Effects of Inflation and Interest Rate on Exchange Rate in Ghana

Abstract

The study assessed the effects of inflation and interest rate on exchange rate in Ghana using data from 1991 to 2016. Inflation rate, interest rate, government expenditure, private investment and money supply were used as independent variables whereas exchange rate was taken as dependent variable. Augmented Dickey-Fuller (ADF), Philips-Perron (PP) unit root tests were applied to find the level of integration in the time series. Auto-Regressive Distributive Lag and its error correction model were applied to find long run and short run relationships. The study found the existence of long run and short run relationships in the estimated model. Inflation, interest rate, government expenditure and money supply exerted positive and significant impact on exchange rate both in the short run and long run. Inflation and money supply had higher impacts in the short run compared to the long run. Private investment showed a negative effect on exchange rate in the short run and long run. The Granger causality test results revealed a unidirectional causality from interest rate to exchange rate. However, there was a bi-directional causality between inflation and exchange rate. It was therefore recommended that the Bank of Ghana needs to ensure a stable exchange rate in order to stimulate economic growth in Ghana. Thus, the Bank of Ghana needs to put measures in place to ensure a stable exchange rate for sustained period of time.