Effect of exchange rate on inflation in the inflation targeting framework: Is the threshold level relevant?

Abstract

The continuous depreciation of the exchange rate in Ghana has raised concern about its effect on inflation and the economy at large. This paper examines the threshold effect of exchange rate pass-through (ERPT) on inflation using a monthly data from January 2002 to December 2018. The relevance of the exchange rate threshold in the Taylor rule has also been examined. Using the threshold autoregressive (TAR) method, the results of the ERPT model revealed that exchange rate depreciation beyond a monthly threshold of 0.70% has a significant positive pass-through effect on inflation, which gives credence to the relevance of threshold level. The results of the monetary policy rule model also showed that regardless of the threshold level of 0.51%, the exchange rate significantly influences the monetary policy rate positively. Therefore, paying proper attention to the exchange rate in the policy rule despite the threshold (0.51%) will prevent the exchange rate depreciation from exceeding the optimal level (0.70%) and hence no ERPT on inflation. Based on these findings, it is suggested that monetary regulators should view the exchange rate at any level essential to adjust the policy rate.

Keywords

• Exchange rate
• Inflation
• Monetary policy rate
• Threshold autoregressive
• Ghana