A Study of the Relation between Inflation and Exchange Rates in the Fiji Islands: A Cointegration and Vector Error Correction Approach

By Paul, Muthucattu Thomas; Tang, Yih Pin et al. | The Journal of Developing Areas, Fall 2014 | Go to article overview

A Study of the Relation between Inflation and Exchange Rates in the Fiji Islands: A Cointegration and Vector Error Correction Approach


Paul, Muthucattu Thomas, Tang, Yih Pin, Bhatt, Markand, The Journal of Developing Areas


ABSTRACT

The main purpose of this study is to examine the effects of the exchange rates, international prices, and the demand shocks on inflation in Fiji. How the domestic inflation in a pegged exchange rate system is aligned with international price shocks is an important monetarist idea, and this is tested in this study. This study employs annual data from 1975 to 2010. The multivariate cointegration tests are done after the unit root tests, and further, the Vector Error Correction (VEC) model shows that the changes in Fiji's CPI are Granger caused by the long-term trends in all other variables, and the CPI in Australia, and devaluation-year dummies are used as exogenous variables in the VEC model, and the changes in exchange rate and changes in demand shocks are the independent variables but made endogenous in the VEC model. The impulse response function also shows that due to the exchange rate depreciation, inflation has increased for many years in Fiji. The policy implication of our study is that as a monetary policy instrument, the flexibility of the exchange rate policy is indispensable for Fiji to appropriately absorb the international supply and price shocks.

JEL Classifications: E2, E2, E31, C01, C58, C32, F10

Keywords: Exchange rates flexibility, inflation, small open economy, demand and supply shocks, devaluation, cointegration, VEC model.

Corresponding Author's Email Address: tommypaul50@gmail.com; paul_t@usp.ac.fj

INTRODUCTION

This paper seeks to study the impact of the exchange rate, the international prices, the demand shocks, and the devaluations done on different years, on inflation in the Fiji Islands for the years (annual data) 1975-2010 using cointegration and Vector Error Correction approach (VEC). This research paper attempts to study the effects of exchange rates on domestic consumer prices in Fiji after controlling for the effects of supply shocks represented by the foreign prices, the domestic demand shocks, and the devaluation episodes.

However, the motivation of this study is not to test the Purchasing Power Parity (PPP) theory in all its ramifications, though some implications of the PPP theory, especially the effect of exchange rates on prices may be applicable for our study of inflation in Fiji and some aspects of the PPP theory, specifically the effect of domestic prices on exchange rates may not be fully applicable to Fiji, as this country has been following a pegged exchange rate system. In the VEC model, the major research methodology employed in this paper, the Australian consumer prices, and the devaluation-year dummy variables are used as exogenous variables. The Eviews software is used for analysis. As the focus of the study is the inflation in Fiji, some variables relevant to the PPP theory, especially the Australian prices, and the devaluation year's dummies, are not made endogenous to the system. The Australian demand variables are not even used in the study. Similar to any PPP study, the exchange rate variable is made endogenous. Our final results from the VEC model support our judgment that there is no Granger-causality from the inflation of Fiji variable to the exchange rate variable, as the exchange rate is mostly pegged exchange rate system. But how the domestic inflation, in a pegged exchange rate system will align to the international price shocks, is an important monetarist idea, which is being tested in this study. In fact, even the shocks coming from the Australian consumer prices, through the so called Balassa (1964) and Samuelson (1964) effects of higher non-tradable goods' prices from the productivity shocks in Australia, in the normal PPP framework, should cause appreciation in the Australian real exchange rates only, and by implication should depreciate the real exchange rate in Fiji. However, because the Fijian currency is also pegged to the Australian currency, this will work in the opposite direction of the real exchange rates appreciation in Fiji with increase in the nominal exchange rate value and as well as the transmission of the higher Australian consumer price shocks to the consumer prices in Fiji. …

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