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Exchange Rate Volatility and EconomicActivities of Africa's Sub-GroupsAdeolu O. Adewuyi a & Godwin Akpokodje ba Department of Economics , University of Ibadan , Ibadan , Nigeriab Economic Development Department , Nigerian Institute of Socialand Economic Research (NISER) , Ibadan , NigeriaPublished online: 15 Aug 2013.

To cite this article: Adeolu O. Adewuyi & Godwin Akpokodje (2013) Exchange Rate Volatility andEconomic Activities of Africa's Sub-Groups, The International Trade Journal, 27:4, 349-384, DOI:10.1080/08853908.2013.813352

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The International Trade Journal, 27:349–384, 2013Copyright © Taylor & Francis Group, LLCISSN: 0885-3908 print/1521-0545 onlineDOI: 10.1080/08853908.2013.813352

Exchange Rate Volatility and EconomicActivities of Africa’s Sub-Groups

ADEOLU O. ADEWUYIDepartment of Economics, University of Ibadan, Ibadan, Nigeria

GODWIN AKPOKODJEEconomic Development Department, Nigerian Institute of Social and

Economic Research (NISER), Ibadan, Nigeria

Exchange rates have been highly volatile in Africa, especially sincethe move to a floating exchange rate system beginning in the 1980s.Generally, the pattern of exchange rate changes differs betweenAfrica’s two main sub-groups (CFA and non-CFA groups) due to thedifferent monetary/exchange rate systems they adopted. This arti-cle therefore examines the effect of exchange rate volatility on theeconomic activities in Africa and its sub-groups during the period1986–2011 using a panel data approach.

Rational expectation theory informs the division of exchangerate into anticipated and unanticipated. Both the demand andsupply channels are explored to trace the impact of the exchangerate volatility on price as well as aggregate demand and itscomponents. Empirical results reveal differences in the impact ofexchange rate volatility on economic activities between Africa’stwo sub-groups. Exchange rate volatility produced more significanteffects in the non-CFA group than in the CFA group.

KEYWORDS exchange rate volatility, economic activities, CFAand non-CFA, Africa, panel data model

I. INTRODUCTION

Exchange rate volatility has always been at the core of the raging debate onthe performance of exchange rate regimes. A major concern of policy makers

Address correspondence to Adeolu O. Adewuyi, Department of Economics, University ofIbadan, Ibadan, Nigeria. E-mail: aoadewuyi@yahoo.co.uk

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350 A. O. Adewuyi and G. Akpokodje

at the demise of the Bretton Woods system is the consequence of exchangerate volatility perceived to be a prominent feature of a flexible exchange ratesystem. This concern was reinforced by the large movements in nominalexchange rates that characterized world financial markets since the move toa managed floating exchange rate system in 1973. Further, exchange ratevolatility was substantially much higher than the early advocates of floatinghad expected (Bailey & Tavlas 1988; Hassan & Wallace 1996).

The impact of exchange rate volatility on an economy comes throughits impact on trade (export and import) since it is used to determine anddenominate export and import prices. This is the reason why most of theearlier studies on this subject matter focused exclusively on its impact ontrade. Subsequent studies have also gone ahead to look at its impact onother economic activities such as output, consumption, investment, and pricelevel. This is because exchange rate volatility has important implications notonly for the achievement of external balance but also for the realization ofinternal balance and the growth prospects of countries.

The debate on the optimal management of exchange rates attractedrenewed attention as the knowledge of the degree to which exchangerate volatility affects trade and other economic activities is important forthe design of exchange rate, trade, and other macroeconomic policies. Forinstance, if exchange rate volatility leads to a reduction in exports, tradeadjustment programs that emphasize export expansion could be unsuccess-ful if the exchange rate is volatile. In addition, the intended effect of a tradeliberalization policy may be doomed by a variable exchange rate and couldprecipitate a balance of payments crisis (Arize 1998; Arize et al. 2000).

The empirical literature has shown that the effect of exchange ratevolatility on economic activities is complex. It depends on many factors,including the form (depreciation or appreciation: large or small) and expecta-tions about exchange rate changes (anticipated or unanticipated: permanentor transitory), policy environment (fiscal and monetary policy stance—expansionary or contractionary), degree of openness of the economy, andlevel of financial development and productivity of the economy (Barkoulas,Baum, & Caglayan 2002; Canzoneri et al. 1984; Darby et al. 1998; Diallo 2007;Gros 1987; Khandil & Dincer 2008; Monacelli & Perotti 2006; Serven 2002;Volberg 2005).1 However, since different exchange rate regimes produce dis-similar exchange rate volatility, there will be differential impact on economicactivities. A flexible exchange rate regime is characterized by high exchangerate volatility (Bailey & Tavlas 1988; Hassan & Wallace 1996). This suggeststhat countries which adopt this exchange rate regime are likely to feel moreimpact from volatility than otherwise.

1 The importance of these factors in determining the impact of exchange rate volatility on economicactivities as discussed in the above-listed studies is highlighted in the theoretical framework of this article.

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Effects of Exchange Rate Volatility in Africa 351

Exchange rate liberalization was a major component of the economicreform programs of most African countries in the 1980s. Consequently, thesecountries have witnessed highly volatile exchange rates depending on theirmonetary systems. Specifically, the annual percentage average changes inexchange rate in Africa during the 1980–2011 period was over 10%. This isfar higher than those of the UK (0.43%), United States (−0.81%), and China(−2.40%). These figures also vary widely between the two main Africa’sgroups, with 4% for the franc zone (CFA group)2 and 16.5% for the non-franczone (non-CFA group).3 Thus, a remarkable difference exists in the behaviorof their real exchange rates. Real exchange rates in the CFA countries gen-erally follow a downward trend (appreciation) unlike the non-CFA countrieswhere they follow an upward trend (depreciation). This difference stemsfrom the fact that they pursue different monetary and exchange rate sys-tems. It is hypothesized that this difference may engender differential impacton their economic performances which may also reflect in their empiricalresults.

The issues of concern are: how has exchange rate volatility affectedeconomic activities in Africa where a forward exchange market is eithernonexistence or rudimentary, and where different monetary or exchangerate systems exist? This article empirically examines the effect of exchangerate volatility on the economic activities (trade, consumption, investment,output) and price level in Africa and its sub-groups (CFA and non-CFAgroups). It is motivated by the theoretical and empirical inconclusivenessof the effects of exchange rate volatility on economic activities (see Todani& Munyama 2005). Further, empirical evidence on the effect of exchange ratevolatility on economic activities in Africa is very sparse. There exist few paneldata studies in this connection (Ghura & Greene 1993; Sekkat & Varoudakis2000).

However, these studies are limited by the period of observationemployed, the risk measures adopted, and issues addressed. Besides, theyonly touched tangentially on exchange rate volatility. Moreover, previousstudies employed pooled data of both fixed and flexible exchange rateperiods. The use of such non-homogenous samples may unduly bias theresults (see Arize & Walker 1992; De Grauwe 1988; Himarios 1989; McNown& Wallace 1992). This therefore informs the limit of the coverage of thispresent study to the period of the adoption of a flexible exchange rate regime(1986 to 2011) in which large volatility has occurred.

2 Members of the franc zone share a common currency (CFA franc) that is fixed to—and convertiblewith—the euro through special monetary arrangements with France, while the other African countries(non-franc zone members: non-CFA) adopted variable exchange rate policies.3 The changes in the real exchange rate of the different countries were computed from the WorldBank (2012) World Development Indicators (WDI).

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352 A. O. Adewuyi and G. Akpokodje

Empirical results reveal differences in the impact of exchange ratevolatility on economic activities between the two Africa’s sub-groups.Exchange rate volatility produced more significant effects in the non-CFAgroup than in the CFA group. The rest of the article is organized as fol-lows: Section two examines the economic performance of Africa and itssub-groups (CFA and non-CFA groups). This is followed by the review ofrelevant literature in section three. The theoretical framework and method-ology are presented in section four, while in section five we discuss theempirical results obtained, and conclude in section six.

II. ECONOMIC PERFORMANCE OF AFRICA

Exchange Rate Movements in Africa

African countries can be classified into two major groups based on theirexchange rate policies—the franc zone and the non-CFA zone. The Africanmembers of the franc zone share a common currency, the CFA franc, that isfixed to—and convertible with—the euro through special monetary arrange-ments with France. On the other hand, the non-CFA countries have adopteda variable exchange rate policy. These economic arrangements could affectthe trade and other economic performance of the countries involved.

There has been unstable movement in real exchange rates in Africaand a remarkable difference exists in the behavior of the real exchangerates between the CFA and non-CFA sub-groups. Real exchange rates inthe CFA group generally reflect a downward trend (appreciation) unlikethe non-CFA countries where it has been an upward trend (depreciation).In the CFA group, appreciation of the average real exchange rate, which wasaround 1.88% in the 1970–74 period, rose to 2.84% in 1975–79 (Table 1).However, the CFA group’s currency depreciated during the subsequent peri-ods 1980–84, 1990–94, and 1995–99 in which most countries implementedadjustment reforms.

