Download inflation and exchange rate depreciation: a

Economics and Finance Review Vol. 3(09) pp. 22 – 42, July, 2014
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INFLATION AND EXCHANGE RATE DEPRECIATION: A GRANGER CAUSALITY
TEST AT THE NAISSANCE OF ZIMBABWE’S INFAMOUS HYPERINFLATION (2001 -2005).
Blessing Mandizha
BA ISAGO University, Private Bag F238, Francistown, Botswana.
E-mail: [email protected]; [email protected]
ABSTRACT
Using five year panel data from the middle of the infamous Zimbabw ean hyperinflation, the study seeks to find
the impetus behind Zimbabwe’s hyperinflation; which is infamous as an inflation episode that went on for years
unabated until adding machines lost count, and everyone eventually kept quiet about it. The inflation, and all the
problems that consequently bedeviled the nation from around 2000-2008 were largely self-made when the
economy on the “Black Friday” of 14 November 1997 decided to print the Zimbabwean dollar (ZWD$) enmass
to honour liberation war veterans. This act led to a great meltdown of an economy that once stood as the bread
basket of Africa. The repertoire of solutions during the hyperinflation ran far and wide. Most efforts were based
on the premise that inflation was the “number one” enemy in the country. The view might have been myopic,
forced or just political. Adopting the Granger causality test, the paper unveils a contradicting conclusion about
the direction of the flow of cause and effect in the economy, during the period stretching 2001 to 2005 – a period
that stood as the core of the hyperinflation. Judging by the eventual solution, adopted at beginning December
2008, the results from the study are validated. Exchange rate pass-through dynamics also show differences
between the short run and long run.
Keywords: Granger causality, hyperinflation, exchange-rate depreciation, pass-through, Zimbabwe
1.1
INTRODUCTION
The study of inflation is central to economists especially in less developed countries (LDCs). Inflation is perilous
to a country’s economy because it undermines the ability of its currency to perform its traditional functions of
unit of account, store of value and reliable medium of exchange. In this study the causal relationship between
inflation and exchange rate depreciation, will be analyzed.
The impact of both a weak currency and high inflation on the purchasing power of the Zimbabwean dollar in the
post Economic Structural Adjustment Programme (ESAP) era is going to be analyzed. Inflation and a
depreciating exchange rate have been accused of occasioning a shift in the allocation of resources from
productive sectors to speculative activities (Zimbabwe Financial Gazette Archives, 2005). Most experiences of
high inflation have taken place during or after periods of wars, as in the case of Germany (1921-1922) and or
political instability as in the case of Hungary (1921-1924).
The study will investigate the causal relationships between high inflation and a depreciating Zimbabwean dollar
(Z$); based on time-series data of the Zimbabwean economy. Parkin and Bade (2013) conclude that both
inflation and a weak currency are caused by a high growth in the money supply. Kamin and Rogers (2000)
believe there is one-way causality between the exchange rate and the rate of inflation. Other findings suggest that
there is a very strong correlation between the inflation variable and exchange rate depreciation (Noer, Arie and
Piter, 2010; Kamin and Khan, 2003; and Choudhri and Hakura, 2006). For Kamin & Khan this is particularly
strong in South America rather than in Asia. On the other hand other authors using the Kamin-Rogers (K-R)
methodology have mixed conclusions about the relationship between inflation and exchange rate depreciation
(Vinh and Fujita 2007; and Shi, 2006). However, Khan, Sattar and Rehman (2012) find no causality exists in any
direction between inflation and exchange rate in Pakistan, and the authors suggest there is thus no reason to use
any exchange rate oriented policies to impact on inflation and other macroeconomic variables.
Ito and Sato (2007) conclude that the degree of exchange rate pass -through to the price level is high in those
countries experiencing currency crises. The evidence is picked from Latin American countries during their
currency crises, which soon turned into high rates of inflation ever experienced in the region. High currency
volatility therefore has a major role in inflation rate in the short run.
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Economics and Finance Review Vol. 3(09) pp. 22 – 42, July, 2014
Available online at http://www.businessjournalz.org/efr
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1.2
BACKGROUND OF THE STUDY
The Pandora box of Zimbabwe’s financial crisis was opened on the Black Friday of 14 November 1997. This day
became the naissance of the early signs of high inflation in Zimbabwe. Some most recent episodes of high inflation are Bolivia 1985, Argentina 1989, Nicaragua 1987-1989 and Peru 1988-1989’s hyperinflations. By
January 2004, Zimbabwe’s inflation had reached a local peak of 624 percent; this was the highest inflation rate
the world had seen in more than a decade, and for Zimbabweans it felt as if the economy had reached rock
bottom - hindsight tells us this was just the beginning.
The disbursement of unbudgeted War veterans’ gratuities, led to massive increase in money supply, since it was
financed through seignorage (Zimbabwe Financial Gazette Archives, 2005). A drastic increase in liquidity left
the economy was grappling to meet the sudden increase in ag gregate demand for final goods and services ,
lending support to Say’s Law, that ‘‘supply creates its own demand” (Say 1 ).
The Black Friday gave birth to Zimbabwe’s foreign currency woes. The suspension of the remaining US$159
million of an IMF stand-by arrangement for BOP support in the last quarter of 1999 also adversely affected the
already gloomy foreign currency inflows from the donor community (Finhold Group Annual Report, 2000). An
increasing budget deficit emanating from the government’s involvement in the DRC war, which started in
August 1998, and some structural shocks all pointed to an overvalued currency on the formal market. A
speculative attack on the country’s currency resulted and this forced the monetary authorities to periodically
devalue the Zimbabwean dollar (ZWD$) in a bid to retain export competitiveness (The Zimbabwe Independent
Archives, 2004).
Negative international publicity in the aftermath of the February 2000 referendum and in the run up to the June
2000 parliamentary elections led to a loss of investor confidence in the country, further worsening already
dimming economic prospects . The drought phenomenon Cyclone Eline in the 1999-2000 agricultural seasons
together with disruptions to commercial farming activities negatively affected output in many agro-based sectors
and exacerbated the dwindling foreign currency inflows. The “fast track”, land redistribution exercise of 20002001 reduced agricultural output hitherto, mainly affecting tobacco and maize output among other crops ; all this
despite frantic efforts to equip most of these “new farmers ” (Finhold Group Annual Report, 2000).
Foreign currency black market activities thrived as demand continued to outstrip supply. The increased demand
for foreign currency caused the local currency to depreciate continuously, with free fall. An auction system to try
and ration the limited foreign currency to the power utility (Zimbabwe Electricity Supply Authority, ZESA) and
to other manufacturing firms managed to give temporary relief for a few month but could not last for long as
funds dwindled by the day and applicants got fed -up of the of the cumbersome application process. (The
Business Chronicle, 2005)
The year 2004 was a turnaround year especially in the fight against inflation, a lbeit the banking crisis that also
characterized it (Reserve Bank of Zimbabwe, 2005a). However, in 2005, an unfavorable climate and increased
oil prices on the world market brought back memories of the huge maize imports of 1992 and 2002 and black
market dealings for foreign currency and fuel respectively. Zimbabwe’s foreign currency inflows fell from
US$3878 million in 1996 to US$301 million in 2003 and efforts to get support from IMF and other multi-lateral
finance institutions were thwarted by the growing political impasse between the West and Zimbabwe.
