Chart 5.18
CHAPTER SIX
MODEL ESTIMATION AND EMPIRICAL V LIDATION
"It is important to remember that mathematics is a Tool not an End ill itself, and that
if
ideas are to influence policy-makers they must be translatedfrom equations into the English Language. "Marris (1984)
6.1 Model Estimation
Each model was estimated in both the direct linear and the log-linear forms. After estimation we solved the models in these two form and carried out simulation-error analysis to enable us determine which form (direct linear or log-linear) better tra ked our data. We
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decided on the basis of the simulation-error analysis to utilize the log-linear form for further analysis. Appendix 2 contains the result of the direct linear estimation.
In estimating we employed the Ordinary Least Squares (OLS) technique and corrected for first order serial correlation where necessary. The models are block-recursive and their properties make the OLS an appropriate estimation procedure (pindyck and Rubinfeld, 1981). Below we discuss the log linear results on the basis of issues highlighted in 4.1 above.
The first hypothesis we attempted to investigate is, that market determined exchange rates fuel inflation. This implies that there is a significant pass through from exchange rates
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to domestic prices which is heightened under market determined exchang rates. Table 6.1 gives an indication of whether this hypothesis holds or not. (Note that for all the tables the figures in brackets are the 't' statistics).
TABLE 6.1
Estimation Result For Dependent
Variable· Domestic Prices (pD)
Country Dependent COIISla INDEPENDENT VARIABLES
Variable nt
LogRI Log Log Log Log It, Log Rl DW
MSS EN RD PD,.,
Nigeria LogPD 0.44 .0.22 0.22 0.05 0.06 0.13 0.74 .98 \.91
(0.98) (2.21) (2.36) (0.55) (2.26) (9. 0)
Ghana l..o&PD 0.39 .o.J5 0.19 0.02 0.17 0.18 0.85 .98 1.88
(·2. 6) (2.S6) (0.56) (2.25) C4.70) (\4.70)
Uganda l..o&PD 2.16 .0.17 0.16 0.11 0.49 0.10 0.82 .99 1.89
(·3.68) (4.70) (3.12) (3.96) (2.34) (l6.90)
Note thefigures inbracket lirethe 'r' Statistics.
From table 6.1 we see that in Nigeria the exchange rate of domestic prices is 5%, and the relationship is statistically significant at the 5% level. However the money supply elasticity of domestic prices is more pronounced, standing at 22% while the elasticity of domestic prices with respect to inflationary expectations is 13%. All the relationships were statistically significant at the 5% level. These results show that in Nigeria there is indeed some pass through from nominal exchange rates onto prices, but the impact is not as pronounced as that of mo ey supply or inflationary expectations or that of real income on prices. Though real income had the effect of lowering prices whenever it (real income)
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175 rises.
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In Ghana there does not seem to be any pass through from nominal exchange rates onto domestic prices, given an exchange rate elasticity of domestic prices of only 2% which is also not statistically significant at the 5% level. Nominal money sup ly in Ghana, however, impacted significantly on domestic prices at the 5% level and so does real income.
The money supply elasticity of domestic prices was 19% and real income elasticity - 35%.
Similarly, as in Nigeria expectations with respect to inflation influenced current prices with an elasticity of 18% the relationship also proved to be statistically significant. Nominal domestic rate of interest also proved to be a powerful propeller of prices in Ghana. These Ghanaian results confirm the contention of Chibber and Shaffik (1989) that in Ghana it is not so much nominal exchange rate depreciation that fuels inflation asit is reckless increases in money supply often engendered by reckless fiscal deficits.
In Uganda there is a remarkable pass through from exchange rates unto domestic prices. The exchange rate elasticity of domestic prices in Uganda is 11% and this is statistically significant at the 5% level. This result seems to contradict Elba wi (1990) wherein he maintained that in Uganda it is excessive fiscal deficits that fuel inflation rather than official exchange rate depreciation. It is however important to note that the impact of nominal money supply on domestic prices is much more remarkable. The money supply elasticity of domestic prices in Uganda is 49% and this is statistically significant at the 5%
level. Another varia le that seems to impact considerably ondomestic prices is the domestic
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rate of interest. One is therefore tempted to conclude that Elbadawi (1990) may be right to the extent that both money supply and domestic rates of interest proved to be more powerful propellers of prices in Uganda, than the nominal exchange rate. Then one might say government monetary policy action which often is taken to finance its fiscal deficits is the major source of inflation and not nominal exchange rates.
