Impact of Market‐based Policies and External Fiscal Discipline on Ghana's Inflation

• Author: Charles Barnor,Kwaku Amakye,Philip Kofi Adom,William Bekoe,George Quartey
• DOI: http://doi.org/10.1111/rode.12228
• Published date: 01 November 2016
• Date: 01 November 2016

Impact of Market-based Policies and External Fiscal

Discipline on Ghana’s Inflation

Philip Kofi Adom, William Bekoe, George Quartey, Kwaku Amakye,

and Charles Barnor*

Abstract

This study investigates the impact of liberalization of the forex exchange and financial sectors and

external prudent fiscal management in C^

ote d’Ivoire on Ghana’s inflation. We find that, in the financial

sector, there is a case for liberalization, in terms of lowering inflation. However, a quasi-liberalized

system in the sector proves to have a greater potential to reduce inflation in Ghana. In the exchange

market, non-liberalization has the edge over liberalization in reducing inflation in Ghana. However, a

quasi-liberalized system in the sector has a greater potential to lower inflation. There is evidence of a

strong intra-continental transfer of inflation from C^

ote d’Ivoire to Ghana, but this transmission has been

significantly moderated downwards by the implementation of prudent fiscal management in C^

ote

d’Ivoire. We also find that monetary targeting and inflation targeting have deflationary effects, but we

cannot claim that this has significantly reduced inflation. The implication of the result is that; a system

that achieves the correct balance between the market mechanism and command system in the exchange

and financial sectors has a greater potential to lower inflation in Ghana. Also, domestic monetary policies

should not only be anchored on internal factors.

1. Introduction

Inflation levels in Ghana remained very high peaking at 123% in 1983. The high

inflation between 1960 and 1983 has been linked to the institutionalization of

government controls in the country. Exchange rate and interest rate were

controlled, and the Bank of Ghana also instituted an interventionist monetary policy

that is the direct credit control. These controls discouraged production, reduced

exports and increased imports, which worsened the terms of trade and weakened the

financial sector causing repression in the end. Consequently, growth rates became

negative reaching –4.56% in 1983. One of the primary objectives of the Economic

Recovery Programme in 1983, which was financed by the World Bank, was to create

a market-based economy to deal with the inefficiencies that have plagued the

economy. The first of these liberalization attempts was the liberalization of the

foreign exchange market in 1983. This was followed by the abolition of the

minimum and maximum deposits in 1987 that marked the commencement of

financial liberalization in the country. This process continued as the government

again abolished the minimum and maximum lending rates of commercial banks. The

*Adom (Corresponding author): Centre for Environmental and Resource Economics (CERE),

Department of Forest Economics, Swedish University of Agricultural Sciences (SLU), Ume



a, Sweden.

Tel: +46-(0)760847277; E-mail: Philip.kofi.adom@slu.se. Also affiliated to Department of Banking and

Finance, University of Professional Studies, Accra, Ghana. Bekoe: Department of Economics, University

of Ghana, Accra, Ghana. Quartey: Faculty of Accounting and Finance, University of Professional

Studies, Accra, Ghana. Amakye and Barnor: Department of Banking and Finance, University of

Professional Studies, Accra, Ghana. This article benefited from the useful comments of two anonymous

reviewers and the editor. The authors are very grateful for their comments. The usual disclaimer applies.

Review of Development Economics, 20(4), 794–816, 2016

DOI:10.1111/rode.12228

©2016 John Wiley & Sons Ltd

20% mandatory lending to the agriculture sector was also abolished in 1989. By

1991, the financial sector was almost fully liberalized (Sowa and Acquaye, 1999).

The Bank of Ghana also instituted a market-based monetary management scheme

in 1992. The country seems to have benefited from these market-based policies as

growth improved and inflation levels dwindled. For instance, the inflation rate

dropped from 123% in 1983 to 40% in 1984 and further to 10% in 1985. Since the

period after the reform in 1983, inflation rate has averaged 23% between 1984 and

2012 compared to the average of 32.5% for the period between 1960 and 1983. This

means that inflation, on average, has improved approximately by 10%.

Many have attributed this achievement to the institution of a liberalized market

economy and monetary management policy (see Adom et al., 2015). If this is true,

then one should expect the inflationary effects of money growth, exchange rate and

interest rate to accordingly change. However, it is still not clear from the literature

(see Adom et al., 2015; Ahiakpo, 2014; Chiaraah and Nkegbe, 2014; Adu and

Marbuah, 2011; Kovanen, 2011; Ocran, 2007; Bawumia and Abradu-Otoo, 2003;

Sowa, 1994) the extent to which specific reforms in the financial sector and foreign

exchange market and monetary management have contributed to the deflationary

process in Ghana after the reform. Though there are studies that come close to

achieving this goal (see Sowa and Acquaye, 1999; Kyereboah-Coleman, 2012); it

still remains unclear, in these studies, the extent to which the inflationary effects of

exchange rate, interest rate and money supply have evolved over time.

Another important, but often ignored possible, factor is international price

developments in C^

ote d’Ivoire. C^

ote d’Ivoire experienced impressive growth rates

between 1960 and 1980. However, this growth was threatened by the plunging of

major export prices in the 1970s, which reached its peak in 1980. The significant fall

in export revenue in the country made public expenditure and investment

substitutes for growth financing in the country. This increased public deficit and

caused large fluctuations in the domestic currency, which contributed to domestic

inflation between 1960 and 1980 (see Figure 1). Around the same time, Ghana’s

inflation also increased. As a recovery strategy from the crisis, the government of

C^

ote d’Ivoire instituted prudent fiscal management policies such as eliminating

budget deficit; cutting down civil servant salaries and generating surplus in the

primary budget. Inflation, in C^

ote d’Ivoire, began to take a downward trend as

depicted in Figure 1, and this also coincided with a downward trend in Ghana’s

inflation, though the latter occurred after 1983. The symmetry in inflation trends in

both countries cannot be described as a mere coincidence.

C^

ote d’Ivoire is a major import destination for Ghana. For instance, in 1998,

imports from C^

ote d’Ivoire constituted about 7% of total Ghana imports, which

made her the third highest import destination country after the UK and the USA.

In 2001, this rate fell to 4.7% (which made her the fifth highest import destination

after Nigeria, UK, USA and the Netherlands) and further to 4.6% in 2005 (which

made her the sixth highest import destination after Nigeria, China, USA and UK).

In 2010, total imports by Ghana from C^

ote d’Ivoire hit 7.3% making her the third

highest after China and USA. The rate further increased to 12% in 2013, which

ranked her as the second highest import destination after China (data source: Atlas

media, MIT, see http://atlas.media.mit.edu). On average, China, USA, Nigeria and

C^

ote d’Ivoire are the major import destination countries for Ghana. However, a

look at Figure 1 shows that, the symmetry in inflation trends seems stronger for

C^

ote d’Ivoire and Ghana than for the other countries.

1

Apart from formal trade,

another important factor that may explain the strong symmetry in inflation trends

GHANA’S INFLATION 795

©2016 John Wiley & Sons Ltd