1.3
RESEACH PROBLEM
The twin evils of a chronically depreciation Zimbabwean dollar (ZWD$) and high inflation in the post-2000
period necessitated this research. The governor of the Reserve Bank of Zimbabwe in a number of monetary
policy presentations between 2003 and 2004 was quick to state that inflation as the number one enemy in the
country (Reserve Bank of Zimbabwe: Monetary Policy Statement, 2004). This assertion shall be put to test in
light of evidence from a number of authors suggesting that there can be bi-directional causality between inflation
and exchange rate (Ahmad and Ali, 1999); or one directional causality from exchange rate depreciation to
inflation (Obadan, 2006; and Noer, Arie and Piter (2010), and finally no causality (Khan, Sattar and Rehman,
2012).
1
See the original text on www.economyprofessor.com.economictheory: “Traite a historical Analysis” French Economist J.B Say
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The question the paper will attempt to answer is how significant is the relationship between exchange rate
depreciation and high inflation in Zimbabwe, and whether there is a permanent way out of the hyperinflation
quagmire for Zimbabwe?
1.4
OBJECTIVES OF THE STUDY
The researcher in this project seeks:

To test for the presence and direction of any causal relationship between exchange rate depreciation and
inflation.

To determine the magnitude and dynamics of exchange rate pass-through in the short run and long run.

To assess critically the effectiveness of government policies in solving the problem and its symptoms.
1.5
SIGNIFICANCE AND JUSTIFICATION OF THE STUDY
Zimbabwe needs an urgent s olution to its economic problems, which are basically buttressed by a high rate of
inflation and very minimal foreign currency inflows, especially in the face of massive speculative activity on the
Zimbabwean dollar (Z$). It is therefore imperative, that the true underlying relationship between exchange rate
depreciation and high inflation is established and a way forward cultivated.
The paper brings a new dimension to the study of the subjects of inflation and foreign currency crises especially
in Zimbabwe. It will be of specific importance to the central bankers, bankers, employers and employees,
importers and exporters, industry and trade officials, politicians, academics, the general reader and the general
public as well.
Moreover, the vicious circle that seems to exist between inflation and exchange rate depreciation in Zimbabwe
will be analyzed in full. For the success of both monetary and fiscal policies there is an urgent need to identify
the exact relationship between inflation and exchange rate d epreciation. The paper intends to fill this information
gap through its empirical findings of the economy. The study is also unique in that it uses parallel market (real)
exchange rates and the consumer price index.
1.6
HYPOTHESIS
The impact of the Black Friday of 14 November 1997 on the foreign exchange market in Zimbabwe is historical
and has been used to illustrate Dornbusch’s Overshooting model of exchange rates. The sudden depreciation of
the local currency gave birth to a number of economic problems that include that of high domestic prices,
especially in the face of expected imported inflation.
Thus the researcher adopts the following hypothesis:
H0 :
Null-hypothesis: Granger causality runs from exchange rate depreciation to inflation.
H1 :
Alternative-hypothesis: Granger causality does not run from exchange rate depreciation to
inflation.
1.7
ORGANISATION OF THE PAPER
The rest of the paper is organized as follows ; section two, reviews related literature to this study; section three,
entails the methodology used by the researcher in analyzing the causal relationship between exchange rate
depreciation and inflation in Zimbabwe. In section four, the results obtained from the estimation procedures of
the study are analyzed and finally section five concludes with policy recommendations.
LITERATURE REVIEW
2.1
INTRODUCTION
This section looks at theories and views on inflation and foreign exchange rates. It will also touch on related
researches by other researchers on other countries that have experienced high inflation and significant exchange
rate depreciations - this is critical in the justification of the methodology.
2.2
THEORETICAL LITERATURE
2.2.1 The Cagan Inflation Model
The hyperinflation model by Cagan (as cited in Friedman, 1956) asserts that the demand for real cash balances
(money demand) is inversely related to the expected rate of inflation. It therefore means that a higher expected
rate of inflation translates to lower demand for real cash balances to hold as wealth. The fact that mon ey is no
longer demanded as a means of wealth leads to an increase in demand for other assets (foreign currency, cars,
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buildings, inflation adjusted securities inter alia). The effect is an increase in the price level, as the excess
demand cannot be satiated by domestic supply of goods and services, and a fall in the value of the local currency
ceteris paribus. Even though the demand for real cash balances depends on other variables like income among
others, Cagan underscores the fact that during a high inflation episode the expected rate of inflation is a dominant
variable.
2.2.2
The Monetarist theory
The Monetarist School led by Milton Friedman (1968), takes inflation as a monetary phenomenon caused by
expansionary monetary and fiscal policies, such as government deficit financing and expansionary credit
policies. The Monetarists hold the view that expansion in the money supply will have a large and direct positive
influence on output, but only in the short run. In the long run a rise in the money supply does not affect real
output. They also view an increase in the demand for money as a rise in the demand for products and services;
which becomes inflationary as prices increase. The theory further emphasizes that the control of inflation
requires a necessary and sufficient condition, the control of money supply such that it grows in tandem with the
growth of money demand at stable prices, Ghatak (1995).
2.2.3 The Structuralist theory
Structuralists allege that the cause of inflation in Less Developed Countries (LDCs) is in certain structural
characteristics of the developing countries, which make them susceptible to inflation. Structural inflation arises
as a result of supply inelasticity and structural rigidities such as drought and inefficient production. It is Ghatak
(1995), who brings the element of foreign exchange constraints as a cause of inflation. Ghatak outlines structural
characteristics such as, the relative inelasticity of the supply of food; foreign exchange constraints; very limited
ability of capital markets to support the large volume of government borrowing and the fixed nature (in real
terms) of government expenditure.
2.2.4 Mundell-Fleming Model
2
The theory by Mundell and Flemming (1960) , considers three markets: money, assets and goods
market under perfect price flexibility in the long run. One implication is that devaluation may lead to
further devaluation if fiscal discipline, inflation and B.O.P disequilibria are not well managed. Another
implication is that the higher degree of re-export industry the country has, the lower the impact of
devaluation for current account improvements, this is because more and more foreign currency would
be spent on importing raw materials from abroad. Therefore the theory in brief asserts that a fall in the
external value of a country’s currency either through a devaluation or depreciation will eventually lead
to a worsening trade or current account balance.
2.2.5 The Neo Liberal “Crisis of Confidence Model”
In the ''crisis of confidence'' model, some events, such as involvement in a costly war or defeats in battle remove
the belief that the Central bank or the government issuing the money will remain solvent. When sellers and or
speculators, realize that there is a higher risk for the currency, they start chargin g more than yesterday. In this
model, the method of ending the high inflation is to change the backing of the currency - often by issuing a
completely new currency. Wars, civil unrest, capital flight, sometimes because of “contagion” or a global “smear
campaign” against a nation are some major causes of crisis of confidence 3 . The model also points at how the
government would try to increase the amount of domestic currency in circulation in an attempt to buy time
without coming to terms with the root cause of the lack of confidence per se. Finally either too little confidence
forces an increase in the money supply, or too much money destroys confidence 4 .
