Exchange Rate Pass-Through and Inflation in Ghana: A New Keynesian DSGE Approach
Using a New Keynesian DSGE model on Ghanaian data from 2006 to 2025, this study finds that exchange rate depreciation leads to incomplete but significant pass-through to inflation (0.7 coefficient), while monetary policy rate hikes effectively reduce both inflation and the output gap.
Original paper licensed under CC BY 4.0 (https://creativecommons.org/licenses/by/4.0/). This is an AI-generated explanation of the paper below. It is not written or endorsed by the authors. For technical accuracy, refer to the original paper. Read full disclaimer
In the complex machinery of a national economy, prices are not set in a vacuum; they are the result of a constant, invisible tug-of-war between what people want to buy, what the government charges to borrow money, and the value of the country's money compared to the rest of the world. For nations like Ghana, which rely heavily on goods imported from abroad, the value of their local currency acts as a critical lever. When that currency loses value against major currencies like the U.S. dollar, the cost of bringing those foreign goods into the country rises. This phenomenon, known as exchange rate pass-through, is the process by which a drop in currency value translates directly into higher prices for everyday items on the shelf. Understanding how quickly and completely this happens is vital for central banks, which must decide whether to raise interest rates to cool down inflation or keep them low to encourage growth. If the link between a falling currency and rising prices is too strong, the economy becomes vulnerable to external shocks, making the job of keeping prices stable incredibly difficult.
Researchers Dennis Nchor set out to measure exactly how this mechanism works in Ghana, using a sophisticated computer simulation known as a New Keynesian Dynamic Stochastic General Equilibrium model. This type of model acts as a digital laboratory where economists can test how an economy reacts to different shocks, such as a sudden drop in currency value or a change in interest rates, by simulating the behavior of households, businesses, and the central bank over time. The study focused on monthly data spanning two decades, from 2006 to 2025. By feeding real-world data into this model, the researchers could isolate the specific impact of the exchange rate on consumer prices and the overall health of the economy, while also testing how effective the central bank's main tool—the monetary policy rate—is at controlling those prices.
The simulation revealed a clear and somewhat worrying picture for the Ghanaian economy: the link between a falling currency and rising prices is strong, though not perfect. When the Ghanaian cedi depreciated, it did not cause prices to rise by the exact same percentage, but the effect was substantial. The model estimated that for every one percentage point the cedi lost value against the dollar, domestic inflation rose by 0.7 percentage points. This means that if the currency dropped by 10 percent, prices for consumers would jump by 7 percent. Furthermore, this depreciation had a side effect on the economy's output, pushing the gap between actual production and potential production up by 0.6 percentage points, a sign that the economy was reacting to the shock by shifting spending toward domestic goods. The researchers found that this high level of pass-through suggests that most businesses in Ghana are pricing their imported goods in foreign currencies, meaning that when the local currency weakens, the cost of those goods rises immediately and almost fully, leaving little room for local prices to absorb the shock.
The study also tested the power of the central bank to fight this inflation by raising interest rates. The results showed that the monetary policy rate remains a potent tool for stabilizing the economy. In the simulation, when the central bank increased its policy rate by one percentage point, inflation fell by 1.1 percentage points, and the output gap shrank by one percentage point. This indicates that tightening the cost of borrowing successfully cools down both prices and economic activity, effectively counteracting the inflationary pressure caused by currency weakness. The findings suggest that while the economy is highly sensitive to currency swings, the central bank has the capacity to manage these shocks if it acts decisively. However, the study also highlighted that the effectiveness of these policies relies on the central bank maintaining its independence and communicating its actions clearly to the public, as uncertainty can undermine the confidence needed to keep inflation in check.
Ultimately, the research paints a picture of an economy that is deeply integrated with global markets and highly susceptible to currency fluctuations. The high pass-through rate implies that the dampening effect of local pricing strategies is largely muted, meaning that external price shocks travel quickly to the consumer. To build a more resilient economy, the study suggests that Ghana needs to reduce its reliance on imported goods through industrialization and diversification, which would strengthen the local currency's position. Additionally, curbing the practice of pricing domestic goods in foreign currencies is essential, as this dollarization limits the central bank's ability to control the money supply and can trigger panic when the currency weakens. By understanding these dynamics, policymakers can better navigate the delicate balance between maintaining price stability and fostering economic growth in a volatile global environment.
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