Causes of Exchange Rate Volatility

Abstract

This study examined the determinants of exchange rate volatility basing evidence on 7 African countries; Niger, Sudan, Cameron, Equatorial Guinea, Tunisia, Congo, and Cote D’Ivoire from 1990-2023. The study conducted the Autoregressive Distributive Lag (ARDL) bounds testing for co-integration and also estimated the error correction model. Furthermore, ARCH and GARCH models were analyzed to measure the volatility of a time series by fitting an autoregressive model to the squared residuals of the time series. The ARCH and GARCH results suggest the volatility of the exchange rate markets in the aforementioned countries is not random. The speed of adjustment of the volatility in the exchange rate of the Sudanese economy is 39%, in Niger Republic it is 50%, in Cameroon it is 52%, in Tunisia it is 55%, in Congo the speed is 32%, in Equatorial Guinea, the speed of adjustment is 58% and in Côte D’Ivoire the speed is 45%, respectively. The study found that the determinants of exchange rate volatility among African countries vary depending on the specific country. The observed volatility in the Sudanese exchange rate was anchored by the significant positive influence of inflation and income differentials as well as the significant negative influence of interest rate differential. In Niger Republic, exchange rate volatility was driven by the significant positive influence of productivity growth and money supply as well as the significant variation in oil prices and interest rate differentials. The observed short-run volatility in Cameroon's exchange rate was significantly and positively influenced by inflation differential and money supply variation whereas it was significantly but negatively propelled by interest rate differential and oil price shock. In Tunisia, exchange rate volatility was stimulated by the significant positive influence of inflation differential, productivity growth, oil price shock, and the significant negative role played by trade balance. The observed short-run volatility in the Congolese exchange rate was induced by the significant positive impact of inflation differential, income differential, trade balance, variation in money supply, and the significant negative impact of interest rate differential. In Equatorial Guinea, the observed exchange rate volatility was determined based on the significant and positive impact of differential in the inflation rate, oil price shock, changes in the money stock, and the foreign balance of trade. The observed volatility in the Côte D’Ivoire exchange rate was significantly and positively driven by the differentials in inflation rate, interest rate, and income level, the foreign trade balance but significantly stimulated by the negative influence of oil price shock. The general policy advice is that governments of all the countries covered by the study should implement exchange rate controls to limit the volatility of their currency fluctuation by imposing a limit on the amount of foreign currency that can be traded in the country. African governments should monitor the inflation differential between their own country and their trading partners to see if it is becoming too large. If it is, the government might raise interest rates to make its currency more attractive to investors.