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


African Development Bank, Tunis, Tunisia


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. Tothis 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 errorvariance 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. Morespecifically, 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 inflationequation, 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 forBurundi for 1970-1998. An important finding from the dynamic models presented is that the error correction terms are statistically significant.

JEL Classification: O11, E17, C52

Key Words: Monetary variables, Inflation, Vector Error Correction, Co-integration, Causality

1. Introduction

Over the last decade, the Burundian economy has been subjected to a number of major adverse externalshocks. The protracted internal conflict that erupted in 1993 has dramatically affected the performance of the economy which in the pre-crisis periods recorded sustainable growth rates estimated at over 4 percent per annum between 1980-1991.

The stagnant economy was accompanied by rapidly rising inflation and the deterioration of the balance of payment and accumulation of arrears. The sharpdeterioration of the current account was largely attributed to negative terms of trade shocks and falling coffee production, which accounts for over 90 percent of export revenues. Indeed, the coffee prices in the world market established at US$346 cents per kilogram in 1980 fell to US$137 in 2001.

Coffee production which averaged 45,000 tons in the pre-crisis period fell to 18,000 tons in2001. The imbalances in the economy were also policy driven, resulting from the controls on the allocation of credit and foreign exchange, intensive exchange and trade restrictions, distortions in the pricing system including exchange rates, interest rates and domestic energy prices in an environment of inadequate demand management.

This has induced inefficiency in the allocation ofresources, rendered the economy less competitive and wakened its capacity to respond to external shocks. All these factors have led to chronic inflation peaking at 31 percent in 1997 after five consecutive years of double digits. As a result, the objectives of monetary policy have been mainly concerned with maintenance of adequate foreign exchange reserves and price stability. The country has...
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