# Relationship between inflation and devaluation of currency

### Devaluation - Wikipedia

A devaluation leads to a decline in the value of a currency making exports more competitive and imports more expensive. This can cause inflation - but in some. In this lesson, you'll learn about appreciation and depreciation of currencies and examine their impact on the inflation of a country. We'll also. The result of ARDL in the short run shows that devaluation of the nominal has devalued the Birr by 15 percent against international currencies (NBE, ). . 15) have investigated the relationship between inflation and the.

The pass-through into wholesale producer prices was found to be much larger, with complete pass-through within a period of about 6 months. The study also found that the factor input prices worker compensation has increased by around 0. Bhattacharya et alp. They have also estimated the impact of a change in the nominal exchange rate on the wholesale and consumer price indices.

They found that one percent increase in exchange rate causes a 3. The short-run effect was found to vary between According to them, if the effects of monetary policy are not taken into consideration, 10 percent of the exchange rate shock passes into the CPI in the next period and falls to 6.

Thus, they found that the exchange rate pass-through is incomplete for India. Bangura et alp. The findings show that the pass-through to consumer prices is significant and incomplete.

Thus, they suggested that exchange rate depreciation is a potential source of inflation in Sierra Leone. Bwire et alp.

### Currency appreciation and depreciation - Wikipedia

They found a strong and significant association between the exchange rate movements and inflation in Uganda. The pass-through to domestic inflation, although incomplete, was modest and persistent with a dynamic exchange rate pass-through elasticity of 0.

Thus, they suggested that exchange rate movements are a potential source of inflation in Uganda. The study has covered the period from to On the basis of the CPI model, it was suggested that the exchange rate shock has passed to consumer prices by an average of 47 percent. Thus, the study concluded that exchange rate pass-through is a potentially important source of inflation in Sudan. The exchange rates pass-through to import prices has an upward trend starting from 7 percent in the first year to percent in the tenth year.

The error correction terms of import prices and consumer prices have indicated that the elimination of 33 percent and 12 percent of disequilibrium respectively within one year. The exchange rate pass-through into import prices was found to be lower than that of consumer prices. Consumer prices have adjusted within two lags compared to one lag in the adjustment of import prices. The exchange rate pass-through to inflation was found to be very low and incomplete.

The exchange rate pass-through elasticity suggests that the pass-through was low and incomplete on both imported and consumer prices. The study suggested that the exchange rates pass- through on consumer prices and imported prices was estimated to be at 0. After eight quarters, the exchange rate pass-through on both the consumer prices and import prices were estimated to be at 0. Exchange rate pass-through for the group of all consumer prices was estimated at a level of 0.

The response of core prices, prices of tradable and import tradable was 0. For core food prices, the ERPT coefficient was somewhat higher 0. In the short-run, the degree of exchange rate pass-through for raw food prices have risen to 0.

All ERPT coefficients were statistically significant at a one percent confidence level. Ntsosa and Nkwep. They have used a vector error correction model to investigate the presence of pass through to the economy due to currency depreciation. The study relates to the period to and was based on the data from first quarter of to last quarter of The exchange rate pass-through was found to be incomplete with a coefficient of 0.

Mohammed et alp. The study related to the period to and has used SVAR methodology. They estimated that the elasticity of domestic prices to the change in exchange rate was about 33 percent. They found a positive relationship between exchange rate pass-through and inflation for the Nigerian economy. Studies in Ethiopia As there were variations in the exchange rate in Ethiopia, there are a few studies about the impact of devaluation in Ethiopian economy especially on inflation in the country.

The important studies in Ethiopia about the relationship between exchange rate and inflation are briefly reviewed in the following paragraphs. One of the earliest studies about the impact of exchange rate variations on inflation in Ethiopia has been by Helenp.

The objective of the study was to examine the exchange rate pass-through in the case of Ethiopia. Her study found that ERPT in Ethiopia during the study period has been significant and moderate, and persistent in the case of import prices. However, the ERPT was low and short lived in the case of consumer prices. More specifically, she found that the elasticity of import prices to the change in exchange rate was about 0.

