Macroeconomic Effects of Exchange Rate Volatility in Zambia

Similar to global currencies, the Zambian currency (kwacha) has varied considerably against major currencies since the early 1990s. Existing empirical evidence reveals that fluctuations in exchange rates can potentially generate distortions in the economy. However, insufficient empirical evidence on Zambia exists. Thus, this thesis contributes empirically to the literature on exchange rate volatility and its impact on the economy with Zambia as a case study. Consequently, volatility in the kwacha bilateral exchange rates is modelled using three alternative GARCH models in order to characterise the underlying currency volatility. The influence of fundamental factors on conditional volatility of exchange rates is also examined. In addition, principal components analysis (PCA) is used to capture the common underlying pattern in the estimated conditional volatility series through which a new GARCH series (GARCH-PCA) is constructed and used in trade and monetary and foreign exchange intervention rule analysis as an alternative measure of exchange rate risk. PCA has not been previously employed in such analyses. Cointegration analysis is used for trade-exchange rate volatility analysis while SVAR and GMM are employed with variations to the conventional specification of monetary and foreign exchange intervention rules in the literature in determining the relevance of exchange rate volatility in monetary and foreign exchange policies. The results reveal that the kwacha bilateral exchange rates examined are characterised by different conditional dynamics in terms of volatility persistence and response to price shocks. The positive influences of exchange rate regime, money supply and openness on conditional volatility predominate. Exchange rate volatility affects international trade flows and underpins monetary policy and foreign exchange decision-making process. Thus, the results are amenable for trade policy formulation and monetary policy improvements and they justify foreign exchange interventions. GARCH-PCA, an index of exchange rate volatility, reflecting influences from Zambia proves to be a useful alternative measure of exchange rate volatility. Its performance is comparable to the trade-weighted measure in terms of sign, size and statistical significance of the estimated coefficients.