Short-Run Dynamics of Inflation: Do Monetary and Exchange Rates Policies Matter? A VECM Analysis for Burundi

Jean NDENZAKO[1]

African Development Bank, Tunis, Tunisia

Abstract

Using the generalized impulse response analysis advocated by Pesaran and Shin (1998), this paper attempts to empirically investigate the importance of monetary factors in the dynamics of inflation in Burundi. To this end, we employ a vector error autoregression (VECM) model that incorporates as its endogenous variables: CPI, exchange rate, money growth. The generalized impulse response approach is more advantageous that the widely used orthogonalized impulse response analysis since it is invariant to the ordering of the variables in the VECM, i.e. allows us to construct order invariant forecast error variance decomposition. The results of both co-integration and error correction confirmed that there is a long run equilibrium relationship between prices, money, exchange rate and income. In line with the monetarist thesis, the findings demonstrate that, in the long run, inflation is positively related to money supply and the exchange rate while it is negatively related to real income. More specifically, using M1 as explanatory variable in the inflation equation, we found that in the long run, a one percent increase in M1 would raise inflation by 0.76 percent, a one percent depreciation of the BIF on the parallel markets would raise inflation by 0.28 percent and a one percent increase in real income would reduce inflation by 0.64 percent. Using M2 as explanatory variable in the inflation equation, a one percent increase in M2 would raise inflation by 0.72 percent; a one percent depreciation of the BIF in the parallel markets would raise inflation by 0.25 percent while a one percent increase in income would reduce inflation by 0.86 percent. The existence of a long run equilibrium relationship among money, price, exchange rate and income appears to be supported by annual data for