2.2.6 The Purchasing Power Parity Theory
The purchasing power parity (PPP) theory by Gustav (1921) 5 , gives us a basic and fundamental relationship
between the exchange rate and the price level. Also known as the “Law of one price”, PPP is based on the
premise that prices of comparable goods should not be different in two different locations. The hypothesis
stresses that countries that experience high depreciation also have high inflation. The relative form of the PPP or
“law of one price” affirms that starting from a base of an equilibrium exchange rate between two currencies, the
2
See Bibliography for, Robert A. Mundell (1960)
Original text from the article in WWW.Wikipedia, The Free Encyclopedia: Hyperinflation
4
ibid
5
See, Cassel’s 1921 article “ The worlds money problem”
3
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future of the exchange rate between the two currencies will be determined by the relative movements in the price
level in the two countries. The hypothesis thrives in an economy that has floating exchange rates. The equation is
given as follows:
P = r. Pf
Where ():
r – Exchange rate, price of say US ($) in ZW ($), that is, price of the foreign currency.
P – Domestic price level
Pf – Average price level for the rest of the world
2.2.7 The Neo-Classical model
In the neo-classical model, an increase in money supply, or drop in basic money stock, makes it impossible for a
government to improve its position by resorting to printing money (seignorage). That is, when government
obligations are more expensive to cover through printing money, because the cost of printing fiat money is
higher than the gain realized from printing the money. This is because the increase in the supply of money is
not matched with any increase in demand for it. On the other hand the price of the currency relative to other
currencies, that is the exchange rate, naturally falls. The purchasing power of the currency drops so fast that
holding cash for even a day results in unacceptable losses in purchasing power. As a result, no one holds
currency, which increases the velocity of money, and wors ens the crisis 6 .
2.2.8 The Classical Quantity Theory of Money
The classical theory of money tells us that prices of goods reflect stocks of money. Where we have:
P= MV
Y
If we hold income and the velocity of circulation constant:
P. Y = M. V
As illustrated above, if output Y and the velocity of circulation V are held constant an increase in money supply
will only lead to an increase in the price level. We can see that the thrust of the theory is that a slack monetary
policy especially on money supply management could fuel inflation tremendously.
2.3
EMPIRICAL LITERATURE (JUSTIFICATION FOR THE METHODOLOGY)
Maswana (2005), tests the causal pattern among inflation, money supply growth and the exchange rate. Using
Granger causality tests for Congolese monthly data for the period 1990:1 to 1996:9 and natural logarithms for
M3, CPI and parallel Zaire / US$ average for the period. The Akaike Information Criteria (AIC) was used to get
five (5) as the best lag level. The Phillips Perron test for non-stationarity was used to test for unit roots. The
results suggested that there is feedback causality between inflation and broad money supply, causality from
broad money to the exchange rate and finally from exchange rate to inflation. The results suggest that the
overriding goal of disinflation needs to be accomplished initially by exchange rate stabilization followed by a
direct inflation targeting.
Beatrix (2000)’s study uses biweekly data for the period 1945: August to 1946: June and sets out to test the
direction of causality between inflation as measured by the CPI and money creation. The monetary aggregate
(M2) was also used as an alternative measure of inflation; this view is also carried by the IMF and Wo rld Bank
comments in Zimbabwe Quoted Companies Survey (2005) where they say that M2 can act as a better measure of
price changes in a hyperinflationary economy than the CPI. Log (CPI) and log (M) were used for the price level
and money creation respectively. Due to few degrees of freedom a dummy could not be used. Lags of length
from two to twelve were used. The results found the existence of unilateral Granger causality, which ran from
inflation to money creation and that income from seignorage or inflatio n tax remained positive throughout the
high inflation period. Results from the proxy of inflation (M2) were also consistent with those that used the CPI.
Canetti and Greene (2000) studies ten African countries namely, Ghana, The Gambia, Kenya, Nigeria, Sierra
Leone, Somalia, Tanzania, Uganda, Zaire and Zambia. The paper tests the null hypothesis whether inflation is
6
ibid
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ISSN: 2047 - 0401
caused by money supply growth or exchange rate depreciation. Both vector auto regression (VAR) and the
Granger causality tests are used. The appropriate lag length of four (4) was set based on the Schwarz Criteria; the
minimum value of the criteria was found at lag four after an experimental exercise. Quarterly data from 1978:1
to 1989:4 was used.
In the VAR method, variance decomposition graphs suggested that money supply changes dominantly influence
inflation levels in 4 countries, in 3 countries exchange rate depreciation dominates and influences inflation whilst
in the other 3 they affect each other equally. Even after different ordering the results did not differ much for
variance decomposition. At lag length four and eight the Granger causality test produced consistent results,
showing the existence of feedback causality between the CPI and M3 growth, unidirectional causality from
broad Money supply to exchange rate and from exchange rate to the CPI. The study went on to emphasize that
despite large lag lengths being relevant in providing more past evidence, in this study a large lag length could
cause the regression to coincide with large devaluations such as two years before an uncorrelated inflationary
surge. It could thus lead to a spurious equation insignificant on the eight lag of exchange rate depreciation with
CPI.
Domac (2003) uses Vector Auto Regression (VAR) to study the relationship between the exchange rate,
inflation, inflation expectations and money supply growth in 53 developing countries. The study uses annual data
for the period 1964 – 1998 to test the level of causality between the exchange rate, inflation, inflatio n
expectations and money supply growth. Using the average nominal effective exchange rate for the exchange rate,
the consumer price index (CPI) for inflation, the CPI lagged one period backwards for inflation expectation and
finally M3 growth for money supply growth. The results show that 67% of the variances in the rate of inflation in
both the long run (three months and beyond) and the short run (one to two month) is explained by exchange rate
depreciation. On the other hand expected inflation explains ab out 10% – 20% of movements in the rate of current
inflation both in the short run and long run.
Odusola and Akihlo (2001)’s study on the Nigerian economy also uses the VAR technique to analyze the
relationship between the official exchange rate, the parallel and the rate of inflation. Quarterly data was used for
the period 1970:1 to 1995:4. The rate of inflation was found through log differencing of the Nigerian CPI. The
parallel exchange rate came from a private economic consultant and the Bank of Nigeria ’s economic research
department. The Augmented Dickey Fuller and Phillips Peron tests were used to test for non -stationarity. The
cointegration test suggested that it was integrated of order one, that is, I (1). The VAR results using impulse
responses suggested that the innovations in the parallel exchange rate caused positive though minor changes in
the CPI. The innovations in the rate of inflation resulted in a slight but positive change in the official exchange
rate and finally the innovations in the exchange rate led to significant movement in the CPI.
Salvatore (2004) looks at the advantage from currency depreciation that is lost because of inflation. The case
study looks at the period between 1997: second quarter to 1999: third quarter. See table 2.0 below. Table 2.0
shows that, except for Indonesia, the inflation rate in the Asian countries considered was less than one -third of
the rate of depreciation of their currencies. In other words, about one-third of the price of the price advantage that
the nations received from currency depreciation was wiped out by the resulting inflation.