TABLE 1 Change in Average Real Exchange Rate of the CFA and Non-CFA Groups

Sub-Group/Period CFA Non-CFA Sub-Group/Period CFA Non-CFA

1970–74 −1.88 −2.46 2005 −0.15 5.231975–79 −2.84 −0.22 2006 −0.88 9.221980–84 8.09 8.55 2007 −9.10 2.801985–89 −7.30 12.56 2008 −7.03 3.341990–94 7.05 17.39 2009 3.16 11.231995–99 1.76 18.81 2010 2.66 9.522000–04 −3.74 8.13 2011 −4.96 2.26

Source: Computed by the author, underlying data from World Bank, World Development Indicators (WDI)(2012).

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Effects of Exchange Rate Volatility in Africa 353

The period 2000 to 2008 and the year 2011 were characterised bypersistent appreciation of the currency of the CFA group. This phenomenoncould be linked with the formation of economic and monetary unions suchas the West African Economic and Monetary Union (WAEMU). In contrast,average real exchange rate in the non-CFA sub-group which appreciatedduring 1970–79, depreciated persistently in the subsequent periods. Forinstance, it could be said that, with the introduction of adjustment reformsin the mid-1980s by most countries in the non-CFA group, exchange ratedepreciation rose from 8.55% in 1980–84 to 18.81% in 1995–99. However,it moderated until 2009 when the depreciation rate rose to 11.23%. It canbe seen from this analysis that the difference in the trends of real exchangerate of the two Africa’s sub-groups is due to the different economic andmonetary systems adopted.

Africa’s Trade Performance

Africa’s share in world trade declined over time, as it fell from an annualaverage of 2.35% in the period 1970–79 to 1.34% in 2000–09 and 1.7% in2011 as shown in Table 2. Comparatively, the relative shares of Asia anddeveloping countries increased, particularly during 2000–11. Africa has beendescribed as being marginalized in world trade and this manifests in theregion’s exports and imports. The share of Africa’s exports was the lowestregional contribution to world export. Indeed, Africa’s share in world exportwas substantially less than the combined share of developing countries thatstood at 40.7% in 2011.

Africa’s share in world exports consistently declined from an annualaverage of 2.48% in 1970–79 to 1.38% and 0.92% in the 1980s and 1990s,respectively; and in 2000–11 it was over 1.3%. This is in contrast to whatobtains in other regions such as Asia where it has consistently increasedfrom a mean annual share of 6.77% in 1970–79 to 20.1% in 2011. Theextensive erosion of Africa’s market shares in Organization of EconomicCooperation and Development (OECD) countries contributed to this declineas the region’s traditional exports were displaced by similar goods from com-peting suppliers. Market share losses for 30 of Africa’s largest exporters havebeen estimated to have reduced annual export earnings by about $11 billion(Sekkat & Varoudakis 2000). These competitive losses coupled with the factthat global demand was generally below average for the primary goods thatAfrican countries produced, reduced the growth rates for their exports wellbelow that for world trade.

Related evidence showing growth rates for exports from Africa and otherregions of the world is presented in Table 3. Although there was a generaldrop in the growth rates of exports in most regions in the 1980s, the declinein Africa’s export was massive, from 27.62% in the 1970s to only 2.37% inthe 1980s but peaking at 46.4% in 1990–99. It fell, however, to as low as

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TAB

LE2

Afr

ica’

sSh

are

inW

orld

Tra

de

Com

par

edto

Oth

erReg

ions

(%)

Shar

ein

World

Exp

orts

Shar

ein

World

Imports

Tota

l

Dev

eloped

Dev

elopin

gA

sia

Afr

ica

Dev

eloped

Dev

elopin

gA

sia

Afr

ica

Dev

eloped

Dev

elopin

gA

sia

Afr

ica

1970

–79

73.9

126

.09

6.77

2.48

76.4

423

.56

5.78

2.24

75.1

824

.82

6.27

2.35

1980

–89

75.3

424

.66

6.36

1.38

75.4

324

.57

6.8

1.27

75.3

824

.62

6.59

1.33

1990

–99

75.5

124

.49

8.85

0.92

73.5

226

.48

8.57

0.92

74.5

25.5

8.7

0.91

2000

–09

67.7

832

.22

14.9

81.

3470

.35

29.6

512

.41.

3769

.130

.913

.65

1.34

2010

60.5

39.5

20.4

1.6

62.9

37.1

18.0

1.7

61.7

38.3

19.2

1.7

2011

59.3

40.7

20.1

1.8

62.7

37.3

17.9

1.7

61.0

39.0

19.0

1.7

Sou

rce:

Com

pile

dfr

om

the

World

Inte

grat

edTra

de

Solu

tion

(WIT

S)D

atab

ase

(n.d

.).

354

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TAB

LE3

Gro

wth

ofA

fric

a’s

Exp

orts

and

Imports

Com

par

edto

Oth

erReg

ions

(%)

Exp

ort

Gro

wth

Import

Gro

wth

Asi

aA

fric

aD

evel

opin

gIn

dust

rial

World

Afr

ica

Asi

aD

evel

opin

gIn

dust

rial

World

1970

–79

27.6

827

.62

37.2

834

.84

35.4

18.6

323

.99

22.2

720

.26

20.7

219

80–8

9−3

.62.

37−3

.52

0.66

11.5

13.

4412

.27

6.92

7.19

7.06

1990

–99

52.0

546

.86

56.3

49.2

542

.26

4.26

9.16

7.97

5.96

6.52

2000

–09

22.0

615

.36

16.3

313

.52

15.2

58.

047.

287.

474.

965.

8720

1014

.914

.410

.640

.326

.78.

317.

119.

56.

98.

2220

1132

.719

.29.

823

.327

.35.

16.

917.

216.

26.

89

Sou

rce:

Com

pile

dfr

om

the

World

Inte

grat

edTra

de

Solu

tion

(WIT

S)D

atab

ase

(n.d

.).

355

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356 A. O. Adewuyi and G. Akpokodje

14.0% in 2010, although there was a marginal increase to 19.2% in 2011.Africa’s export growth rates are lower than those of other regions of theworld. Several explanations have been provided for the poor performanceof Africa’s exports. A major one is that Africa has been and remains the mostheavily primary commodity-dependent region in the world. It has also beenattributed, in part, to the overvaluation of the exchange rate (Ndulu et al.1995; Oyejide 2004).

In the case of imports, the trend is similar to that of exports. The shareof Africa’s imports was also the lowest contribution to world imports. Thisshare fell from 2.24% in 1970–79 to 1.7% in 2011, not comparable to thefigure for Asia which rose from 5.78% in 1970–79 to 17.9% in 2011. It wasfar less than the share of developing countries which increased from 23.56%in 1970–79 to 37.3% in 2011. The rate of growth of Africa’s imports fell from18.6% in 1970–79 to 8.0% in 2000–09 and 5.1% in 2011. Although the rate ofgrowth of imports also fell drastically in other regions of the world, it wasnot as much as that of Africa, except in 2000–09.

Overall, there appears to be a slight difference in the average trade per-formance and trade openness in the CFA and non-CFA groups from 1970 to2011. For instance, trade as a share of GDP was higher in the CFA group thanin the non-CFA during the 1970s and 1980s (Table 4). However, the positionchanged in subsequent periods, the 1990s and 2000–11 when trade sharewas relatively higher in the CFA than in the other group. Also noticeable inTable 4 is the consistent increase in the trade share of the non-CFA group.The annual average trade share rose from about 62% in the 1970s to 88.9% in2011. But the trade share of the CFA group rose consistently from an annualaverage of 64.0% in the 1970s to 66.55% in the 1980s, but fell to 59.9% in the1990s. It later rose consistently to 83.4% in 2011.

Analysis of the rate of growth of exports and imports between the twoAfrica’s sub-groups shows some differences. Table 5 indicates that in the1970–84, the growth rate of imports of the CFA group surpassed that of thenon-CFA group. However, the pattern changed in the subsequent period asthe growth rate of imports in the non-CFA outweighed that of the CFA group.

TABLE 4 CFA and Non-CFA Countries Share of Trade in GDP (%)

Exports Share Imports Share Total Trade Share

CFA Non-CFA CFA Non-CFA CFA Non-CFA

1970–79 28.3 26.7 35.7 35.3 64.0 62.01980–89 29.5 27.1 36.9 38.0 66.5 65.11990–99 28.1 28.1 31.8 40.2 59.9 68.32000–09 34.1 34.7 35.5 45.5 69.6 80.22010 41.7 32.4 40.5 45.9 82.2 88.42011 42.4 35.1 40.9 47.9 83.4 88.9

Source: World Bank, World Development Indicators (WDI) (2012).

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Effects of Exchange Rate Volatility in Africa 357

TABLE 5 Average Real Exchange Rate and Growth Rates of Exports and Imports

CFA Non-CFA

Period

RealExchange

RateChange

Imports(AnnualGrowth)

Exports(AnnualGrowth)

RealExchange

RateChange

Imports(AnnualGrowth)

Exports(AnnualGrowth)

1970–74 −1.88 7.57 7.80 −2.46 3.40 8.901975–79 −2.84 7.60 8.80 −0.22 6.36 7.231980–84 8.09 4.74 6.61 8.55 1.00 0.311985–89 −7.30 −0.56 1.30 12.56 5.08 4.421990–94 7.05 −1.21 2.18 17.39 3.22 3.061995–99 1.76 7.06 5.93 18.81 6.56 7.592000–04 −3.74 1.93 2.50 8.13 13.25 8.772005 −0.15 2.84 1.98 5.23 4.99 8.622006 −0.88 3.13 1.57 9.22 9.99 8.552007 −9.10 6.46 −1.21 2.80 11.00 18.362008 −7.03 2.79 1.69 3.34 12.92 14.052009 3.16 9.68 4.08 11.23 −2.15 0.992010 2.66 3.39 1.55 9.52 8.46 6.192011 −4.96 8.04 4.16 2.26 9.13 8.24

Source: Computed by the author, underlying data from World Bank, World Development Indicators (WDI)(2012).