However, the degree of exchange rate pass-through to consumer prices was found to be insignificant in the long run which indicated an absence of exchange rate pass through to consumer prices. Thus, on the basis of the co-integration analysis, the study concluded that there was incomplete ERPT to import prices and absence of pass-through to consumer prices in the long run. The study used six variables to estimate variance decomposition and impulse response function and have used unrestricted VAR model.

To measure the effect of the change in exchange rate on CPI coefficient of the exchange ratethe study utilized the standardization of change in the exchange rate which can convert the shock from one standard deviation to one percent. He found that, on an average, a one percent change in exchange rate will increase the CPI by 4.

The effects of the changes in exchange rate has stopped after two years of exchange rate shock. Mekasha and Molla They have used SVAR model to realize their objective. The study found that the exchange rate pass-through to consumer price index was small and incomplete.

In other words, according to their study, about 16 percent of the variation in consumer prices in Ethiopia was explained by shocks in nominal exchange rates. The above review of studies show that although there are a large number of studies about the relationship between exchange rate and domestic prices in developed and developing economies, such studies in Ethiopia are few and far between. The three available studies that have examined the exchange rate pass-through to prices in Ethiopia are by MohammadnurHelen and Mekasha and Molla These studies relate to different periods, based on different data sets, considered different variables and have used different models and hence have reached contradictory results.

Over and above these limitations, none of these studies have examined the short-run dynamics. Finally, in a dynamic world, where everything is changing, the findings of a study may not be accurate and applicable across time. Hence, there is a need to examine the effect of exchange rate devaluation on inflation on account of a shock to the exchange rate using the bound testing to co-integration of an Autoregressive Distributive Lags model in Ethiopia. Methodology The objective of this study is to examine the effect of devaluation of Birr on the domestic price along with the effect of changes in Money Supply, world commodity price index and the output gap on the Consumer Price Index in Ethiopia.

The study covers a period of 22 years from to The data has been analyzed using the software EViews 9. The theoretical foundation of the effects of changes in exchange rates on domestic prices is associated with the purchasing power parity PPP theory. The linear functional form of the model is: We can specify the equation in a log-log form for easy estimation as below: The ARDL includes the lags of both the dependent variable and independent variables as regressors.

The ARDL model of this study is represented as follows: In the ARDL bounds test of co-integration, F-statistics is used to examine the null hypothesis of no co-integration among the variables. In the ARDL bounds test, the estimated F-statistics value is compared with the two sets of critical values of the upper- and lower-bounds.

If the estimated F-statistics value is higher than the upper bound critical values, then the null hypothesis of no co-integration is rejected there is co-integration among the variables. If the value is lower than the lower bound critical values, the null hypothesis of no co-integration is not rejected there is no co-integration among the variables.

If the estimated value of F-statistics lies between the two critical values, the conclusion is indecisive. From the bounds test, if a hypothesis of long-run relationship among the variables is accepted, then the long-run elasticity can be estimated from the following equation. The short run relationship can be modeled as follows: It shows how much of the equilibrium error is corrected each period. The error correction term indicates the speed of adjustment due to any short-run disequilibrium after a shock.

A negative and statistically significant error correction term certifies the coming together of the dynamics to the long-run equilibrium. It should be noted that the speed of adjustment to equilibrium is dependent upon the magnitude of adjustment coefficient, meaning that: Andthen there is no adjustment.

Most of the time, the dynamic features of a VECM are scrutinized by conducting two types of structural analysis — the variance decomposition and impulse response function.

The impulse response function measures the effect of an impulse in one variable on the other variable in later periods. Results and Discussion Unit Root Test In order to get stationary series, a stochastic process requires the mean, variances and auto-covariance to be finite and independent of time. Hence, it is crucial to know whether the variables under study have a real economic relationship or not. According to the table, all the variables are stationary at first difference.

However, money supply and output gap are stationary at level and at first difference. Therefore, it is integrated of order 1 or I 1. There is no variable that is stationary at second difference and hence, the test results of the ADF unit root test can be justified for using the ARDL approach bounds test approach of co-integration.