Table 1: Advantage from currency depreciation that is lost because of inflation
Asian Countries Currency
Inflation
Currency Depreciation Price Advantage lost
Depreciation
through Inflation
Indonesia
67.6%
49.0%
49 / 67.6 = 72.5%
Malaysia
40%
8.6%
8.6 / 40.0 = 21.5%
Korea
25.4%
8.1%
8.1 / 25.4 = 31.9%
Thailand
32.1%
9.3%
9.3 / 32.1 = 29.0%
Source: Salvatore (2004)
Bawumia and Otoo (2003), provide rich empirical evidence on the relationship between inflation and monetary
growth. The paper explores the relationship between monetary growth, exchange rates and inflation in Ghana
using an error correction mechanism (Engle and Granger, 1987). Using logarithms of the percent age changes in,
the CPI, real income, M2 and the Cedi depreciation (the Cedi is Ghana’s official currency). Monthly data was
used for the period 1983:1 to 1999:12.The ADF test was used to test for non -stationarity and the data was found
to be integrated of order one: I (1). The lag length was determined using the Hendry’s General – to – Specific –
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Modeling Strategy and it suggested the use of 11 lags. After using the error correction model (ECM) the results
for the sample period 1983: January to 1999: December showed that a one percent increase in money supply
(M2) led to 0.41 percent rise in inflation; a one percent depreciation of the Cedi led to a 0.29 percent rise in
inflation and finally a one percent rise in real income led to a 0.25 percent fall in in flation.
Siklos (1991) also uses vector auto regression (VAR) technique to test the impact of past values of prices and
money supply growth on the price level and money supply respectively in Hungary during the hyperinflation.
Siklos uses a wide range of data for the period (1922:M1 to 1928:M12). The results illustrate that after four
periods, that is, lagged four months, money supply responds by 45% to inflation shocks during the hyperinflation
and by only 15% in the post-hyperinflation. This result reflects the comparatively greater sensitivity of money
supply to inflation during the hyperinflation phase precisely what is expected a priori.
2.4
CONCLUSION
The theoretical and empirical literature in this section has illustrated and evidenced some of the techniques used
in studying the causal relationships between inflation, exchange rates, money supply and other economic
fundamentals. Both the theoretical and empirical literature is important in the formulation of models that can be
used to test for the presence and direction of causality and forecasting the level of depreciation inter alia. The
consolidated effect of this chapter will come in handy even as the researcher formulates policies that can be used
by the Zimbabwean government in its fight against both high inflation and a depreciating exchange rate.
METHODOLOGY
3.1 MODEL SPECIFICATION
3.1.1 Granger Causality Approach
The model chosen is in line with the method of testing for Granger causality between two given variables,
illustrated in a paper on “Investigating Causal Relations by Econometric Models and Cross -Spectral Methods”.
Granger starts from the premise that the future cannot cause the present or the past. The model will thus give
results based on whether movements in the rate of inflation precede movements in the rate of exchange, or vice
versa, or they are simultaneous.
In Granger’s test Granger causality relationship is expressed in two pairs of regression equations by simply
twisting independent and dependent variables as follows :
Granger Methodol ogy
t = β 1,1 t-1 +β1,2 t-2 +β 1,3 t-3 +…+β 1,t t-p +β 2,1 Ex.rt-1 +β 2,2 Ex.rt-2 +…+β 2,p Ex.rt-p +  1,t ---Ex.rt = β 2,1 Ex.rt-1 +β2,2 Ex.rt-2 +…+β 2,p Ex.rt-p +β1,1 t-1 +β1,2 t-2 +…+β 1,t t-p + 2,t ------------
(1)
(2)
Equation (1) and (2) above are called the unrestricted equations, (3) and (4) below are restricted equations.
t = β 1,1 t-1 +β1,2 t-2 + β 1,3 t-3 +…+β 1,t t-p ----------------------------------------------------------- (3)
Ex.rt = β 2,1 Ex.rt-1 +β2,2 Ex.rt-2 +…+β 2,p Ex.rt-p ------------------------------------------------------ (4)
According to Granger’s definition of causal relationships:
Ex.r does not cause , if β 2,1 = β 2,2 =…= β 2,p = 0 ------------------------------------------------- (5)
And
 does not cause Ex.r, if β 1,1 = β 1,2 =…= β 1,3 = 0 ------------------------------------------------ (6)
In order to judge whether these conditions hold, Sims employ the following F- Statistic to be applied to equation
(1) and (2) relative to equation (3) and (4):
( (R2 UR - R2 R ) / m )
F=
( (1- R2 UR ) / (n –2m –1) )
Where ():
R2 UR
= the coefficient of determination of unrestricted equation
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R2 R
n
m

Ex.r
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= the coefficient of determination of restricted equation
= the number of observations
= the number of lagged period
= inflation
= exchange rate
With Sims test, the direction of causality is judged as follows:
The Result of F test
Direction of Causality
1. (5) holds, (6) does not hold
: 
causes Ex.r
(
2. (5) does not hold , (6) holds
: Ex.r causes 
(Ex.r
3. Both (5) and (6) hold
: Feedback between ( 
4. Neither (5) nor (6) holds
:  and Ex.r are independent
Ex.r )
)
Ex.r)
However, the availability of the econometric computer package E-views makes it very simple for the causal
relationship to be identified and thus the researcher shall use E-views to test for causality and compare the Fstatistic found in E-views with the one obtained from the statistical tables.
3.1.2 The Vector Auto-regression (VAR) method
The researcher will also apply the Vector Auto-regression (VAR) method as a non-nested test to detect if it
reinforces the results obtained from the Granger’s method of testing for causality. This method also gives the
percentage effect of one variable’s movements on the other variable. The Vector Auto -regression (VAR) method
is commonly used for forecasting systems of interrelated time series and for analyzing the dynamic impact of
random disturbances on the system of variables. The VAR approach avoids the need for structural modeling by
modeling every endogenous variable in the system as a function of th e lagged values of all the endogenous
variables in the system. OLS will be used as an estimation technique and this will be achieved by use of an
econometric package called E-views.
VAR Methodology:
With two lagged values of the exchange rate (X) and inflation (Y) the system will be as follows:
Ex.rt = a 11 Ex.rt-1 +a 12 t-1 +b 11 Ex.rt-2 + b 12 t-2 +c1 + ε1t
t = a 21 t-1 + a 22 Ex.rt-1 + b 21 t-2 + b 22 Ex.rt-2 +c2 + ε2t
Where (): a, b and c are parameters to be estimated.
3.2 JUSTIFICATION OF VARIABLES
3.2.1
Inflation
The consumer price index (CPI) is going to be used to stand for this period from Jan uary 2001 to June 2005. The
period from which the year-on-year monthly inflation was 57.01percent until June 2005 were the rate of inflation
was 164 percent. Without any universally accepted definition of a hyperinflation, the researcher will look at the
period stated above as the period during which most individuals preferred to keep their wealth in non -monetary
assets or in a relatively stable foreign currency and the general population regarded monetary amounts not in
terms of the local currency but in terms of relatively stable foreign currencies. This is because the researcher
places emphasis on the hyperinflationary period from 2001 until now. Thus lagged values of the consumer price
index (CPI) will be used as part of the endogenous variables in the model.
3.2.2
Exchange Rate
The feedback process between the exchange rate and the rate of inflation is emphasized in most of the theories of
inflation. The exchange rate of the Zimbabwean dollar (Z$) to the United States of America dollars (US$) will be
used as the rate of exchange. The fact that the US$ is one of the most powerful hard currencies in the world and
that most foreign transactions are made simple by using the US$ as a base currency, makes it the ideal exchange
rate to be used. Most of the hedging by investors, speculators and the government is done in US$ terms in most
cases. Parallel market rates will be used to estimate the relationship between inflation and the exchange rate; this
is so because most of the foreign currency dealings during a hig h-inflation take place on the informal/parallel
market.