In the case of exports, the growth rate was higher in the non-CFA groupthan the CFA group in most of the periods. This suggests that exchange ratedepreciation in the non-CFA group favors export growth.

Trend of Income, Prices, Consumption, and Investment in Africa’sSub-Groups

Generally, real GDP growth rates of the two groups were less than 10.0%during 1970 to 2011 .The average growth rate of real GDP was higher inthe non-CFA group compared to what obtained in the CFA group during theperiod (Table 6). While the average growth rate of investment was relativelyhigher in the CFA group than in the non-CFA group during 1970–90, thereverse was the case during 1995–2011, except 2009 and 2010. Also notice-able in the table is that the rate of growth of private consumption was higherin the non-CFA group than in the CFA group for most of the period. Further,the inflation rate was single-digit in the CFA group over the period, while thenon-CFA group witnessed deflation during most of 1975–2005, but inflationbegan to soar beginning in 2007.

III. REVIEW OF EMPIRICAL STUDIES

Because studies on exchange rate volatility started with its effect on tradeflows before extending the analysis to other economic activities, the review

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TAB

LE6

Ave

rage

Annual

%Chan

gein

Rea

lExc

han

geRat

ean

dG

row

thRat

esofM

acro

econom

icIn

dic

ators

(%)

Rea

lExc

han

geRat

eG

DP

Inve

stm

ent

Consu

mptio

nPrice

Leve

l

Gro

up/Per

iod

CFA

Non-C

FACFA

Non-C

FACFA

Non-C

FACFA

Non-C

FACFA

Non-C

FA

1970

–74

−1.8

7−2

.46

4.65

5.66

15.3

411

.33

2.69

5.52

4.08

12.8

919

75–7

9−2

.84

−0.2

24.

694.

67.

326.

956.

06.

626.

07−1

.79

1980

–84

13.0

98.

552.

571.

470.

464.

153.

41.

925.

13−6

.36

1985

–89

−7.3

12.5

62.

133.

676.

626.

622.

072.

822.

24−0

.319

90–9

47.

0517

.39

0.58

0.55

3.21

3.18

−0.2

2.24

8.28

2.98

1995

–99

1.76

18.8

14.

535.

369.

1110

.62

5.12

5.05

7.02

−8.4

920

00–0

4−3

.74

8.12

2.75

5.16

4.36

8.4

1.99

4.62

2.54

−4.4

820

05−0

.15

5.23

4.16

6.22

11.4

513

.34

2.53

7.34

2.34

3.21

2006

−0.8

89.

223.

967.

2610

.420

.07

3.05

3.11

2.73

4.38

2007

−9.1

2.8

3.27

6.69

4.71

15.4

77.

0111

.17

1.24

18.4

120

08−7

.03

3.34

4.16

5.41

7.03

13.2

13.

685.

17.

8337

.57

2009

5.16

11.2

32.

663.

3515

.94.

790.

036.

394.

5427

.99

2010

4.66

9.52

5.16

5.82

17.6

37.

231.

884.

94.

6721

.22

2011

−4.9

62.

262.

754.

9610

.26

10.7

14.

45.

925.

6320

.17

Sou

rce:

World

Ban

k,W

orld

Dev

elop

men

tIn

dic

ato

rs(W

DI)

(201

2).

358

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Effects of Exchange Rate Volatility in Africa 359

will follow this order. There are many works in the literature on the effect ofexchange rate volatility on exports of developed countries.4 The findings ofthese studies have, however, been conflicting (Adewuyi & Akpokodje 2010;Garces-Diaz 2008). On the one hand, Hooper & Kohlhagen (1978); Gotur(1985); & Asseery & Peel (1991); among others, do not find support for thenegative impact of exchange rate volatility on export. On the other hand,Akhtar and Hilton (1984), Kenen & Rodrik (1986); Arize (1997); Dell’Ariccia(1999), & Doroodian (1999) reported an adverse effect of exchange ratevolatility on exports. However, comprehensive studies on the effect ofexchange rate volatility on components of aggregate demand beyondexports and imports are scarce. Besides, such studies are not available forAfrica where there is high volatility due to heavy dependence on primaryproduct exports.

An error correction approach was employed by Callabero and Corbo(1989) to investigate the effect of real exchange rate uncertainty on exportsfor six developing countries (Chile, Colombia, Peru, Philippines, Thailand,and Turkey). They found that real exchange rate uncertainty did reduceexports in the short run and the results were substantially magnified in thelong run. The cointegration technique was adopted by Samanta (1998) toexamine the implications of exchange rate volatility for India’s exports. Theresults showed that over the period, 1953–89, exchange rate risk had a signif-icant adverse impact on exports. The results are similar to those obtained byHassan and Tufte (1998) for Bangladesh’s aggregate exports over the period1977 to 1992. Similarly, Sweidan (2013) examines the impact of exchangerate on Jordan’s exports and imports during the 1976–2009 period. The studyemploys the bounds testing approach to cointegration and the error cor-rection model and found that Jordan’s competitiveness declines over time.It was also discovered that the effect of Jordan’s exchange rate on exportsand imports is significant in the short run only.

Savvides (1992) divided exchange rate volatility into its anticipatedand unanticipated components and tested the hypothesis that only theunanticipated component significantly affects trade flows. The study, whichcovered the period 1973–86, found that unanticipated exchange rate volatilityinhibited the growth of exports of the developing countries. In a morecomprehensive manner, Kandil & Mirzaie (2002) investigated the effectsof exchange rate fluctuations on the US economy. They employed bothaggregate and disaggregate (sectoral) data for output and price for theUnited States. Exploring both demand and supply channels they found lit-tle evidence of a significant effect of the dollar appreciation on growth of

4 Broadly speaking, studies on the effect of exchange rate volatility can be distinguished in terms ofconcept (anticipated and unanticipated: negative and positive), methodology adopted (and measures ofrisks and technique of analysis), and coverage of issues and countries. A review of the various measuresof risk is in Cote (1994).

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industrial output. However, they noted that dollar appreciation decreasesoutput growth significantly in the finance industry, while dollar depreciationdecreases output growth significantly in the wholesale trade industry. Theypointed out that demand contraction and supply expansion are consistentwith a negative response of price to exchange rate shocks. They found thatinflation in the finance industry is significantly higher in the face of dollarappreciation, perhaps due to reduced liquidity in dollar-denominated assets.They concluded that given the small degree of openness in the US indus-tries, the results of external shocks and exchange rate fluctuations generatemoderate price effects without significant adverse effects on output growth.Therefore, anticipated adverse effects of dollar appreciation on economicperformance are not confirmed by this study.

Further, Kandil (2004) analyses the effects of exchange rate fluctuationson real output growth and inflation in a sample of 22 developing coun-tries. It was found that exchange rate depreciation (both anticipated andunanticipated) produces negative effect on real output growth and inflation.He concluded that the results confirm the issue about the negative effectsof currency depreciation on economic performance in developing countries.Similarly, Kandil, Berument, & Dincer (2007) & Kandil & Dincer (2008) con-ducted studies on the impacts of exchange rate volatility on real output,price level, and real value of components of aggregate demand in Egypt andTurkey. Based on a model that divides exchange rate fluctuation into antici-pated and unanticipated components, the empirical analysis was conductedby exploring both demand and supply channels. In the case of Turkey,it was reported that anticipated exchange rate appreciation has significantadverse effects on the growth of real output and the demand for investmentand exports, and worsened inflation. It was also reported that in spite ofan increase in export growth, random fluctuations have asymmetric effectsthat reflect the importance of unanticipated depreciation in attenuation out-put growth and the growth of private consumption and investment. Withrespect to Egypt, it was discovered that export growth decreases with antici-pated exchange rate appreciation. The net effect of unanticipated exchangerate fluctuations in the country is decrease in real output and consumptiongrowth and increase in export growth, over time.

For Africa, similar studies are very sparse but include Ghura & Grenne(1993) and Sekkat & Varoudakis (2000). A panel data approach wasemployed by Ghura and Grennes (1993) in exploring the effect of exchangerate volatility on the trade flows of Sub-Saharan Africa countries. Gaugingexchange rate volatility by the coefficient of variation and utilizing data cov-ering the period 1972–87, the study found that exchange rate volatility hada significantly negative and robust impact on trade flows. The study, how-ever, focused exclusively on the fixed exchange rate era and therefore didnot investigate the likely impact of increased volatility during the flexibleexchange rate period on trade flows.

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An assessment of the impact of exchange rate policy on disaggregatedmanufactured exports in Sub-Saharan Africa over the period 1970–92 wasundertaken by Sekkat & Varoudakis (2000) using standard econometrics tech-niques. They found that exchange rate volatility had a significant negativeeffect on textile and chemical exports of non-CFA countries but an insignif-icant positive effect on those of CFA countries. The usefulness of the studyis, however, limited by its utilization of pooled data of both fixed and flex-ible exchange rate periods. The use of such non-homogenous data couldintroduce bias into results (Arinze & Walken 1992; Dwyer & Wallance 1992).Besides, these studies on Africa are very limited in scope in terms of theconcept and measurement of exchange rate volatility and issues addressed.

