EXCHANGE RATE AND BALANCE OF PAYMENTS ADJUSTMENT IN SIERRA LEONE, 1970-2005
Date
2008-08-22
Authors
KORSU, ROBERT DAUDA,
Journal Title
Journal ISSN
Volume Title
Publisher
University of Ibadan
Abstract
In spite of series of exchange rate adjustments in the 1980s and the adoption of the managed
floating exchange rate regime in 1990, Sierra Leone still experiences poor external sector
performance. The nominal exchange rate has been depreciating since the 1980s without
reflection on the real exchange rate and the balance of payments. Both the theoretical and
empirical literature on the effects of the nominal exchange rate on the real exchange rate and,
hence, the balance of payments, are inconclusive. Previous studies on Sierra Leone focused on
the elasticity approach, ignoring the wide macroeconomic implications of changes in the
exchange rate. This study therefore examined the role of the exchange rate in balance of
payments adjustment in Sierra Leone.
Based on the absorption approach to the balance of payments, a small open-economy
macroeconomic model that incorporated the linkages among fiscal, monetary and exchange rate
policies, and the balance of payments was constructed using annual data from 1970 to 2005. The
empirical analysis was based on estimating the macroeconomic model using the three stage least
squares, and counterfactual policy simulations. Using Ordinary Least Squares with moving
average errors, an equilibrium real exchange rate model which was derived from the basic
tradable and non-tradable goods framework was also estimated.
Although increase in the nominal exchange rate was inflationary, it increased the real
exchange rate, non-mineral export, aggregate export, output, absorption and import. Moreover, it
decreased the trade balance and increased the overall balance of payments. The correlation
coefficients between actual and simulated series ranged from 0.5 to 0.94, while the covariance
proportions of the Theil’s inequality coefficients ranged from 0.47 to 0.98. An 85 % increase in
the nominal exchange rate increased the price level by 3.9 %, real exchange rate by 6.9 %, non mineral export by 117.1% and the balance of payments by 22.6% while it decreased the trade
balance by 48.4%. Loose fiscal and monetary policies and trade restrictions reduced the potency
of nominal exchange rate in attaining real exchange rate depreciation and improvement in the
balance of payments of Sierra Leone. The estimated equilibrium real exchange rate model
showed that an increase in investment appreciated the equilibrium real exchange rate, implying
that investment took place more in the non-tradable goods sector than the tradable goods sector
of Sierra Leone. Also, deterioration in-terms-of trade and trade restrictions appreciated the
equilibrium real exchange rate.
Nominal exchange rate depreciation leads to depreciation of the real exchange rate, and
expansionary fiscal and monetary policies appreciate the real exchange rate. Although nominal
exchange rate depreciation increases export and hence income, it raises import and therefore
deteriorates the trade balance. It is, therefore, recommended that fiscal and monetary policies be
coordinated such that tight monetary policy is given priority, as this enhances the benefit of
nominal exchange rate depreciation. Also, bolstering domestic capacity for the production of
import-competing goods is essential.
Description
Keywords
Exchange rate, , Balance of payments, , Macroeconomic model, , Sierra Leone