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3.3 DATA CHARACTERIS TICS
Monthly secondary data will be used for both the year-on-year inflation and the parallel exchange rate of the Z$
to the US$; thus it means the study will be mainly quantitative in all senses. The information has been obtained
the Reserve Bank of Zimbabwe, the Central Statistics Office publications, The Zimbabwe Independent Archives,
The Financial Gazette Archives and Techfin Research.
Data for the period 2001:1 (January 2001) to 2005:6 (June 2005) will be used and this will give a sample size of
fifty-four observations. The rate of inflation will be taken as raw Consumer Price Index figures; this is important
for the data to be admissible, consistent with theory and exhib it data coherency. If the year-on-year monthly
figure were to be used the upward trend in the price level would not be noticed. Inflation would start coming
down in February 2004 whilst the rate of the Z$ to the US$ was rising – this would give spurious results and this
would give a spurious regression.
RESULTS AND INTERPRETATION
4.1
PRESENTATION OF RESULTS
4.1.1 Unit Root Tests
Both the inflation and the exchange rate were tested for non -stationarity and were found to be stationary at their
own level. See Appendix A2. The Augmented Dickey – Fuller (ADF) statistic is greater than the critical values
for the exchange rate it is 3.514836 which is significant from -2.6072, -1.9470 and -1.6191 the critical values at
1%, 5% and 10% respectively. In the same line inflation (CPI) is also stationary as shown by the ADF statistic of
3.487467 against the above critical values. The researcher took these two variables as stationary and adopted
them for the lagged model since they were found to be stationary at their own level that is I (1)
4.1.2 Lag Length Test
The Akaike Information Criteria (AIC) in Table 2 below has been used to calculate the appropriate length. At lag
5 it was 12.284 this is where the AIC is minimized, see Table C1 in Appendix C for the original E-views results.
The researcher tested until lag 12 since empirical literature has encouraged the use of at most twelve lags for
monthly data. In the hyperinflationary period under study the rate of pass – through from exchange rate to
domestic prices is expected to be less than twelve months.
Table 2: Results from the Akaike Information Criteria (AIC)
Akaike
Information
Criteria
12.7
12.6
12.5
12.4
12.3
12.2
12.1
1
2
3
4
5
6
7
Lag Level
8
9
10
11
12
4.1.3 Standard Results from the 5 Lag Co-integration Model
C – Constant
Y1 to Y5 – Lagged levels of Inflation and
X1 to x5 – Lagged levels of Exchange rate
Table 3: Standard Results from the 5 Lag Co-integration Model
Variable
Coefficient
Standard Error
C
-62.10663
23.51534
Y1
0.301787
0.174845
Y2
-0.015569
0.176523
Y3
0.156792
0.207316
Y4
-0.089751
0.24474
Y5
0.546441
0.190056
t - value
-2.641112
1.726021
-0.088198
0.756296
-0.43837
2.875160
P - value
0.0119
0.0925
0.9302
0.4541
0.6632
0.0066
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X1
X2
X3
X4
X5
0.045682
0.039934
0.203600
-0.009542
-0.002702
0.021121
0.040417
0.049701
0.050239
0.041742
R2 = 0.99924
Adjusted R2 = 0.99904
DW = 1.88
Y=
ISSN: 2047 - 0401
2.162896
0.988063
4.096472
-0.189929
-0.064719
0.0369
0.3294
0.0002
0.8504
0.9487
Akaike Information Criterion = 12.284
F-statistic = 5002.055
Prob (F-stat) = 0
– 62.10663 + 0.301787*Y1 – 0.015569*Y2 + 0.156792*Y3 – 0.089751*Y4
(-2.641)
(1.726)
(-0.088)
(0.756)
(-0.438)
+0.546441*Y5 + 0.045682*X1 + 0.039934*X2 + 0.203600*X3 – 0.009542*X4 – 0.002702*X5
(2.875)
(2.163)
(0.988)
(4.096)
(-0.1899)
(-0.0647)
t – Statistics in parenthesis
See Appendix C for original E-views results.
4.1.4 Pair wise Granger Causality Test results
Pair wise Granger Causality tests for a lag length of five were conducted and provided the results depicted below
in Table 4. However, this was done for all the lags from one to twelve as illustrated in Table 2 above.
Table 4: Results from lag 5
Lags:5
Null Hypothesis
Exch rate does not Granger cause Inflation
Inflation does not Granger cause Exch rate
Observations
49
F-Statistic
27.5254
8.36533
Probability
1.1E-11
0.0000021
Where (): Exch – exchange rate depreciation
Inflation – price increases
Table 5: Consolidated Results
A
B
C
D
Series 1
Series 2
Exchange Rate Depreciation Inflation Granger causes
Granger causes Inflation
Exchange Rate Depreciation
Lag Level F-calc series 1 F-calc series 2
1
2
3
4
5
6
7
8
9
10
11
12
88.6159
35.3593
31.7694
26.662
27.5254
21.7879
17.3678
14.366
12.815
10.3991
11.1231
17.222
0.88832
1.06968
6.6513
5.69995
8.36533
4.13542
4.18673
4.03819
5.01429
5.53081
5.44721
6.38315
F-critical at
5%
Decision
Decision
3.19
2.59
2.30
2.18
2.10
2.05
1.99
2.01
2.03
2.05
2.10
2.19
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
No
No
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
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The F values indicated in asterix, in equation Y above, indicate the F-calculated using of E-views, which is the
same with what manual operation could have provided for the researcher. This F value was compared with the F
– critical, column B above (Table 5), which was obtained from the statistical tables using adjusted degrees of
freedom at each lag level.
4.2
DISCUSSION OF RESULTS
4.2.1 Granger Causality Results
The Granger causality tests conducted at 5 percent level of significance gave the results illustrated above in table
4.1. In the first two months it was found that causality runs from exchange rate depreciation to inflation (prices).
The same results were obtained at both 1% and 10% as well, only the first two months had unidirectional
causality as stated above. There is feedback Granger causality between inflation and exchange rate depreciation
from lag three to lag twelve; it takes at least three months for changes in the consumer price index (CPI) to
transit into exchange rate depreciation. However exchange rate depreciation affects prices with just one -month
difference.
The impact lag of price changes on exchange rate depreciation is longer than that for exchange rate depreciation
on the price level; this is because inflation only starts to feedback into exchange rate depreciation after three
months of the initial change in prices whilst exchange rate only does so after one month. This may be resultin g
from the fact that most of the commodities purchased using foreign currency in Zimbabwe in the past four years
are basic necessities that are purchased almost every month by individuals and companies, thus exchange rate
depreciation will quickly feed into prices. After three months domestic prices are higher than foreign prices as
compared using the purchasing power parity (PPP) calculation. The currency will thus be overvalued and
depreciation takes place, especially on the parallel market, and causality results.
At lag 1, causality is running from exchange rate depreciation to inflation and there is no reverse relationship.