IV. THEORETICAL FRAMEWORK AND METHODOLOGYOF THE STUDY

Theoretical Framework: Rationale, Concept, Effects, and Forms ofExchange Rate Volatility

Economic policy variables (such as exchange rate) do change in responseto both internal and external forces, including change in the policy stanceof government, changes in the domestic demand and supply factors, andchanges in the international demand and supply conditions (Dornbusch1976; Handy 1998). Also, market prices, especially exchange rates, reflectexpectations of the participants about the future policy stance of the mone-tary authority. For instance, participants form expectations about timing andmagnitude of changes in the exchange rate. The rational expectation the-ory is about the extent to which market participants can foresee (anticipate)changes in policies and the extent to which the changes come as surprises(unanticipated shock). It is assumed that exchange rate fluctuates aroundthe long-run equilibrium and such deviation distorts resources allocation indifferent sectors of the economy (Dincer & Kandil 2008; Kandil, Berument& Dincer 2007; Lee & Lin 2003). According to rational expectation theory,anticipated changes in economic policies do not affect real variables butunanticipated changes do. However, if forward exchange markets do notexist, such as in most African countries (and risks arising from the antici-pated changes cannot be managed), then anticipated changes in economicpolicies may impact real variables but the impact may be less than that ofthe unanticipated changes (shock).

Shocks or uncertainties affect the macro-economy through demandand supply channels. The demand channel works through the effect ofchanges in relative prices of external sector activities (export, import, andcapital flows), financial sector activities (demand for money), and realsector activities (investment and consumption). Similarly, the transmissionvariable in the supply side of the economy (channel) is the cost of imported

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intermediate inputs. All these work together to produce an overall effect onaggregate output and price. Unanticipated exchange rate changes (shock)can be negative-depreciation or positive-appreciation (Aliyu 2009; Dincer &Kandil 2008; Kandil, Berument & Dincer 2007).

The frame work of analysis in this article is an open economymacroeconomic model in which exchange rate fluctuation is a major deter-minant of real variables that make up aggregate demand and supply.In the context of this framework, exchange rate fluctuations determineaggregate demand through exports, imports, consumption, and investment,and also influence aggregate supply (aggregate output) and price levelthrough their effect on the cost of imported intermediate goods (Dincer &Kandil 2008; Kandil, Berument & Dincer 2007). The theoretical basis of themacroeconomic model employed in this article is discussed in the followingsections.

Aggregate Demand Channel

DOMESTIC INVESTMENT AND EXCHANGE RATE CHANGES

The impact of exchange rate movement and volatility on domestic invest-ment depends on a number of factors. The factors include the formand magnitude of exchange rate changes (depreciation or appreciation—permanent or transitory, large or small), trade policy and trade orientation offirms (type and degree of import and export), degree of financial devel-opment (high or low), and level of productivity, scrapping value andopportunity cost of waiting (Darby et al. 1998; Diallo 2007; Serven 2002).

In a developing region such as Africa where firms rely heavily onimported capital and export less output, exchange rate depreciation raisesthe real price of imported capital goods, leading to a reduction in profits,ceteris paribus, and vice versa for appreciation of exchange rate. Therefore,the impact of the exchange rate volatility on the marginal profitability ofinvestment is proportional to the share of imported inputs into production(Diallo 2007). The impact also depends on the expectations of the firm withrespect to exchange rate movement, whether it is going to be permanent ortransitory. In the case where the firms expect the depreciation to be perma-nent, the rise in capital costs forces them to reduce production permanently,and hence, reduce investment. Thus, a permanent anticipated exchange ratedepreciation leads to a relatively large decrease in investment.

In the other case when the firms anticipate the depreciation to be tem-porary, they believe that the profits will come back to their original level,and they will not reduce investment as much as they will in the first case.Therefore the temporary shock reduces investment but not as much as in thepermanent case (Diallo 2007). It has been argued that the effect of exchangerate volatility is large when volatility is high and when there is large tradeopenness combined with low financial development. In contrast, when trade

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openness is low and financial development is high, exchange rate volatilitytends to produce positive effect on investment (Serven 2002).

According to Darby et al. (1998) more exchange rate variability anduncertainty can actually increase investment of firms in industries where thescrapping price of any investment is low and the risk of being stuck with anunwanted investment is high. Also, it occurs when the increase in uncertaintyis large or the initial environment is characterized by low uncertainty, and theopportunity cost of waiting, rather than investing, is high. Greater exchangerate stability would encourage investment in industries with relatively lowerproductivity, high scrapping value, and low opportunity costs of waiting(service industries). However, greater exchange rate stability would tend toreduce investment in industries with low scrapping prices (public utilities)or high entry costs (high-tech and R&D) or in industries with high scrappingvalues combined with high opportunity costs of waiting (financial services).

The conclusion from the previous discussion is that the effects ofexchange rate on investment are ambiguous and non-linear. In our modelspecification, we consider other determinants of investment such as out-put (accelerator theory of investment), interest rate (cost of capital theory),and price level changes. Putting these sets of information together, privatedomestic investment (Inv) tends to be a function of interest rate (r), inflationrate (P), real exchange rate (rer), exchange rate volatility (V), and income(GDP-y), as presented in Equation 1 below:

Invit = a0 + a1 yit + a2 rerit + a3 V + a4 ritt + et

(a1, a2 > 0 ; a3,a4, < 0)(1)

where Invit, yit, Pt, rt, rert, and V are investment, output/income, pricelevel, interest rate, bilateral real exchange rate, and exchange rate volatility,respectively, at time t, while et is the error term.

CONSUMPTION AND EXCHANGE RATE CHANGES

Effect of exchange rate changes on consumption depends on many fac-tors, including the types of products consumed—locally produced andimported; their elasticities of demand—high or low; composition of con-sumers’ wealth—domestic and foreign assets, real and financial; types andmagnitude of exchange rate changes—depreciation or appreciation, small orlarge; financial development—high or low; macroeconomic policy stance(trade, fiscal and monetary policies)—liberal or restrictive, expansionaryor contractionary, changing or switching policies; and consumers’ expecta-tions of the changes—anticipated or unanticipated, permanent or transitory(Monacelli & Perotti 2006; Ravn 2000; Volberg 2005).

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In the case of their effect on consumption of locally produced prod-ucts, exchange rate changes affect the price level through their effects onthe cost of producing the goods, particularly in economies where produc-tion depends heavily on imported inputs. Price level in turn influencesreal variables including consumption. In the context of monetary theory,changes in the price level affect the values of both domestic and foreignassets of consumers whether real or financial assets, and hence their pur-chasing power, demand for money, and consumption. For imported goods,exchange rate depreciation raises prices of these products and hence reducestheir consumption and vice versa for exchange rate appreciation. Therefore,the impact of the exchange rate volatility on consumption is proportionalto the share of imported final products in the consumption baskets of theconsumers.

Following the Structuralist hypothesis, it is argued that exchange ratechanges could influence aggregate consumption particularly where marginalpropensity to consume varies between wage and profit earners (Krugman &Taylor 1987). This implies that when exchange rate changes affect domesticprices they will affect domestic consumption since the purchasing power ofthe people (especially the fixed income earners) will be affected.

Consideration of exchange rate fluctuation is very important for devel-oping countries such as African countries which heavily depend on importsof final goods and capital goods for consumption and production, respec-tively. Based on this argument, exchange rate becomes a determinant ofconsumption in this article. The consumption function to be estimated inthis study is expressed as follows:

cit = z0 + z1 yit + z2 rerit + z3Vtt + z4 rit + et

(z1, z2 > 0 ; z3z4 < 0)(2)

where cit, yit, Pt, rt, rert, and V are consumption, income, price level, interestrate, bilateral real exchange rate, and exchange rate volatility, respectively,at time t, while et is the error term.

TRADE (EXPORT AND IMPORT) AND EXCHANGE RATE CHANGES

The model by Clark (1973) is one of the earliest theories that examine theconnection between exchange rate volatility and trade flows. It considersa competitive firm with no market power producing only one commoditywhich is sold entirely to one foreign market and the firm does not importany intermediate inputs. The firm is paid in foreign currency and convertsthe proceeds of its exports at the current exchange rate, which varies inan unpredictable fashion, as there are assumed to be no hedging possibil-ities, such as through forward sales of the foreign currency export sales.

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Effects of Exchange Rate Volatility in Africa 365

Moreover, because of costs in adjusting the scale of production, the firmmakes its production decision in advance of the realization of the exchangerate and therefore cannot alter its output in response to favorable or unfa-vorable shifts in the profitability of its exports arising from movements in theexchange rate. In this situation, the variability in the firm’s profits arises solelyfrom the exchange rate, and where the managers of the firm are adverselyaffected by risk, greater volatility in the exchange rate—with no change inits average level leads to a reduction in output, and hence in exports, inorder to reduce the exposure to risk. This basic model was elaborated byHooper & Kohlhagen (1978) who also reached the same conclusion of aclear negative relationship between exchange rate volatility and the level oftrade.