If the lag length is too small, then the serial correlation in the errors will bias the test result. However, if the lag length is too large, then the power of the test will suffer. This leads to the fact that there is some optimal lag length Mohammadnur,p, Hence, the study has selected the optimal lag length of one. Lag Length Selection Criteria Bound Test The guide line for the bound test is that if the F test statistic falls below the lower bound, then there is no co-integration.

However, if the F test statistic is greater than the upper bound, then we can assume that there is co-integration.

On the other hand, if the F-statistic lies between the both the critical values, then the test is inconclusive. The following Table Table 3 shows that the computed value of F-statistic 5.

Hence, we can reject the null hypothesis of no long run relationship. Therefore, we can conclude that there is long-run relationship among the variables. After checking for the long-run co-integration between the dependent and explanatory variables, the next step is to estimate the long-run coefficients. It can be seen from the table that in the short-run, nominal effective exchange rate is not a significant factor affecting CPI.

However, there is a positive relationship between the broad money supply and the CPI in the short run. If the broad money supply increases by one percent, then the CPI increases by about 0. Also, there is a relationship between the world commodity prices and the CPI in the short-run.

The coefficient of world commodity prices is 0. Table 4 also indicates the error correction term. However, the residuals are not normally distributed. Therefore the in-existence of vector normality in this model will not affect our estimates.

The table shows that there is a significant and positive relationship between CPI and broad money supply, nominal effective exchange rate devaluationand world commodity prices. Specifically, this would mean that if domestic currency the Birr is devalued by one percent, then the CPI will rise by 2. The relationship between the broad money supply and CPI shows that if the broad money supply increases by 1percent, then the CPI will increase by 0.

The relationship between world commodity prices and CPI shows that if the world commodity price index increases by one percent, then the CPI will increase by 0.

Thus, on the basis of the long run result, we can conclude that nominal effective exchange rate devaluation of the Birr ; money supply and world commodity prices are the most significant factors that affect the CPI in Ethiopia. Hence, it can be concluded that, in the long run, output gap does not affect the CPI significantly. The insignificance of output gap on the CPI in Ethiopia may be because of the predominance of the agricultural sector in total output of the country.

It is seen that, except for the last three quarters, for the study period as a whole, agriculture is the largest contributor to the national output and hence, agricultural sector is the dominant sector in Ethiopia. The higher contribution of agricultural sector to the total output may have negatively affected the commodity prices.

### Relationship Between Exchange Rate and Inflation in Pakistan - Economics

In equation form, we can rewrite the results as follows: Since both the plots remain within the critical bounds at 5 percent level of significance, we can conclude that the model is structurally stable.

Output from EViews 9 Figure 1b. Plots of Cumulative sum of Recursive Residuals Source: More specifically, there is a unidirectional Granger causality running from money supply and nominal effective exchange rate to CPI. However, the granger causality between CPI and world commodity price index are bidirectional.

Pairwise Granger Causality Tests Analysis of Impulse Response and Variance Decomposition Impulse Response Impulse response function shows the impact of a one standard deviation shock to one of the innovations shock, impulse, residuals, and error terms on the current and future values of the endogenous variables.

This helps us to analyze the reaction of one variable on other variables due to a shock. Response of Consumer Price Index As can be seen from table 7, the CPI responds positively to a shock in the nominal effective exchange rate over the whole period and the magnitude of the response increases up to the fourth quarter.

But after the fourth quarter, it decreases up to 8th quarters and remained almost the same for the next quarters.

This implies that a one standard deviation shock to nominal effective exchange rate devaluation leads to a 0. However, the result shows a slight rise in the response of the CPI in the subsequent quarters as it is 0. However, the response falls to 0. The positive response of CPI to the exchange rate is justifiable because the depreciation of currency generally leads to a rise in the imported intermediate and finished goods which in turn impose a pressure on the CPI. The role of apathy seemed manifest in this era as people do consider expected inflation while making their optimization decisions.

The trend of inflation in Pakistan remained low, compared to the other developing nations in s and early s. The annual average inflation rate from to was 7.

The combination of improved performance of commodity goods plus services producing sector, lower public expenditures and turnaround of the nationalization policy played the vital role.