This is because the F – calculated value of 88.6159 is greater than the F – critical value of 3.19, which is
obtained from the statistical tables. In this case we reject the null hypothesis and accept that causality is from
exchange rate to inflation. At lag 2, the same unidirectional causal relationship from the depreciating exchange
rate to inflation is noticed. The F values are 35.3595 and 1.06968 versus an F – critical value of 2.59. Thus in the
very short run Granger causality is unidirectional from exchange rate depreciation to inflation , these findings
correspond to Maswana (2005), and Ahmad and Ali (1999). This may be very true especially if we consider that
the bulk of the country’s inflation is imported because Zimbabwe is both a small and an open economy, which
absorbs global price fluctuations without much or effective resistance. The high oil prices on the world market
always bring home a new level of prices. Therefore, the shortage of foreign exchange in the country puts some
upward pressure on the parallel market rate, this means that as traders import commodities they are supposed to
adjust their prices upwards to cater for the fall in the price of the domestic currency. Policy makers should
therefore strive towards reducing exchange rate depreciations.
4.2.2 Five Lag Co-integration Model
The entire model is significant basing on the F- statistic, which are 5002.055 and a supportive P-value of zero
(0). See Table 3. For the lag model most of the coefficients are not significant by the rule of thumb: t>2 for the
coefficient to be significant. Out of a total of ten only three variables are significant that is infla tion lagged five
times (Y5), exchange rate lagged one and three times (X1) and (X3) respectively. The t -values may be
insignificant because of multicollinearity, which is inherent in the lag model.
The inflation variable Y5 shows that an increase in the price level (CPI) in the current month will Granger cause
an increase in the price level by about 55 percent of the initial increase in five months’ time. On the other hand
the exchange rate variable X1 has an elasticity that is less than 0.05 meaning that the value of exchange rate
depreciation one month ago Granger causes the current level of inflation to rise by about five percent; For X3 the
(impact of a three months backward exchange rate depreciation) on current inflation is a 20 percent increase in
the rate of inflation.
Both the R2 and Adjusted R2 are very high that is, 0.99924 and 0.99904 respectively. This indicates that the
explanatory variables in this model are lagged variables of both the endogenous and exogenous variables. Thus,
after lagging for about five times past variables of the exchange rate and inflation explain more than 99.9% of
the movements in inflation (Y), a close case of nearly exact co llinearity. Even the Adjusted R2 that takes into
account the number of degrees of freedom is still extremely high as well, reinforcing a priori knowledge that the
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value of R2 in lagged models is high. The regression model with five lags is not spurious. The DW>R2:
1.88>0.99924, rendering the lag model relevant and not dubious. Appendix C provide s a correlation matrix for
the model in the short run, and it exhibits serious multicollinearity (which the researcher expected a priori).
4.2.3 Vector Auto Regression
In the longer period over 80 percent of the variances in the rate of inflation (Y) are cau sed by the exchange rate
(X). This is illustrated in Appendix 1E on the Variance Decomposition graph which was obtained E-views. On
the other hand only just under 20 percent of the variances in the exchange rate were due to changes in the rate of
inflation (Y). This is illustrated in Appendix 1F. On the other hand using the Impulse Response Functions only a
smaller proportion of exchange rate changes are responses to innovations (movements/changes) in the rate of
inflation, whilst a large proportion of Inflation changes are responses to changes or innovations in the foreign
exchange rate. See Appendix 1E. Variance decomposition shows that after about five months there is about 70%
pass – through from exchange rate to domestic prices. This means that it takes roughly five months for about
seventy percent of the depreciation in the exchange rate to be completely passed on to inflation , which is
generally high. This affirms Ito and Sato (2007) findings that exchange rate pass-through to inflation is in
countries experiencing currency crises .
4.3
CONCLUSION
The results presented above simply give us a base to work from. The fact that the researcher is not naïve of the
fact that Granger causality is not synonymous with the lay man’s definition of causality means that he clearly
knows that the long run feedback effect is only a result that is obtained on a platform that measures precedence
and information content of one variable over another. However the augmentation of the study by using VAR also
helps in reinforcing the results obtained using the Grangers method. Given that there is strong short run causality
from the exchange rate depreciation to inflation, and the long run exhibits a feedback relationship, proper
policies can now be implemented.
CONCLUSIONS AND RECOMMENDATIONS
5.1
INTRODUCTION
This chapter of the study looks at solutions to the economic problems of high inflation and a rapidly depreciating
currency currently being experienced in Zimbabwe. The results suggest that the depreciating local currency is
“causing” the increases in the consumer price index in the very short run; whilst after about three months there is
a feedback relationship between the depreciating local currency and the inflation rate. This thus means the
majority of the policies to be recommended should have a bias towards solving the shortage of foreign currency
in the country, probably the number one enemy of the country ahead of inflation. A brief review of some policy
literature from less developed countries (LDCs) that have successfully overcome such financial crises will also
be done.
5.2
POLICY RECOMMENDATIONS
The results found in the previous chapter indicate that in the short – run, that is within a time period of one to
two months exchange rate depreciation Granger causes inflation, whilst in the long –run (two months and
beyond) there is bi-directional causality. The results suggest that it is important to differentiate the causal effects
during the short run and long run so as to develop effective policies to curb inflation an d stop the chronic
depreciation of the Zimbabwean dollar.
From the conclusions it can be realized that both monetary authorities and the government should prioritize
addressing the problem of exchange rate depreciation, which is causing high impulse respo nses on the rate of
inflation. Financial and moral support should be focused on achieving exchange rate stabilization followed by
inflation specific policies. Exchange rate depreciation causes the rate of inflation as measured by the CPI to rise,
this is in the form of cost-push factors as most of the price changes emanate from imported inflation. Thus the
policies should curb the level of imports so as to avoid this form of price increase transmission.
The impact lag for exchange rate depreciation on inflation is shorter, that is, one month compared to three
months, which is the impact lag of inflation on the exchange rate. With its managed peg exchange rate system,
the depreciation of the Zimbabwean dollar is felt more noticeable on the parallel market. The depreciations
cannot be said to be resulting from genuine demand and supply market conditions but the greed and speculative
behaviour has caused most of the depreciations.
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Another important element that needs to be looked into is the effect of expec tations on the future exchange rate.
If people in their minds believe that the Zimbabwean dollar (Z$) will depreciate in the next month they may
actually worsen the eventual depreciation in that as they withhold their foreign currency this creates artificial
shortages on the market and the Zimbabwean dollar is forced to depreciate so as to attract this speculators.
Expectations should be addressed carefully through both subtle and open means. The monetary authorities
should avoid public comments, which may be signaling an imminent devaluation or some unfavourable
government policies towards holders of private assets. It should however be very vocal of any changes that will
positively influence the level of foreign reserves in the country.
The amount of the domestic currency in the economy should also be monitored. A sudden rise in the money
supply will cause the price of the foreign currency to rise especially where the demand for foreign goods is high.
The monetary authorities should try to restrict the amount of seignorage they afford to the government; this also
means that the government should be prepared to reduce it spending recurrent expenditure. If money supply
growth is reduced this will reduce the level of aggregate demand and consequently imports.
Policy makers should also adopt policies that enable the general public and business people to adopt import
substitution industrialization and support the “Buy Zimbabwe” campaigns. Companies should use locally
available inputs wherever possible in producing commodities that can be exported and consumed domestically;
this will ease pressure on the available amount of foreign currency available and thus reduce the risk of
depreciation.
