The determinants of real exchange rate in the West African monetary zone (WAMZ)

Abstract

The study seeks to investigate the determinants of both the actual and equilibrium real exchange rate (RER) and to obtain a model-based equilibrium RER and characterise the nature of RER misalignment in the West African Monetary Zone. In order to address these objectives, annual aggregate data from 1970 to 2006 were used to estimate a model of RER, which was developed by taking into consideration the interactions among exchange rate, monetary and fiscal variables. Based on time-series characteristics of the data, an error correction model is formulated to estimate the determinants of RER. The ERER model was also estimated by the application of OLS. The Hodrick-Prescott filter method was used to arrive at the equilibrium exchange rates and hence the RER misalignment. The results for the four countries' models confirmed the significance of variables like the terms of trade, openness, government expenditure, investment as a share of GDP, GDP growth rate, capital flows, domestic credits, nominal and RER (lagged) in line with Edwards' (1989) model, but not in one single country model. Terms of trade, Openness, government expenditure and investment variables were significant in all four countries either in the short or long run models. Variables such as GDP growth rate, capital flows, domestic credits, nominal and RER (lagged) are either significant in only one, two or three countries. The speed of adjustment of the RER to equilibrium ranges from one year in the Gambia to four years in Nigeria. What stands clear is that all the countries RER were found to be misaligned, and the incidence was very high in the fixed exchange rate regime than the managed float regime. The study however, recommends that policies such as monetary, fiscal and as well as commercial should target the tradable sector. Also the current floating exchange rate regime be sustained and improved on.