Eastern Illinois University The Keep Masters Theses Student Theses & Publications 2014 A Monetary Analysis of Ghana: Examining the Relationship between Monetary Policy, Price Stabilization, and the Real Exchange Rate Nana Quaicoe Eastern Illinois University This research is a product of the graduate program in Economics at Eastern Illinois University. Find out more about the program. Recommended Citation Quaicoe, Nana, "A Monetary Analysis of Ghana: Examining the Relationship between Monetary Policy, Price Stabilization, and the Real Exchange Rate" (2014). Masters Theses. 1317. https://thekeep.eiu.edu/theses/1317 This is brought to you for free and open access by the Student Theses & Publications at The Keep. It has been accepted for inclusion in Masters Theses by an authorized administrator of The Keep. For more information, please contact [email protected]. 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A Monetary Analysis of Ghana: Examining the Relationship between Monetary Policy, Price Stabilization, and the Real Exchange Rate (TITLE) BY Nana Quaicoe THESIS SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF Master of Arts in Economics IN THE GRADUATE SCHOOL, EASTERN ILLINOIS UNIVERSITY CHARLESTON, ILLINOIS 2014 YEAR REBY RECOMMEND THAT THIS THESIS BE ACCEPTED AS FULFILLING THIS PART OF THE GRADUATE DEGREE CITED ABOVE DATE THESIS COMMITTEE MEMBER DATE THESIS COMMITTEE MEMBER THESIS COMMITTEE MEMBER DATE A Monetary Analysis of Ghana: Examining the Relationship between Monetary Policy, Price Stabilization, and the Real Exchange Rate Nana Quaicoe Eastern Illinois University 2014 Advisor: Dr. Teshome Abebe Committee: Dr. Ali Moshtagh Dr. Noel Brodsky 1 TABLE OF CONTENTS LIST OF TABLES LIST OF FIGURES ACKOWLEDGMENTS ABSTRACT CHAPTER 1. INTRODUCTION p.8 2. LITERATURE REVIEW p.12 2.1 Financial/Banking Structure p.12 2.2 The Bank of Ghana p.15 2.3 Economic Growth p.17 2.4 Inflation p.18 2.5 Exchange Rate p.19 2.6 Lags of Monetary Policy p.21 2. 7 Monetary Policy in Ghana p. 23 3. DATA AND DESCRIPTIVE STATISTICS p.25 4. METHODOLOGY p.28 4.1 Vector Autoregression p.28 4.2 Vector Error Correction Model p.30 5. SCENARIO A- FINANCIAL MARKET QUANTITY APPROACH p.31 5.1 Lag Selection Order Criteria p.31 5.2 Unit Root Tests p.33 5.3 Cointegration Analysis p.34 5 .4 General Tests p.35 5.5 Results p.39 6. SCENARIO B- FINANCIAL MARKET PRICE APPROACH p.46 6.1 Lag Selection Order Criteria p.46 6.2 Unit Root Tests p.48 6.3 Cointegration Analysis p.49 2 6.4 General Tests p.50 6.5 Results p.54 7. CONCLUSION p.59 REFERENCES APPENDIX 3 LIST OF TABLES Table 1.a- Summary Statistics p.65 Table 1.b- Criteria for Selecting Lag Length p.32 Table 2.b-Augmented Dickey Fuller Unit Root p.33 Table 3.b- Johansen's Test forCoin tegration p.34 Table 4.b-Eigenvalue Stability Condition Tables p. 36 Table 5.b-Lagrange Multiplier Test p.38 Table 6.b-Impulse Response Function Tables p.43 Table 7.b-Forecast Error Decomposition Variance p.44 Table 1.c- Criteria forSel ecting Lag Length p.47 Table 2.c- Unit Root Tests p.48 Table 3.c- Tests forCoin tegration p.49 Table 4.c- Eigenvalue Stability Condition p.51 Table 5.c- Lagrange Multiplier Test p.53 Table 6.c-Impulse Response Function p.57 Table 7.c- Forecast Variance Decomposition p.58 4 LIST OF FIGURES Figure 1.a-GDP Growth (2006Ql-2013Ql4) p.65 Figure 2.a- InflationRate (1992Ml-2013M12) p.66 Figure 3.a- Changes in the World Commodity Price Index (1992Ml-2013M12) p.66 Figure 4.a- World Commodity Price Index (1992Ml-2013Ml2) p.67 Figure 5.a- Monetary Policy Rate (1992Ml-2013M12) p.67 Figure 6.a- M2 Growth (1992Ml-2013M12) p.68 Figure 7.a- LernerIndex (1996-2010) p.68 Figure l.b - Stationarity of Cointegrating Equations p.35 Figure 2.b- Roots of the Companion Matrix p.37 Figure 3.b- Impulse Response Function results p.39 Figure 1.c- Stationarity of Cointegrating Equations forSc enario B p.50 Figure 2.c- Roots of the Companion Matrix forSce nario B p.52 Figure 3.c- Impulse Response Function results forSc enario B p.54 5 ACKNOWLEDGMENTS Much thanks and gratitude goes to God, my family fortheir tremendous support, and the economics faculty at Eastern. Thank you. 6 ABSTRACT The primary objective of this study involves evaluating the link between monetary policy, price levels, and the bilateral real exchange rate in Ghana. To make up forthe sparse and inadequate monetary economics literature in Ghana, the study makes a substantial contribution by delineating between different monetary policy instruments. Using monthly data from 1992- 2013, a Vector Error Correction Model (VECM) is developed forex ploring and measuring the relationship between monetary policy, inflation rate, and the bilateral real exchange rate in Ghana. The growth of broad money supply (M2) and the Monetary Policy Rate are used as the principal monetary policy instruments. Changes in the world commodity price index acts as an exogenous supply shock. Using this framework enables the comparison of existing literature to current research and assists in determining which monetary policy tool is more influential in general price stabilization in Ghana. Also, by incorporating the world commodity price index, the study aims at solving the "price puzzle" effect associated with research of this nature. Results suggest that both financial market quantities and financialmarket prices have an effect on inflation and real exchange rate in Ghana. However, the Monetary Policy Rate has a larger impact on macroeconomic variables than the growth of money supply in Ghana. Supply shocks were foundto have minimal effects on general prices in Ghana. 7 CHAPTER ONE INTRODUCTION Determining how monetary policy affects the economy is critically important both for distinguishing between competing theories of economic fluctuations and for conducting policy (Romer and Romer 2004). For this reason, understanding the relationship between monetary policy, the inflation rate, and the real exchange rate in Ghana is important forbo th economic stability and fordeveloping policy. In evaluating this relationship, I firstpres ent a new model which builds on a Vector Error Correction Model (VECM) frameworkwhere monetarypolicy instruments are delineated into two categories: a financial market quantity category and a financial market price category. Furthermore, I use the world commodity price index as a proxy forexternal supply shocks and I also calculate the forecasterror variance decomposition foreach variable, a technique not utilized before in macroeconomic literature relative to Ghana. I then consider whether using monetary aggregates or interest rates are more effective in influencing both the price level and the real exchange rate in Ghana. Since Ghana's political independence in 1957, the country has undergone financial sector development and various economic reforms. For instance,the Bank of Ghana, once politically dependent is now independent, banking competitiveness has improved, and credit to the private sector has grown over the last fewyears . Also, there have been capital market and money reforms,banking reforms, currency redenomination, and perhaps most importantly, rural banking reforms. How much impact these reforms coupled with different monetary policies have had on the economy in terms of economic growth and development, price level changes, and the exchange rates of Ghana is an important question that arises.