Policies that fight both exchange rate depreciation and inflation sho uld be adopted. From the background
information the country needs some foreign exchange reserves to stabilize the external value of the currency.
This means that more efforts should be cast at getting enough reserves through increasing the avenues of foreign
currency generation. There is need for sustainable exchange rate management for success to be achieved in the
accumulation of enough reserves. The actions and policies of monetary authorities should not be mistaken for
last effort attempts to revive an already useless situation but rather they should be taken as causes towards
fighting the free fall of the domestic currency. This can be achieved with the combined effort of every
Zimbabwean. It is also important that the nation at large take steps towards behavioural change, especially
through reducing indiscipline within some individuals who are quick to make gains through parallel market
activities and other corrupt activities such as money laundering.
Monetary authorities should try and stabilize the financial environment, by strict monitoring of financial
institutions and through increased moral suasion to gather support towards the fight against illegal foreign
currency dealings. Everyone should be prepared to fight corruption and black market activities; probably the use
of whistle blowing should be advocated. More efforts should be directed towards arresting all black marketers
who are causing the rapid depreciation of the local currency. The police force should target the big syndicates of
parallel market dealers and laws should be enacted, such that it becomes difficult and very risky for those who
want to take part in the parallel market.
The Zimbabwean government should adopt strategies that increase the amount of foreign reserve in the country;
this will help in stabilizing the domestic currency in the short run, whilst the long term solutions are being
implemented, or probable in their impact lag stages. To generate and conserve more foreign currency the
Zimbabwean government can still adopt the following ensuing strategies and policies. The foreign exchange rate
market should shift towards complete liberalization so as to enable the Zimbabwean dollar to trade with other on
a basis that takes into account changes in the fundamentals in th e country. This has the effect of making the
authorities stricter and more willing to improve the status quo if they are fully aware of the associated
repercussions of lax fiscal policies. Fortunately the economy has purposed moving towards a market -determined
exchange rate as enunciated by the reserve bank governor (Reserve Bank of Zimbabwe: Monetary Policy, 2005).
Tight monetary policies that are contractionary have been viewed as being a worst scenario case of solving for
hyperinflation in that it caus es the general public to suffer needless pain and s tress as the shock therapy or “Big
Bang” is instituted. However, the Zimbabwean government can actually adopt tight monetary stances such as
reducing the amount of money gradually over a period of time ach ieving low money supply growth rates over
the given time period. The government can also issue treasury bills in foreign currency, but its success depends
on the public’s trust of the government.
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The Zimbabwean government should adopt sound fiscal policies that engender trust of the government within by
the general public and corporations. The government should be serious about reducing its expenditure if it
desires to achieve successes in the fight against high inflation and the rapidly depreciating loca l currency. For
any policy to succeed, especially those that require commitment and sacrifice the government should always
prove ahead of the rest that it is committed in that particular cause. One very important move towards fiscal
austerity is for the government to be seen moving towards reducing the number of ministries in their cabinet; this
will prove to all and sundry that the government is now ready to reduce the amount of seignorage financed
deficits. This can also go a long way towards wooing the s upport of multi-lateral finance institution.
5.3
RECOMMENDED AREAS OF FUTURE SYUDY
The researcher feels that the study has looked at an integral part of that will help form the base of any policy,
fiscal or monetary. Without a correct diagnostic of the problem the monetary authorities are likely to shoot at the
wrong target. The use of some other techniques to establish the direction of causality between variables such as
money supply, the exchange rate, interest rates, inflation, and inflation expectations inter alia will help to affirm
or concretize the results that are obtained using other methods. The researcher recommends the use of the VAR
technique to establish the trivariate relationship between inflation, exchange rate depreciation and money sup ply.
Thorough and dedicated studies of exchange rate pass – through at different stages of the hyperinflation in
Zimbabwe are also recommended as possible areas of future study.
5.4
CONCLUSIONS
The study has enabled the researcher to analyze the causal relationship between two leading economic problems
in Zimbabwe. The findings , that the number one enemy of the country is , rapid exchange rate depreciation comes
as a surprise in a nation where the headline number one enemy has been stated as inflation. This means more
thrust by all stakeholders should focused on getting as much of the foreign currency as possible. Once this area is
solved the “the number one enemy”, inflation would have been solved especially where structural shocks have
affected the productive base of most manufacturing industries which are currently relying on importing most of
their raw materials. Thus imported inflation would be thwarted once the domestic currency starts stabilizing and
foreign currency reserves build up.
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APPENDIX A1: Raw Data
Table 1: Zimbabwe dollar (ZWD $) to US$ Exchange rate and Year-on-year Inflation rates for
the 54 months from January 2001 to June 2005
2001:1
2001:2
2001:3
2001:4
2001:5
2001:6
2001:7
2001:8
2001:9
2001:10
2001:11
2001:12
2002:1
2002:2
2002:3
2002:4
2002:5
2002:6
2002:7
2002:8
2002:9
2002:10
2002:11
2002:12
2003:1
2003:2
2003:3
2003:4
2003:5
2003:6
2003:7
2003:8
2003:9
2003:10
2003:11
2003:12
2004:1
Consumer Price Index
Y
71.10
74.60
80.50
84.50
87.60
94.80
99.00
105.00
121.70
133.00
137.00
144.60
154.10
161.40
171.80
180.80
195.00
203.50
221.30
246.80
292.00
324.70
377.30
432.20
474.90
518.00
563.40
667.50
780.20
945.10
1,105.50
1,299.60
1,622.30
2,032.10
2,714.60
3,019.90
3,432.40
Parallel Exchange Rates
X
77
80
85
90
110
145
150
350
250
300
350
320
330
320
320
330
450
470
675
680
720
1000
1600
1650
1650
1500
1400
1425
2000
2500
3300
5550
5600
5900
6200
6100
3950
37
Economics and Finance Review Vol. 3(09) pp. 22 – 42, July, 2014
Available online at http://www.businessjournalz.org/efr
2004:2
2004:3
2004:4
2004:5
2004:6
2004:7
2004:8
2004:9
2004:10
2004:11
2004:12
2005:1
2005:2
2005:3
2005:4
2005:5
2005:6
3,638.90
3,852.00
4,038.80
4,281.30
4,674.10
5,117.20
5,386.10
5,702.90
6,279.60
6,766.50
7,028.70
8,017.10
8,268.20
8,616.90
9,251.20
10,462.30
12,354.20
ISSN: 2047 - 0401
4400
4800
5350
5600
5950
7000
7300
7500
8000
8900
8400
8250
11250
13750
15500
22000
28000
54 observations
APPENDIX A2: Unit Root Tests
Unit Root Test at Own Level Exchange Rate
ADF Test Statistic
3.514836
1% Critical Value*
5% Critical Value
10% Critical Value
-2.6072
-1.9470
-1.6191
*MacKinnon critical values for rejection of hypothesis of a unit root.
Augmented Dickey-Fuller Test Equation
Dependent Variable: D(X)
Method: Least Squares
Date: 11/10/05 Time: 23:32
Sample(adjusted): 2001:03 2005:06
Included observations: 52 after adjusting endpoints
Variable
Coefficient
Std. Error
t-Statistic
Prob.
