Dollarization and macroeconomic instability in Ghana

A Doctoral Thesis Submitted in fulfilment of the requirements for the award of Doctor of Philosophy, The Graduate School of Business Administration, University of the Witwatersrand February 2016The liberalization of foreign exchange markets occasioned by the widespread acceptance of floating exchange rate systems brought about prevalent acceptance of foreign currency (usually U.S. dollars) in many developing and transition economies. Facing both domestic and foreign imbalances, a number of developing economies have embraced foreign currencies as a store of value (asset substitution), and in some instances as a medium of exchange for domestic transactions (currency substitution). This thesis examines dollarization/currency substitution, its impact on macroeconomic fundamentals, and the challenges it poses for effective formulation and transmission of monetary policy in Ghana. The entire thesis is organised into five empirical essays, each touching on a specific subject within the broad theme of dollarization and economic instability. The first essay explores the macroeconomic determinants of financial dollarization. The evidence establishes that exchange rate depreciation and financial development drive dollarization. Additionally depreciation of the domestic currency increases demand for foreign currencies, while a more developed financial sector tends to curtail dollarization. The second essay models a long-run money demand function for Ghana within the portfolio balance framework. The results indicate that, although foreign interest rates and expected exchange rates (either separately or jointly) are relevant elements in the money demand function, there evidence is more in support of capital mobility and not currency substitution. The third essay provides evidence on how financial dollarization affects the volatility of nominal and real Ghana cedi/U.S. dollar exchange rates. The study showed that the effect of financial dollarization on nominal exchange rate volatility in Ghana is positive, thus, as demand for U.S. dollars becomes more extensive, the cedi/dollar exchange rate becomes more volatile and unstable. The fourth essay investigates the role of dollarization in the dynamics of inflation and inflation uncertainty. Contrary to common logic, the results indicate that dollarization has not played a significant role in the dynamics of inflation volatility. The study posits that, although there is no significant impact of dollarization on inflation volatility, inflation targeting affects the inflation-inflation uncertainty relationship in Ghana. The last essay considers the effectiveness of monetary policy transmission in Ghana and examines whether the degree of dollarization hinders or facilitates that process by accounting for the role of the inflation targeting. The results show that credit and exchange rate channels dominate the transmission mechanism, with the former assuming a more significant role in the inflation targeting period. Moreover, the contribution of dollarization has diminished in the post-inflation targeting era, suggesting that monetary authorities have paid more attention to the effects of dollarization in the current monetary regime. A number of policy prescriptions arising from the thesis are presented to guide domestic authorities in smoothing the path of the instability in the economy.MB201