In addition, the country has a very middle-of-the-road rate of increase in money stock when compared internationally. The State Bank has allowed the money supply to increase by only about 15 percent annually between and The whole sale price index WPI almost reached twenty percent by the middle of the decade, with the consumer price index CPI not lagging far behind.

It was the period of liberalized policies, frequent changes of the governments, inconsistency of the policies and of nuclear explosion. Increase in procurement prices of wheat Hassan et al.

In the era ofthe inflation has shown a mixed trend. During inflation remained low but CPI shot up in and it reached to 9. It dropped to 8 percent in but it again shoot up in and reached to its historical high level. Non-government sector borrowing and rise in import prices may be the factors behind it. The causing factors of inflation in Pakistan remained inconclusive in both fiscal and monetary aspects. Heavily dependent on specifications, the varying econometric results have yet to resolve the debate.

Some of the empirical studies see for instance, Bilquees ; Hassan et al. Information plays an important role to change the business scenario and it also change the expectation of the people regarding market.

Therefore foreign investors require more return if risk is more to relative country. Such information is perceived from different macroeconomic variables. For example, information related uncovered interest rate can change the exchange rate and risk premium between two countries Duartea and Stockman, Macroeconomic variables can change the economic phenomenon as well as it leads to change the exchange rate at domestic level.

Nominal or real change in the interest rate is the main important feature of the monetary policy and it reason to change the exchange rate.

## Devaluation

In addition, the positive change in real or nominal interest at domestic level can appreciate the exchange rate at domestic level and vice verse Kim and Roubini, However, information regarding macroeconomic variables can be divided into two types whether it is strong or weak.

But strong announcement of macro-economic variables reason to appreciate the exchange rate. Although in long run there is a co movement in interest and exchange rate and this movement also leads to require the risk premium Fausta et. Moreover, daily intervention by central economic authority also set the exchange rate but the benefit can be achieved for short term not for long term Dominguez, Subsequently, economic news related macroeconomic variables like interest; inflation and monetary policy increase or decrease the value of the currency.

In addition, positive change in fundamental of the economy can appreciate the value of currency while unexpected negative change in the economic variable leads to decrease the value the domestic currency Ehrmann and Fratzscher, Consequently, variation in inflation also changes the spot and forward exchange rate while it depends upon direction of the inflation of one country to other country.

In addition, it is observed positive change in exchange rate if direction of inflation in two countries is same but domestic inflation remains low as compare to other country Simpson et. However, macroeconomic variable and exchange rate are positively correlated but it depends upon the time duration Ray, Accordingly, inflation and interest rate both have negative relation with nominal exchange rate.

However, expectation regarding real exchange rate has positive relation with nominal exchange rate Hsing, On the other hand, thereis a co movement between interest rate and exchange rate and sensitivity depends upon the monetary structure of the relative country.

The country having strong monetary structure has low co movement between exchange rate and interest rate Holtemoller, The above literature denotes the importance of interest rate and inflation in the determining the exchange rate.

The existing work also investigates the relation of inflation and interest with exchange rate. However, less work is done on this issue related to Pakistani scenario and the robust work enhances the knowledge at academic level as well as domestic level. The monetary policy in Pakistan aims at stabilizing the domestic and external value of the currency and to foster economic growth.

Therefore, the exchange rate pass-through to domestic wholesale and consumer prices is an important link in the process of monetary policy transmission. Any appreciation or depreciation of the exchange rate will not only result in significant changes in the prices of imported finished goods but also imported inputs that affect the cost of the finished goods and services. Specifically, exchange rate movements can influence domestic prices through direct and indirect channels see Chart 1. In case of direct channel, exchange rate movements can affect domestic prices through changes in the price of imported finished goods and imported inputs.

In general, when a currency depreciates it will result in higher import prices while lower import prices result from appreciation in price taker countries like Pakistan. The potentially higher costs of imported raw material and capital goods associated with an exchange rate depreciation increase marginal costs and lead to higher prices of domestically produced goods.

In case of indirect effect, the exchange rate depreciation affects the net exports which in turn influence the domestic prices through the change in aggregate demand, putting upward pressure on domestic prices.

In addition, import-competing firms might increase prices in response to foreign competitor price increases in order to maintain profit margins.