Over the past 40 years, Ghana has experienced fiscal consolidation, and comprehensive economic high and variable rates of inflation. Inflation is no and political reform. The policies in turn can be bol- longer as high compared to the politically turbulent stered through the redenomination of a currency 1970’s and 1980’s, yet remains stubbornly elevated when the nominal value of all prices is reduced. A compared to economies of similar size (Magnus & number of countries such as, Turkey (2005), Roma- Fosa, 2011). Countries that suffer from high inflation nia (2005), Belarus (2006, 2016) have pursued this must consequently deal with undesirable economic strategy, including the country in question, Ghana outcomes such as increasing uncertainty associat- (2007). This raises the question of whether curren- ed with a firm’s expected profits, variable patterns cy redenomination is an effective qualitative tool of household saving and investment, and decreased in the disinflation process. Specifically, the goal of purchasing power (Adom, Zumah, Mubarik, Ntodi & this paper is to examine the impact of the Ghanaian Darko, 2015). currency redenomination in 2007 on the disinflation This problem persists even if the country is al- process using the Chow Test and Vector Autore- ready on the disinflation path. Conventional dis- gression, then evaluate whether it may be an effec- inflation solutions may involve reducing fiscal -ex tive policy option for monetary authorities. penditure and restrained monetary policies. In THE GW UNDERGRADUATE REVIEW • VOLUME 1 38 Bank of Ghana Interest Rate & Interbank Weighed Average 2000-2017 50 Bank of Ghana Act 612 40 30 Interest Rate 20 10 2000m1 2002m1 2004m1 2006m1 2008m1 2010m1 2012m1 2014m1 2016m1 2018m1 Time Inter-Bank Weighted Average Monetary Policy Rate (%) GRAPH 1. Graph 1 depicts poor monetary policy transmission before the 2002 Bank of Ghana Act 612 (shown with a vertical line), with significant spreads between the Inter-Bank Weighted Average (“IntBkWAve”) and the BoG Monetary Policy Rate (“MPR”). INFLATION AND GHANA economy experiencing elevated inflation, the changes in As noted in the introduction, Ghana has had a his- the money supply lead to an approximate proportional tory of high and variable rates of inflation. Inflation is change in the price level. It is also important to note that the continual increase in the price level of goods and money growth may hit inflation rates with a lag, which services in the economy, responding to variables like suggests the need to include autoregressive distributed lag components in the analysis. inflation expectation, money supply, growth in output, and government deficits. The quantity theory of money (“QTM”) as expressed by the equation of exchange, GHANA’S MONETARY POLICY AND INFLATION MV = PY, where M is money supply, V is the velocity of TARGETING FRAMEWORK money, P is the price level, and Y is real GDP, indicates that: 1) changes in the money supply lead to proportion- The Bank of Ghana (“BoG”) initially announced the al changes in the price level; where P=(M*V)/Y shows public notice stating their intent to redenominate the constant money velocity and GDP; and 2) the inflation Cedi in June 2007. The BoG Public Notice (2007) released rate, π is the growth rate of money supply minus the the following statement: growth rate of aggregate output π = % ΔM - %ΔY (Mish- The Bank of Ghana is planning to redenominate kin, 2016). These implications of the quantity theory of the current cedi by setting ten thousand cedis to money are evident in long run data, but not in short run one new Ghana Cedi (GH¢), which will be equiva- data. Therefore, this paper will use time series data over lent to one hundred Ghana Pesewas (Gp). That is the long run: January 2000 to September 2017. Addi- ¢10,000=GH¢1=100Gp. New notes and coins will be tionally, the estimated coefficients of M2 growth are issued to replace the existing notes and coins over a close to one in countries marked by high money growth period of at least 6 months (p.1) and inflation (Maroney, 2002). This implies that in an This announcement followed substantial economic and political reforms. In January 2002, the Bank of Ghana Act 39 SPRING 2018 • THE GEORGE WASHINGTON UNIVERSITY 612 was passed by the Parliament of Ghana. BoG Act 612 include institutional reforms such as increasing the gave operational independence to the central bank, es- statutory independence of their central bank (Mosley, tablished an implicit inflation targeting (“IT”) framework, 2005). For example, in preparation for its entry into the and created the Monetary Policy Committee (“MPC”) to European Union, Romania’s central bank in 2005 por- oversee monetary policy (Burkel, 2008). The indepen- trayed its currency redenomination process as demon- dence aspect of the law authorized the BoG to employ strating that “the days of hyperinflation are over and the any measure available to achieve its primary objective of new currency will help keep things that way” (BBC, 2005) price stability (Bank of Ghana, 2015). Following the BoG Thus, in Romania, redenomination was used at the end Act 612, the MPC implemented institutional and opera- of a macroeconomic stabilization process, indicating to tional reforms, such as accountability and transparency the ECB authorities that Romania was ready to enter the mechanisms to enhance the effectiveness of mone- European Union. tary policy (Bank of Ghana, 2015). Graph 1 depicts poor Secondly, the currency redenomination can be imple- monetary policy transmission before the 2002 Bank of mented concurrent to the disinflation process. The prin- Ghana Act 612 (shown with a vertical line), with signif- ciple for employing redenomination during the disinfla- icant spreads between the Inter-Bank Weighted Aver- tion process is the assumption that the Money Illusion age (“IntBkWAve”) and the BoG Monetary Policy Rate Effect may influence inflation expectation. The Money (“MPR”). In May 2007, the BoG formally announced a full- Illusion Effect refers to a “tendency to make biased judg- fledged inflation targeting framework as their monetary ments about the real value of transactions on the basis policy strategy, with the redenomination policy follow- of their nominal values” (Dzokoto et al., 2010, p.521). ing soon thereafter (Addison, 2008). Mosley (2005) hypothesizes such an effect may comple- ment the disinflation process because the lower nominal LITERATURE REVIEW value convinces citizens that a return to high inflation is unlikely. Explicit commitments to specific macroeco- Redomination in Theory nomic targets, in conjunction with redenomination may Existing literature that addresses the theoretical and improve the effectiveness of the monetary authorities. practical aspects of redenomination includes: Impact In economic theory, efforts to influence market actors of Currency Redenomination on Inflation Case Study through commitments regarding future monetary policy Turkey (Žídek & Chribik, 2015),A Tale of Two Cedis: are called “forward guidance” (Kuroda, 2017). Policies Making Sense of

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