The strong conclusion of a negative effect of exchange rate volatility ontrade flows by earliest studies mentioned above was based on a number ofsimplifying assumptions. First, it is assumed that there are no hedging pos-sibilities either through the forward exchange market or through offsettingtransactions. One reason why trade may be adversely affected by exchangerate volatility stems from the assumption that firms cannot alter factor inputsin order to adjust optimally to take account of movements in exchange rates.When this assumption is relaxed and firms can adjust one or more factors ofproduction in response to movements in exchange rates, increased volatilitycan in fact create profit opportunities. This situation has been analyzed byCanzoneri et al. (1984) and Gros (1987), for example. The effect of suchvolatility depends on the interaction of two forces at work. On the onehand, if the firm can adjust inputs to both high and low prices, its expectedor average profits will be larger with greater exchange rate volatility, as itwill sell more when the price is high, and vice versa. On the other hand, tothe extent that there is risk aversion, the higher variance of profits has anadverse effect on the firm and constitutes a disincentive to produce and toexport. If risk aversion is relatively low, the positive effect of greater pricevolatility on expected profits outweighs the negative impact of the highervolatility on profits, and the firm will raise the average capital stock and thelevel of output and exports.

Some authors have developed theoretical models in the context of theforward exchange market. For example, Barkoulas, Baum, & Caglayan (2002)developed a model in which exchange rate volatility had positive effect onexports. But the effect is adverse when the assumption of the existence ofthe forward exchange market is relaxed.

Given the foregoing, the model for analyzing export supply that is moreapplicable to the African economies is that which takes cognizance of the factthat Africa exporters face the issue of exchange rate not only in the productmarket (at the point of product sale as assumed in the earlier model) butalso in the input market (input procurement) since imports (raw materialsand capital goods) are critical to production. This implies that such a model

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366 A. O. Adewuyi and G. Akpokodje

should recognize the possibility of adjusting output and input levels andsubstitute inputs in response to changing exchange rates. Thus, this leadsto the modified version of the standard “two-country” models of trade suchas those developed by Dornbusch (1980) and subsequently employed byGyimah-Brempong & Gyapong (1993). In this model, a country’s exportsresponds to changes in real foreign income, relative prices, and volatility ofexchange rate. The estimated export equation is as follows:

xit = δ0 + δ1 y∗it + δ2 Vit + δ3 rerit + et

(δ1, δ3, > 0 ; δ2 < 0)(3)

where x is export, y∗ is world or foreign income (income of the tradingpartners), V is exchange rate volatility, and rexr is bilateral real exchangerate, respectively. The last letter in the equation (e) is the error term, while iand t denote individual country and year, respectively.

Theoretically, the income of foreign trading partners positively influ-ences exports. Most empirical work treats exchange rate volatility as a risk.The impact of exchange rate volatility on trade flows is negative withinthe context of African countries where forward exchange markets are non-existent. Real exchange rate movements are negatively correlated to realexports. An increase in the real exchange rate means a real depreciation ofthe domestic currency, which makes exports cheaper and therefore booststhe demand of foreign trading partners. If the real exchange rate appreciates,the reverse is likely to occur.

The standard determinants of imports in the literature are domesticincome and real exchange rate. The domestic income measures capacityto import, while real exchange rate measures the relative price. The importequation can be expressed as follows:

mit = m0 + m1 yit + m2 rer + m3 Vitt + et

(m1, m2 > 0 ; m3 < 0)(4)

where m is import, y is domestic income, V is exchange rate volatility, rer isbilateral real exchange rate, and (e) is the error term, while i and t denoteindividual country and year, respectively.

Aggregate Supply Channel: Domestic Output and Price Level

According to Khandil, Berument, & Dincer (2007), the combination ofdemand and supply-side channels indicates that real output dependson unanticipated movements in the exchange rate, the money supply,

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Effects of Exchange Rate Volatility in Africa 367

government spending, and the price level. In addition, supply-side channelsestablish that output varies with anticipated changes in the exchange rate.

The effects of real exchange rate fluctuations on the price level andoutput are complex when analyzed through demand and supply channels.In the product market, an unexpected depreciation of the domestic currencywill make exports less expensive and imports more expensive. As a result,the competition from foreign markets will increase the demand for domes-tic products, increasing domestic output and price. In the money market,an unexpected depreciation of the domestic currency, relative to its antic-ipated future value, prompts agents to hold more domestic currency andincreases the interest rate. This channel moderates the positive effect of theexchange rate shock on aggregate demand, output, and price. On the sup-ply side, changes in the exchange rate, both anticipated and unanticipated,determine the cost of imported intermediate goods. As the domestic cur-rency depreciates, producers are inclined to decrease imports of intermediategoods, decreasing domestic output and increasing the cost of productionand, hence, the aggregate price level.

Anticipated changes in government spending (g) and the money supply(ms) shift aggregate demand, increasing price. Given a constant level ofnominal effective exchange rate, the rise in domestic price decreases thereal effective exchange rate, reducing the real cost of imported intermediategoods. Accordingly, g and m have positive effects on real output. The outputand price level equations are expressed as follows:

yit = q0 + q1 Vit + q2 rerit + q3 git + q4 msit + et

(q4, > 0 ; q1, q3, q2 <> 0)(5)

Pit = p0 + p1 yit + p2 rerit + p3 Vitt + p4 msit + p5 git + et

(p2, q3, p4, p5, >< 0 ; p1 < 0)(6)

Methodology

MODEL SPECIFICATION

Based on the theoretical framework, the equations to be estimated areexpressed in growth terms as follows:

cit = z0 + z1 yit + z2 rerit + z3 Vtt + z4 rit + et (1)

Invit = a0 + a1 yit + a2 rerit + a3V + a4 rit + et (2)

Xit = δ0 + δ1 y∗it + δ2 Vit + δ3 rerit + et (3)

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368 A. O. Adewuyi and G. Akpokodje

Mit = m0 + m1 yit + m2 rer + m3 Vit + et (4)

yit = q0 + q1 Vit + q2 rerit + q3 git + q4 msit + et (5)

Pit = p0 + p1 qit + p2 rer + p3 Vitt + p4 ms + p5 g + et (6)

These variables are redefined in the estimation results as shown in Table 7.

TABLE 7 Definition of Variables and Theoretical Expectations

Exchange rate variables (Rexr and V) = (a) Anticipated exchange rate (antrexrc);(b) Unanticipated exchange rate: (i) positive shock: pos-shock (unant) and(ii) negative shock: neg-shock (unant)

Other variablesyt, pt, ct, Invt, xt, mt = real GDP growth rate (rGDPgrt), price level change (inflation),

growth of real consumption (rCONSgrt), growth of real investment (rINVgrt), growth ofreal exports (rEXPgrt), growth of real import (rIMPgrt), respectively

rt, yit∗, gt, mst = interest rate (intrate), growth of real income of the rest of the world(rYRoWgrt), growth of real government expenditure (rGEXPgrt), growth of real moneysupply (rMSgrt), respectively

Additional variables = openness and WTO membership

The theoretical expectations of the impact of exchange rate are summarized by Dincer andKandil (2008), as follows:

In the short run, the transmission mechanism through the demand and supply channelspoint to the idea that real output depends on changes in the exchange rate, the moneysupply, and government spending around full-employment equilibrium. The overallresults of the impact of exchange rate fluctuations are a function of the complexity ofdemand and supply channels as follows:

The goods market (demand side) effect: With a positive exchange rate shock (anunexpected appreciation) exports will become more expensive and imports lessexpensive. Consequently, this generates foreign markets competition which decreases thedemand for domestic products, which in turn leads to a fall in domestic output and price.

The money market effect: A positive exchange rate shock (an unexpected temporaryappreciation) prompts agents to hold less domestic currency and this phenomenondecreases the interest rate. This channel normalizes the contraction of aggregate demand(consumption, investment export and import), and hence the fall in output and pricewhen there is a positive exchange rate shock.

The supply side effect: A positive exchange rate shock (an unanticipated appreciation)leads to a fall in the cost of imported intermediate goods, and consequently reduces theproduction cost. The aftermath is increased domestic output level and reduced aggregateprice level. Further, a positive exchange rate shock (an unanticipated appreciation) resultsin declining competitiveness and fall in export demand, and hence reduction in domesticoutput supply. The net effect of currency appreciation or depreciation on output growthand price inflation depends on the overriding effect of demand or supply channels. (p. 3)

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Effects of Exchange Rate Volatility in Africa 369

METHODOLOGY FOR MEASURING EXCHANGE RATE VOLATILITY

In order to generate the anticipated and unanticipated components of theexchange rate changes, we specify a real exchange rate model. The decisionon the explanatory variables in the real exchange rate equation is basedon the results of the Granger causality tests conducted on the variablesselected based on the theories of exchange rate (Dincer & Kandil 2008).We adopted the real exchange rate, defined as the nominal exchange rateadjusted for price level changes Using data of the countries, the changesin the exchange rate are regressed on its lags as well as lagged values ofvariables that are considered as major determinants (based on causality testresults) of movements in the exchange rate: These variables include govern-ment spending, openness, financial development, foreign investment, andinternational reserves. The lag structure is determined by Final PredictiveError Criteria (FPEC).5 The residual of the exchange rate equation is theunanticipated component of the exchange rate (the exchange rate shock).The residual satisfies conditions for rationality (it is serially uncorrelated andorthogonal to all variables that determine agents’ forecasts of the exchangerate, as they appear in the empirical model).