X(-1)
D(X(-1))
0.115930
0.436749
0.032983
0.162891
3.514836
2.681239
0.0009
0.0099
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.543905
0.534783
939.0744
44093036
-428.6996
2.020229
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
536.9231
1376.804
16.56537
16.64042
59.62628
0.000000
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Economics and Finance Review Vol. 3(09) pp. 22 – 42, July, 2014
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ISSN: 2047 - 0401
Unit Root Test at Own Level Inflation (CPI)
ADF Test Statistic
3.487467
1% Critical Value*
5% Critical Value
10% Critical Value
-2.6072
-1.9470
-1.6191
*MacKinnon critical values for rejection of hypothesis of a unit root.
Augmented Dickey-Fuller Test Equation
Dependent Variable: D(Y)
Method: Least Squares
Date: 11/10/05 Time: 23:35
Sample(adjusted): 2001:03 2005:06
Included observations: 52 after adjusting endpoints
Variable
Coefficient
Std. Error
t-Statistic
Prob.
Y(-1)
D(Y(-1))
0.055769
0.520413
0.015991
0.186690
3.487467
2.787582
0.0010
0.0075
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
0.689010
0.682790
196.1502
1923745.
-347.2669
1.746756
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
236.1462
348.2694
13.43334
13.50839
110.7768
0.000000
APPENDIX B: Granger Causality results lag1 to lag5
Pairwise Granger Causality Tests
Date: 11/10/05 Time: 23:27
Sample: 2001:01 2005:06
Lags: 1
Null Hypothesis:
X does not Granger Cause Y
Y does not Granger Cause X
Obs
F-Statistic
Probability
53
82.6159
0.88832
3.6E-12
0.35046
Obs
F-Statistic
Probability
52
35.3593
1.06964
4.3E-10
0.35134
Obs
F-Statistic
Probability
51
31.7694
6.65130
4.4E-11
0.00084
Pairwise Granger Causality Tests
Date: 11/10/05 Time: 23:27
Sample: 2001:01 2005:06
Lags: 2
Null Hypothesis:
X does not Granger Cause Y
Y does not Granger Cause X
Pairwise Granger Causality Tests
Date: 11/10/05 Time: 23:28
Sample: 2001:01 2005:06
Lags: 3
Null Hypothesis:
X does not Granger Cause Y
Y does not Granger Cause X
39
Economics and Finance Review Vol. 3(09) pp. 22 – 42, July, 2014
Available online at http://www.businessjournalz.org/efr
ISSN: 2047 - 0401
Pairwise Granger Causality Tests
Date: 11/10/05 Time: 23:28
Sample: 2001:01 2005:06
Lags: 4
Null Hypothesis:
Obs
F-Statistic
Probability
50
26.6620
5.69995
6.2E-11
0.00096
Obs
F-Statistic
Probability
49
27.5254
8.36533
1.1E-11
2.1E-05
X does not Granger Cause Y
Y does not Granger Cause X
Pairwise Granger Causality Tests
Date: 11/10/05 Time: 23:29
Sample: 2001:01 2005:06
Lags: 5
Null Hypothesis:
X does not Granger Cause Y
Y does not Granger Cause X
APPENDIX C: Cointegration Equati on Original print results
Table C1: At Lag length 5
Dependent Variable: Y
Method: Least Squares
Date: 11/09/05 Time: 18:00
Sample(adjusted): 2001:06 2005:06
Included observations: 49 after adjusting endpoints
Variable
C
Y1
Y2
Y3
Y4
Y5
X1
X2
X3
X4
X5
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
Durbin-Watson stat
Coefficient
Std. Error
t-Statistic
Prob.
-62.10663
0.301787
-0.015569
0.156792
-0.089751
0.546441
0.045682
0.039934
0.203600
-0.009542
-0.002702
23.51534
0.174845
0.176523
0.207316
0.204474
0.190056
0.021121
0.040417
0.049701
0.050239
0.041742
-2.641112
1.726021
-0.088198
0.756296
-0.438937
2.875160
2.162896
0.988063
4.096472
-0.189929
-0.064719
0.0119
0.0925
0.9302
0.4541
0.6632
0.0066
0.0369
0.3294
0.0002
0.8504
0.9487
0.999241
0.999041
102.0857
396016.7
-289.9641
1.880679
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
F-statistic
Prob(F-statistic)
2789.949
3296.731
12.28425
12.70894
5002.055
0.000000
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Economics and Finance Review Vol. 3(09) pp. 22 – 42, July, 2014
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ISSN: 2047 - 0401
APPENDIX D: CORRELATION MATRIX at lag 5
Y
Y1
Y2
Y3
Y4
Y5
X1
X2
X3
X4
X5
Y
1
0.9978
0.9951
0.9935
0.9922
0.9902
0.9565
0.9719
0.9734
0.9666
0.9547
Y1
0.9978
1
0.9985
0.9970
0.9952
0.9926
0.9411
0.9607
0.9662
0.9679
0.9618
Y2
0.9951
0.9985
1
0.9987
0.9969
0.9945
0.9320
0.9517
0.9561
0.9619
0.9628
Y3
0.9935
0.9970
0.9987
1
0.9985
0.9965
0.9274
0.9473
0.9483
0.9524
0.9565
Y4
0.9922
0.9955
0.9962
0.9985
1
0.9984
0.9274
0.9418
0.9433
0.9434
0.9457
Y5
0.9902
0.9926
0.9945
0.9965
0.9984
1
0.9286
0.9374
0.9348
0.9358
0.9347
X1
0.9565
0.9411
0.9320
0.9274
0.9274
0.9286
1
0.9780
0.9541
0.9217
0.8820
X2
0.9719
0.9607
0.9517
0.9473
0.9418
0.9374
0.9780
1
0.9828
0.9536
0.9278
X3
0.9734
0.9662
0.9561
0.9483
0.9433
0.9348
0.9541
0.9828
1
0.9791
0.9483
X4
0.9666
0.9679
0.9619
0.9524
0.9434
0.9358
0.9217
0.9536
0.9791
1
0.9777
X5
0.9547
0.9618
0.9628
0.9565
0.9457
0.9347
0.8820
0.9278
0.9483
0.9777
1
APPENDIX E: Vector Auto regression results: Impulse Responses
VAR Results: A large proportion of Inflation changes are responses to changes
or innovations in the foreign exchange rate
Response to One S.D. Innovations ± 2 S.E.
Res ponse of Y to X
600000
400000
200000
0
-200000
-400000
5
10
15
20
25
30
35
40
45
50
VAR Results: On the other hand only a smaller proportion of exchange rate
changes are responses to innovations in the rate of inflation
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Economics and Finance Review Vol. 3(09) pp. 22 – 42, July, 2014
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ISSN: 2047 - 0401
Response to One S.D. Innovations ± 2 S.E.
Res ponse of X to Y
1000000
800000
600000
400000
200000
0
-200000
-400000
-600000
5
10
15
20
25
30
35
40
45
50
APPENDIX F: Vector Auto regression results: Variance Decomposition
Varianc e D ec om pos ition
Percent Y variance due to X
100
80
60
40
20
0
5
10
15
20
25
30
35
40
45
50
Time Period
Varianc e D ec om pos it ion
Percent X variance due to Y
100
80
60
40
20
0
5
10
15
20
25
30
35
40
45
50
Time Period
42