It is important to note that real income had an in erse relationship with domestic prices for all three countries indicating that as output rises, prices fall; the relationship though significant for Ghana and Uganda was insignificant for Nigeria, (at the 5% level).
The result for Ghana and Uganda uphold the position in the literature that the higher the level of output the lower the price level would be (Dornbusch 1980, Edwards 1988).
The second issue we investigated is, that market determined exchange rates follow the money supply. If this hypothesis is valid then monetary policy is extremely important for efficient performance of a floating exchange rate regime. Table 6.2 reveals the result of this test.
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TABLE 6.2 Estimation Result For Dependent Variable - Nominal Exchange Rate (EN)
Country Dependent Constant INDEPENDENT VARIABLES
Variable
LogRDF, Log RE,., logY, Log MSS, Rl DW
Nigeria Log EN -2.02 0.37 -0.40 -0.05 0.85 .95 2.10
(0.93) (,-4.13) (-0.34) (3.01)
Ghana Log EN -1.48 ·0.53 -0.50 -0.18 0.54 .85 1.95
(1.20) (-2.71) (-4.49) (2.04)
Uganda Log EN -1.64 O.32w -0.49 -0.13 0.37 .89 1.91
(1.41) (-4.75) (-3.52) (2.97)
In Nigeria nominal exchange rate seems quite responsive to changes in the money supply. The nominal money supply elasticity of exchange rates is 85% and this relationship
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is stati tically significant at the 5% level. Another variable that impacted significantly on nominal exchange rates is international reserves (with a one period lag). The reserve elasticity of exchange rate is 40% in Nigeria. The relationship isinverse indicating that the higher the level of reserves the lower (or more appreciated) the exchange rate becomes.
Nominal income however is insignificant in Nigeria in the determination of nominal exchange rates. Both the Ghanaian and Ugandan results follow the Nigerian pattern in this respect. The Ghanaian and Ugandan results indicate that indeed the nominal exchange rote follows the money supply. The money supply elasticity of nominal exchange rates is 54%
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in Ghana and 37% in Uganda.
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These results show that prudent and disciplined monetary policy is very crucial to the success of a floating exchange rate regime in these countries. One interesting point to note is the impact of interest rate differential on nominal exchange rates. The theoretical expectation is that the higher the interest rate differential (i.e domestic rate of interest minus foreign rate of interest) the more appreciated the domestic currency becomes, because a higher domestic rate of interest relative to (the foreign one) should encourage capital inflow, from the three countries this relationship turned out with the wrong sign (positive instead of being negative) and was also statistically insignificant at the 5% level . The probabl reason for this situation is that in the literature it is often assumed that domestic securities are peffect substitutes for foreign securities, so that a higher domestic rate of interest should increase investment in domestic securities by foreign residents. However, in reality, the
'securities of our focus countries are not considered as perfect substitutes for foreign
securities, so that no matter how high domestic rate of interest gets it is not likely to generate any appreciable capital inflow and hence no exchange rate appreciation will follow a rising domestic rate of interest as theory postulates.
A third hypothesis we looked at is that altering the structure of relative prices in the export sector by depreciating nominal exchange rates will generate in reased export value given a two period lag (Khan 1981, Jebuni et al 1991) . Table 6.3 reveals the result of this test.
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TABLE 6.3 Estimation Result For Dependent
Variable - Export Value (X)
Country Dependent Constant INDEPENDENT VARIABLES Variable
Log RIS, Log ETOT'.l Log IM,.I Log Rl DW DPX,.l
Nigeria Log X, -49.41 0.70 -1.01 0.38 1.69 .92 2.10
(3.79) (-2.57) (3.85) (3.80)
Ghana Log X, -10.10 0.77 0.43 0.78 0.28 .96 1.90
(5.55) (4.31) (2.14) (2.23)
Uganda Log X, -8.04 0.67 -0.78 0.56 0.57 .93 2.10
(5.32) (-4.92) (5.80) (5.72)
From table 6.3 we found that the elasticity of exports with respect tochanges in the i'elative export price (ETOTt•2) in Ghana is 43% and this is statistically significant at the 5%
level. This reveals the fact that altering the structure of relative prices in the export sector given a two period lag can be quite important in increasing export value. For Nigeria and Uganda however the result came out with the wrong sign (Negative instead of Positive), The suspicion here is that for these two Countries (Nigeria and Uganda) a two-period lag is not the appropriate lag structure, probably some other lag structure will elicit the appropriate respon,se.
Another way by which we tried to see the impact of nominal exchange rate movement on exports is through the actual price of exports in domestic currency terms