Following Bollerslev (1986) & Aliyu (2012); the GARCH model weadopted makes the conditional variance to be a function of past information,which varies over time. Consequently, the conditional variance is predictedby past forecast errors and past variance. The issues of heteroskedasticityand volatility clustering, which largely characterize macroeconomic timeseries data, are well taken care of in the GARCH model. The GARCH (1, 1)specification employed is as follows:

Yt = Xt′θ + εt (7)

εt = Zt√

ht (8)

Zt ∼ N (0, 1) (9)

σ 2t = ω + αε2

t−1 + βσ 2t−1 (10)

The mean equation (Eq. 7) is expressed as a function of exogenous vari-ables with an error term, which is distributed as zt stated in Eq. 8, then Eq. 9indicates that the variance ht is identically and independently distributed(iid). Yt is the dependent variable which is the real exchange rate obtainedfor the panel of sample countries. Xt is a 1’k vector of lagged endogenousvariables (discussed above), divided into trend and cyclical components,

5 The results of final exchange rate equations can be produced upon request.

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370 A. O. Adewuyi and G. Akpokodje

included in the information set. θ is a k’1 vector of unknown parameters.The conditional variance equation specified in Eq. 10 is a function of thefollowing terms:

a. a constant term: ω;b. news about volatility from the previous period, measured as the lag of the

squared residual from the mean equation: ε2t - 1 (the ARCH term); andc. last period’s forecast variance: σ2t - 1 (the GARCH term).

σ2 is measurable with respect to Yt; ω > 0, α > 0, β ≥ 0, and α +β < 1, such that the model is covariance stationary, that is, the first twomoments of the unconditional distribution of the return series is time invari-ant. We divided the generated exchange rate shock (unanticipated changein the exchange rate) into its positive and negative components using theapproach adopted by Khandil (2004) and Dincer & Kandil (2008) as follows:

neg = −0.5 {abs (Drst) − Drst} and pos = 0.5 {abs (Drst) + Drst}Drst is the exchange rate shock and neg and pos are the negative and pos-itive components of the shock, which can be interpreted as unexpecteddepreciation and appreciation of the exchange rate.

DATA MEASUREMENT AND SOURCES

Time series data which are derived from international sources are collectedfor 1986–2011 (covering the flexible exchange rate period) for the panels ofthe countries. For the purpose of adopting a standard and common measurefor all countries, the required data are measured in U.S. dollars, while thebilateral real exchange rate is measured in terms of domestic country toU.S. dollar adjusted for price level changes between each of the countryand United States. The use of U.S. dollar is informed by the idea that itis a major convertible currency used by all these countries in internationaltrade transactions. Since these African countries trade with many countries ofthe world, world income is used as a proxy for trading partners’ income. Allthese data including the consumer price index of each country were obtainedfrom the World Bank, World Development Indicators (2012), as well as theInternational Monetary Fund, International Financial Statistics (2012).

ESTIMATION PROCEDURE

Estimating equations (1 to 6) using cross-country time-series (panel)data raises some methodological challenges. A chief one is that there islikely to be correlation between the country specific disturbances andthe determinants. Another problem emanates from the possibility of the

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Effects of Exchange Rate Volatility in Africa 371

determinants (explanatory variables) being jointly determined with depen-dent variables. Tackling these challenges involves differencing the equationto remove the time-variant disturbance. Instrumental variables will haveto be used to correct for the endogeneity. However, this procedure hasmany drawbacks that can be overcome by constructing an alternativeGMM estimator that combines the level and first difference specifications,using lagged levels of the variables as instruments for the first differencespecification. The variables in the equations were estimated in growth form.

The analysis is conducted for panels of non-CFA and CFA. Based onavailability of data, the list of the non-CFA panel and the CFA panel isattached in the Appendix Table A1. There are numerous advantages ofusing panel data (Aboagye & Gunjal 2000; Baltagi 1995; Ho 2001; Hsiao1996). These include increased number of observations, and increased rangeof variation of the variables in the model, thereby allowing for more pre-cise estimates and reduced multicollinearity among explanatory variables.In addition, the use of panel data provides the potential to study dynamiceffects. Thus, the use of panel data in this study made possible valid infer-ences beyond what can be done using only individual country case studydata. As a robust check, both the static and dynamic panel estimationprocedures are adopted.

V. EMPIRICAL RESULTS AND DISCUSSION

Empirical Results Analysis

The estimation results of both the static panel data models (fixed and ran-dom effects models) and dynamic panel data model (Arellano & BondGeneralized Method of Moment [GMM]) were examined for analysis whichcovers the entire Africa and its two groups (CFA and non-CFA groups).Comparing the fixed effect models with the Random Effects models, thenon-significance of the Hausman test p-value for all the models suggests thatthe fixed effect models cannot be better than the random effect models. Also,a comparison between the results of the random effect models with that ofthe dynamic panel models reveals that the latter (dynamic mode) results arebetter than former (random effect models) results. The Sargan tests of over-identification restriction confirm the appropriateness of the dynamic modelresults. Thus, the parameters of the dynamic (GMM) models are interpretedand analyzed for the aggregate Africa.

Similarly, the results for the fixed effect models for the CFA and non-CFA countries are also examined. The Hausman specification test p-valuessuggest that the random effect models are better than the fixed effect models.However, the GMM result for the two groups of Africa have better fits thanthe fixed and random effect models (based on Sargan test and other modelparameters) as in the case of the aggregate models for Africa. Thus, the

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372 A. O. Adewuyi and G. Akpokodje

empirical analysis for the two African groups is also based on the parametersof the dynamic (GMM) models. Only the results of the GMM estimations (fortotal Africa, CFA, and non-CFA) in Tables 8, 9, and 10 are presented, whilethe results of the static panel data models can be presented upon request.

Discussion of Results

EXCHANGE RATE VOLATILITY AND DOMESTIC PRODUCTS GROWTH (ECONOMIC

GROWTH)

Anticipated exchange rate changes produced a significant positive effect oneconomic growth in Africa. Specifically, anticipated exchange rate depre-ciation promoted the economic growth. Similarly, both the unanticipatedexchange rate depreciation and appreciation have significant positive effectson economic growth in Africa. These results are consistent with some previ-ous studies on growth inducing anticipated and unanticipated exchange ratedepreciation (Kandil 2007). Concerning other control variables, trade open-ness and government spending both impact economic growth. A significantnegative effect on economic growth is exerted by interest rates; and moneysupply equally produces a negative impact. This shows both price and quan-tity effects of monetary policy. The inflation rate did not have a precipitousimpact on the gross domestic product.

Results for the CFA group show that most of the factors determiningeconomic growth are not significant. Unanticipated exchange rate deprecia-tion has a significant positive effect on the growth rate of GDP. Similarly,the unanticipated appreciation has a significant positive impact on eco-nomic growth. The anticipated exchange rate changes do not affect GDPgrowth. This result is in line with Kandil & Mirzaie (2002). The results forthe non-CFA group show that both the unanticipated exchange rate depreci-ation and appreciation impact economic growth negatively. The anticipatedexchange rate changes, however, have a significant positive effect on eco-nomic growth. The results for the non-CFA group are very similar to that ofthe aggregate Africa. The similarity is more pronounced for the control vari-ables. Specifically, all the control variables in the model have a significantpositive effect on economic growth except money supply with a significantnegative effect.

EXCHANGE RATE VOLATILITY AND CHANGES IN DOMESTIC PRICE LEVEL

(INFLATION)

Beginning with all of Africa, results indicate that the anticipated exchangerate changes and unanticipated exchange rate appreciation impact inflationpositively. However, the unanticipated exchange rate depreciation produceda significantly negative impact on inflation. Trade openness and government

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TAB

LE8

Afr

ica:

Exc

han

geRat

ean

dM

acro

econom

icVar

iable

s:G

MM

Res

ult

Var

iable

rGD

Pgr

tIn

flat

ion

rCO

NSg

rtrI

NV

grt

rEX

Pgr

trI

MPgr

t

D.an

tree

rc0.

0038

∗∗0.

1078

∗∗∗

−0.0

015∗∗

0.11

02∗∗

∗0.

0002

8∗∗−0

.003

2∗∗

D.neg

-shock

(unan

t)0.

0427

∗∗∗

−0.0

460∗

0.01

64∗∗

∗−0

.070

2∗−0

.016

8∗∗∗

−0.0

039

D.pos-

shock

(unan

t)0.

0599

∗∗0.

1728

∗∗−0

.055

5∗0.

0389

∗0.

0055

∗∗0.

0203

∗∗

D.rM

Sgrt

−0.0

019∗∗

0.42

40∗∗

∗0.

0054

∗0.

4239

∗∗∗

−0.0

014

0.00

27D

.open

nes

s0.

0328

∗∗∗

−0.1

437∗∗

0.02

82∗∗

−0.1

727∗∗

0.01

54∗∗

∗0.

0497

∗

D.in

tra

te−0

.053

4∗∗∗

−0.0

116

−0.0

283∗

0.02

00∗∗

∗

D.rG

EX

Pgr

t0.

0137

∗−8

.193

0∗∗∗

−0.0

132

−8.2

850∗∗

∗0.

0162

0.11

57∗∗

∗

D.rG

DPgr

t0.

0687

0.14

52∗∗

∗0.

5945

∗∗∗

0.23

42∗∗

∗0.

0176

∗∗∗

D.rY

RoW

grt

0.52

14∗∗

D.W

TO

mem

ber

ship

−5.1

526

1.02

20LD

.rC

ON

Sgrt

0.17

268∗

LD.In

flat

ion

−0.0

376∗∗

−0.0

377∗

LD.rE

XPgr

t−0

.014

3∗

LD.rI

NV

grt

−0.3

4278

∗

LD.rI

MPgr

t−0

.074

4∗∗

LD.rG

DPgr

t0.

0936

2∗

Const

ant

−0.1

213

−1.3

990∗∗

∗−0

.112

5∗∗∗

−1.1

628∗∗

∗0.

0479

30.

0075

41s

tord

erse

rial

corr.(p

-val

ue)

0.00

000.

2958

0.00

470.

0000

0.00

010.

0002

2nd

ord

erse

rial

corr.(p

-val

ue)

0.75

820.

3110

0.26

450.

2087

0.17

930.

8701

Saga

nte

st(p

-val

ue)

0.48

690.

4082

0.42

710.

5428

0.32

860.

6881

Adju

sted

R2

0.74

560.

6843

0.71

450.

8437

0.78

120.

7502

Sou

rce:

Com

pile

dfr

om

regr

essi

on

resu

lts.

∗ p<

0.05

;∗∗

p<

0.01

;∗∗

∗ p<

0.00

1.

373

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ust 2

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TAB

LE9

CFA

Gro

up:Exc

han

geRat

ean

dM

acro

econom

icVar

iable

s:G

MM

Res

ult

Var

iable

rGD

Pgr

tIn

flat

ion

rCO

NSg

rtrI

NV

grt

rEX

Pgr

trI

MPgr

t

D.an

tree

rc0.

0732

70.

1100

2∗0.

0722

∗∗0.

0300

10.

1478

−0.0

019

D.neg

-shock

(unan

t)0.

0441

∗∗∗

−0.0

380∗∗

∗0.

0370

∗∗−0

.007

10.

2112

−0.0

044

D.pos-

shock

(unan

t)0.

0944

∗0.

1642

−0.1

100∗∗

∗0.

0331

0.27

17∗∗

0.05

84∗∗

D.rM

Sgrt

−0.0

860

−0.0

053

0.32

01∗∗

0.16

90∗∗

∗−0

.039

00.

1005

∗∗∗

D.open

nes

s0.

0103

0.00

25−0

.009

40.

0441

∗∗∗

−0.0

721

D.in

tra

te0.

1330

0.10

010.

1122

−0.1

639

D.rG

EX

Pgr

t0.

0230

−0.0

557

0.55

110.

2300

∗0.

6702

0.14

12D

.rG

DPgr

t−0

.047

00.

0840

−0.0

630∗

−0.0

280

D.rY

RoW

grt

4.60

01∗

D.W

TO

mem

ber

ship

−4.5

010

1.00

40LD

.rC

ON

Sgrt

0.19

003∗

LD.In

flat

ion

0.58

01∗∗

∗

LD.rE

XPgr

t−0

.330

1∗∗

LD.rI

NV

grt

0.29

120∗

LD.rI

MPgr

t−0

.170

0∗∗

LD.rG

DPgr

t0.

1311

∗

Const

ant

−0.3

611∗∗

0.54

122.

3356

9.80

810.

7573

1∗0.

7771

∗

1stord

erse

rial

corr.(p

-val

ue)

0.04

460.

0010

0.06

100.

0463

0.03

130.

2066

2nd

ord

erse

rial

corr.(p

-val

ue)

0.59

590.

2792

0.36

250.

7554

0.23

590.

5595

Saga

nte

st(p

-val

ue)

0.98

100.

8911

0.97

100.

9413

0.68

110.

4102

Adju

sted

R2

0.52

330.

4645

0.53

320.

6122

0.50

110.

5262

Sou

rce:

Com

pile

dfr

om

regr

essi

on

resu

lts.

∗ p<

0.05

;∗∗

p<

0.01

;∗∗

∗ p<

0.00

1.

374

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ust 2

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TAB

LE1

0N

on-C

FAG

roup:Exc

han

geRat

ean

dM

acro

econom

icVar

iable

s:G

MM

Res

ult

Var

iable

rGD

Pgr

tIn

flat

ion

rCO

NSg

rtrI

NV

grt

rEX

Pgr

trI

MPgr

t

D.A

ntree

rc0.

0088

∗∗0.

1100

1∗∗∗

−0.0

017∗

0.01

31∗∗

∗0.

0053

∗−0

.015

8∗∗∗

D.neg

-shock

(unan

t)−0

.037

0∗−0

.661

60.

0150

−0.1

443

0.27

00∗

−0.1

710∗

D.pos-

shock

(unan

t)−0

.061

2∗0.

7341

∗∗0.

0924

0∗∗∗

0.25

54∗∗

−0.4

288∗

−0.6

283∗

D.rM

Sgrt

−0.0

022∗∗

∗0.

4201

∗∗∗

0.00

25∗∗

∗−0

.004

9−0

.001

10.

0026

∗∗∗

D.open

nes

s0.

0360

∗∗∗

−1.4

231∗∗

∗0.

0082

0.01

100.

0224

0.09

9∗∗∗

D.in

tra

te0.

0600

∗∗∗

−0.0

31∗∗

0.19

00∗∗

0.03

03D

.rG

EX

Pgr

t0.

0166

∗∗−9

.500

∗∗∗

−0.1

610∗∗

∗0.

0680

∗∗0.

0728

∗∗0.

093∗∗

∗

D.rG

DPgp

rt3.

1123

∗∗∗

0.52

10∗∗

∗0.

2620

0.22

200.

1920

∗∗

D.rY

RoW

grt

2.00

3∗∗

D.W

TO

mem

ber

ship

1.00

011.

6042

LD.rC

ON

Sgrt

LD.In

flat

ion

−0.0

430∗∗

∗

LD.rE

XPgr

t0.

0211

LD.rI

NV

grt

−0.1

401∗

LD.rI

MPgr

t−0

.062

0LD

.rG

DPgr

tConst

ant

−0.5

701

−3.6

001∗

0.76

55−8

.111

0−0

.910

00.

9982

1stord

erse

rial

corr.(p

-val

ue)

0.00

680.

1476

0.00

880.

0010

0.00

010.

0004

2nd

ord

erse

rial

corr.(p

-val

ue)

0.84

890.

7233

0.47

510.

2612

0.54

770.

9377

Saga

nte

st(p

-val

ue)

0.98

610.

8592

0.99

780.

9996

0.96

920.

3924

9A

dju

sted

R2

0.77

210.

8413

0.69

440.

5897

0.60

110.

8735

Sou

rce:

Com

pile

dfr

om

regr

essi

on

resu

lts.

∗ p<

0.05

;∗∗

p<

0.01

;∗∗

∗ p<

0.00

1.

375

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376 A. O. Adewuyi and G. Akpokodje

spending have a negative effect on inflation. This implies that an increasein these variables is capable of reducing inflation. However, an increase inmoney supply will fuel the inflation rate in Africa. The real GDP growth hasinsignificant negative effects on the rate of inflation.

The results for the CFA group seem to be the same as that of the entiretyof Africa; the effect of growth rate of real GDP on inflation is insignif-icant. Anticipated exchanges rate changes substantially impacts inflationpositively. Moreover, while unanticipated exchange rate depreciation has amajor adverse effect on inflation, the unanticipated exchange rate appreci-ation has an insignificant effect. With respect to the non-CFA group, whileunanticipated exchange rate appreciation has a sizeable positive impact oninflation, unanticipated depreciation did not have a major impact. Anticipatedexchange rate changes produce a large desirable impact on inflation asMoney supply and real GDP growth do. However, trade openness andgovernment spending impact inflation negatively. This means that a unitincrease in all these variables will reduce the rate of inflation in non-CFAcountries.

EXCHANGE RATE VOLATILITY AND GROWTH OF DOMESTIC CONSUMPTION

For Africa, the results indicate that the anticipated exchange rate changesand unanticipated exchange rate appreciation negatively impact consump-tion. However, unanticipated exchange rate depreciation has a major positiveeffect on consumption. Money supply, growth rate of GDP, and tradeopenness affect consumption positively. The impacts of interest rate and gov-ernment spending are, however, insignificant. For the CFA group, while theunanticipated exchange rate depreciation has a significant positive impacton consumption, the impact of unanticipated exchange rate appreciationis significantly negative. Further, the impact of anticipated exchange ratechanges is significantly positive. All the control variables have an insignif-icant effect on consumption, with the exception of money supply with amajor positive impact. For the non-CFA group, anticipated exchange ratechanges exert a negative effect on consumption. However, while the impactof unanticipated exchange rate appreciation is significantly positive, that ofunanticipated exchange rate depreciation is insignificant. While the growthrate of GDP and money supply have a significant positive effect on consump-tion, the significant impacts of inflation, government spending, and interestrate are negative. Trade openness turns out to produce an insignificant effecton consumption.

EXCHANGE RATE VOLATILITY AND GROWTH OF DOMESTIC INVESTMENT

Also for Africa, the anticipated exchange rate changes significantly impactinvestment positively. In the case of the unanticipated exchange rate, while

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Effects of Exchange Rate Volatility in Africa 377

depreciation exerted large negative impact on investment, the effect ofappreciation is significantly positive. This same result was obtained ear-lier by Kenen & Rodrick (1986). The growth rates of real GDP and moneysupply have major positive impact on investment. Other variables—tradeopenness, interest rate, government spending, and inflation rate—negativelyimpact investment, and thus are capable of reducing investment in thecontinent.

For the CFA group, both unanticipated depreciation and appreciation ofexchange rate produced insignificant impact on investment as the anticipatedexchange rate changes do. Real GDP growth rate, government spending,money supply, and openness have substantial positive impacts on invest-ment, while the impact of inflation is significantly negative. For the non-CFAgroup, anticipated exchange rate changes and unanticipated exchange ratedepreciation have insignificant effect on investment. However, unanticipatedappreciation has a pronounced positive effect on investment. Interest rate,government spending, and inflation have a significant positive effect oninvestment.

EXCHANGE RATE VOLATILITY AND GROWTH OF EXPORT

Considering results for the entire continent, anticipated real exchange ratechanges have significant positive effects on exports. In the same vein, theunanticipated exchange rate depreciation and appreciation have negativeand positive significant impacts respectively. A similar result was reportedby Arize (1997). Changes in government expenditure, money supply, andmembership in the World Trade Organization (WTO) have insignificantimpact on exports. However, growth rate of real GDP, trade openness, andworld income have great positive effect on exports. For the CFA group,anticipated exchange rate changes and unanticipated exchange rate depre-ciations do not have significant impact on exports, while unanticipatedexchange rate appreciation produced large positive effect on it. Thecontrol variables have insignificant effects on exports. For the non-CFAgroup, while unanticipated depreciation precipitated a significant positiveeffect on exports, unanticipated appreciation substantially affected themnegatively. Similarly, anticipated exchange rate changes have significant pos-itive effects on exports in addition to government spending and worldincome.

EXCHANGE RATE VOLATILITY AND GROWTH OF IMPORT

The results for all of Africa show that anticipated exchange rate changes havesignificant negative effects on imports. Further, unanticipated depreciationof exchange rate has insignificant impact on imports, while unanticipated

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378 A. O. Adewuyi and G. Akpokodje

appreciation has a desirable outcome. Money supply and WTO member-ship do not have a considerable impact on imports, however, growth rate ofGDP, interest rate, openness, and government expenditure do. For the CFAgroup, unanticipated depreciation of exchange rate has insignificant impacton import, while unanticipated appreciation produces a positive effect. Theeffect of anticipated exchange rate changes is immaterial. Growth of moneysupply produces a significant positive impact on imports. However, for thenon-CFA group, unanticipated depreciation and appreciation have signifi-cant negative effects on import. In the same vein, anticipated exchange ratechanges produce substantial adverse effects on imports as do real growthrate of GDP, openness, government spending, and money supply. However,a major negative effect is caused by inflation.

VI. SUMMARY OF FINDINGS AND CONCLUSION

Anticipated exchange rate changes produced significant positive effects oneconomic growth in Africa. Specifically, anticipated exchange rate deprecia-tion promotes it. Similarly, both the unanticipated exchange rate depreciationand appreciation have substantial positive effects on economic growth.Results for the CFA group show that unanticipated exchange rate depre-ciation and appreciation have major positive impacts on economic growth,While the effect of the anticipated exchange rate changes is insignificant. Theresults for the non-CFA group show that both the unanticipated exchangerate depreciation and appreciation exerted a pronounced negative effect oneconomic growth. The anticipated exchange rate changes, however, have asignificant positive effect on economic growth.

For the entire continent, results indicate that the anticipated exchangerate changes and unanticipated exchange rate appreciation precipitateda positive effect on inflation. However, the unanticipated exchange ratedepreciation produced significantly negative impacts on it. The results forCFA group indicate that anticipated exchanges rate changes significantlyimpact inflation positively. Moreover, while unanticipated exchange ratedepreciation has a sizeable negative impact on inflation, the effect og theunanticipated exchange rate appreciation is insignificant. With respect tothe non-CFA group, while the impact of the unanticipated exchange rateappreciation on inflation is significantly positive, that of the unanticipateddepreciation is not. Anticipated exchange rate changes produce a significantpositive impact on inflation.

The results indicate that for Africa the anticipated exchange rate changesand unanticipated exchange rate appreciation have appreciable negativeimpacts on consumption. However, the effect of unanticipated exchange ratedepreciation on consumption is significantly positive. For the CFA group,while the unanticipated exchange rate depreciation exerts a considerable

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Effects of Exchange Rate Volatility in Africa 379

positive impact on consumption, the impact of unanticipated exchangerate appreciation is significantly negative. Further, the impact of antici-pated exchange rate changes is largely positive. For the non-CFA group,anticipated exchange rate changes exert negative effects on consumption.However, while the impact of unanticipated exchange rate appreciation issignificantly positive, that of unanticipated exchange rate depreciation isinsignificant.

In Africa, the anticipated exchange rate changes produced a size-able positive impact on investment. In the case of the unanticipatedexchange rate, while depreciation adversely impacts investment, appre-ciation impinged significant positive impact. For the CFA group, bothunanticipated depreciation and appreciation of the exchange rate haveinsignificant impact on investment as the anticipated exchange rate changesdo. For the non-CFA group, anticipated exchange rate changes andunanticipated exchange rate depreciation did not precipitous impact oninvestment. However, unanticipated appreciation has a substantial positiveeffect on investment.

Considering results for the entire Africa, Anticipated real exchange ratechanges for the whole continent have significant positive effects on exports.In the same vein, the unanticipated exchange rate depreciation and appre-ciation have large negative and positive impacts on exports, respectively.For the CFA group, anticipated exchange rate changes and unanticipatedexchange rate depreciations have insignificant impact on exports, whileunanticipated exchange rate appreciation produced desirable positive effecton exports. For the non-CFA group, while unanticipated depreciation precip-itated a considerable positive effect on exports, unanticipated appreciationadversely affected them. Further, anticipated exchange rate changes have asignificant positive effect on exports.

The results show that anticipated exchange rate changes impacted neg-atively on imports. Further, unanticipated depreciation of exchange rateshas a little impact on imports, while unanticipated appreciation reflecteda significant positive impact on imports. For the CFA group, unanticipateddepreciation of exchange rates have an insignificant impact on imports, whileunanticipated appreciation produced a positive effect. The effect of antici-pated exchange rate changes is not significant. However, for the non-CFAgroup, unanticipated depreciation and appreciation have significant negativeeffects on imports as in the case of anticipated exchange rate changes (allthe foregoing results are summarized in Table 11).

Arising from the foregoing analysis, there is the need to take appropriatemonetary and fiscal policy actions to stem the rising exchange rate volatilityin Africa. In particular, excessive exchange rate depreciation in the non-CFA should be addressed because production heavily depends on imports,while continuous appreciation is also dangerous to investment, exports, andeconomic growth in the CFA group.

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TAB

LE1

1Im

pac

tofExc

han

geRat

eVar

iable

s

Exc

han

geRat

eVar

iable

sA

ntic

ipat

edExc

han

geRat

eChan

ges

Unan

ticip

ated

Appre

ciat

ion

(Posi

tive)

Unan

ticip

ated

Dep

reci

atio

n(N

egat

ive)

Dep

enden

tVar

iable

Afr

ica

CFA

Non-C

FAA

fric

aCFA

Non-C

FAA

fric

aCFA

Non-C

FA

1G

DP

grow

thSi

gpos

Notsi

gSi

gpos

Sig

pos

Sig

pos

Sig

neg

Sig

pos

Sig

pos

Sig

neg

2In

flat

ion

Sig

pos

Sig

pos

Sig

pos

Sig

pos

Notsi

gSi

gpos

Sig

neg

Sig

neg

Notsi

g3

Consu

mptio

nSi

gneg

Sig

pos

Sig

neg

Sig

neg

Sig

neg

Sig

pos

Sig

pos

Sig

pos

Notsi

g4

Inve

stm

ent

Sig

pos

Notsi

gSi

gpos

Sig

pos

Notsi

gSi

gpos

Sig

neg

Notsi

gN

otsi

g5

Exp

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Effects of Exchange Rate Volatility in Africa 381

ACKNOWLEDGMENTS

We appreciate the support of our students and colleagues (Ebenezer Olubiyi,Afolabi Olowookere, and Damilola Arawomo) as well as the editor of thisjournal for insightful comments.

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APPENDIX

TABLE A1 Grouping of African Countries into CFA and Non-CFA

CFA Group Non-CFA Group

Benin,∗ Burkina Faso,∗ Cameroon,Central African Republic, Chad,Cote d’Ivoire,∗ EquatorialGuinea Gabon, Guinea,∗ Mali,∗

Niger,∗ Senegal,∗ Togo∗

Algeria, Angola, Botswana, Burundi, Cape Verde,Comoros, Djibouti, Egypt, Arab Rep., Eritrea,Ethiopia, The Gambia, Ghana, Guinea, Lesotho,Liberia, Libya, Madagascar, Malawi, Mauritania,Mauritius, Morocco, Mozambique, Namibia, Nigeria,Rwanda, Sao Tome and Principe, Seychelles, SierraLeone, South Africa, Sudan, Swaziland, Tanzania,Tunisia, Uganda, Zambia, Zimbabwe

∗Indicates countries in West Africa.Dow

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