Having explained the monetary policy framework and its tool kit, it is important to understand the theoretical basis underlying this school of thought – that inflation is always a monetary phenomenon and the primary weapon to fight is by raising interest rates.
II Theoretical arguments
The basic principles and theoretical arguments supporting the view that money is the fundamental determinant of the price level over the medium and long term, and that money and its counterparts – notably credit – play a key role in the transmission of the effects of monetary policy to the economy is founded on the premise of the Quantity Theory of Money as postulated by Professor Irving Fisher.
The Fisher Equation lies at the heart of the Quantity Theory of Money: (MV=PT,) where M = Money Supply, V= Velocity of circulation, P= Price Level and T = Total Transactions, which is often substituted for Y = National Income (Nominal GDP). The Quantity Theory has been later refined and restated as the Friedman School of Thought –The Doctrine of Monetarism, which had as its fundamental precept that inflation is everywhere and anywhere a monetary phenomenon.
The determination of the general price level, and its rate of change, requires control of the nominal quantity of base money or of some other monetary aggregate that can be effectively controlled by the Central Bank. This result reflects the role of money both as a medium of exchange and as a unit of account. Under price and wage flexibility, and in the absence of any nominal rigidities, the price level will promptly and fully respond to a change in the money stock. More generally, the determination of the price level by the nominal quantity of money will be established in the long-run equilibrium.
Professor Milton Friedman restated the quantity theory as the theory of the demand for money, whereby the demand for money is assumed to depend on asset prices or relative returns on wealth or income. He shows how a theory of the stable demand for money becomes a theory of prices and output. And this theory is the operating doctrinaire on which most IMF negotiated Financial Programs with African countries are based upon, hence the reserve money paradigm as a means of constricting money growth and spending.
III. The Empirical Evidence
So far, I have argued that theory clearly suggests that money does play a role, but I have also pointed to potential challenges in identifying in practice and estimating with sufficient accuracy the effects of money on the economy over time. What does the empirical evidence available tell us? Is it robust and useful? What are the implications of this evidence, especially in The Gambian context, for monetary policy formulation?
Monetary policy during the period since 1996 to 2006 has been broadly successful in reducing inflation in The Gambia, thereby stabilizing the exchange rate of the DALASI, and facilitating the attainment of the real GDP and balance of payments objectives.
More recently, The Gambia’s economy has displayed remarkable resilience in the face of recent global economic challenges like the COVID-19 pandemic and the ongoing war with Russia and Ukraine. According to the Central Bank’s own Economic Update, despite a sluggish global environment, the country’s real GDP grew by 4.2 % in 2022, signaling a continued recovery from the impact of the COVID-19 pandemic. However, the effects of Russia’s invasion of Ukraine induced high food and fuel prices, and increased freight charges. These external shocks coupled with the strong US dollar appreciation against the DALASI raised inflation from 7.4% in 2021 to 9.6% in 2022. The Inflation Rate in The Gambia increased to 18.36 percent in July from 17.81 percent in June of 2023: (source: GBoS – Gambia Bureau of Statistics).
The Inflation outlook in The Gambia is expected to be 20.40 percent by the end of the next quarter, according to Trading Economics Global Macro Models and Analysts, reflecting high fuel and food prices and further exchange rate depreciation of the DALASI against the major currencies, notably the US Dollar, EURO and Pound Sterling. According to CBG’s own Staff estimates, the near-term inflation outlook is gloomy. CBG Staff’s latest forecast suggests that the risk to inflation remains elevated.
The exchange rate of the DALASI remains important for price stability given the large proportion of imports in the country’s consumption basket. Changes in the exchange rate do have significant impact on the balance of payments, hence the Monetary Authorities do have to take the exchange rate into consideration when setting its monetary policy framework. Occasional interventions in the Interbank Foreign Exchange Market by the Central Bank that aim at smoothening out short term large fluctuations in the exchange rate should be encouraged since they would as well enhance domestic price stability to some extent.
A major indicator of the external sector position in the Balance of Payments is the Net Foreign Assets (NFA) Position of the Central Bank, which is also considered to be an important performance benchmark in the Fund Program. The Net Foreign Assets refer to the total of foreign assets (Foreign Reserves) owned by the Central Bank and the commercial banks, minus the foreign liabilities of these entities. Normally the NFA Position must be able to cover at least four months of import cover, which the Bank has consistently maintained and sometimes surpassed, over the past years. Both the net foreign assets metric and the current account metric are considered important macroeconomic indicators of a country’s overall financial health. They indicate whether a country is in a net position of being able to meet its external financial obligations to the rest of the world. If a net foreign assets metric is positive consistently and substantially, it is likely to stabilize the relative foreign exchange value of the DALASI in the short to medium term.
In the near term, GDP growth is projected to remain below pre-COVID-19 levels, at 5.2% in 2023 and 5.6% in 2024, as uncertainties about Russia’s invasion of Ukraine still persists amidst tighter international financial market conditions. The impact of climate change which is rapidly changing the local farming season could seriously weaken economic activity in agriculture, construction, energy, and tourism. These shocks could also intensify fiscal pressures and affect the debt profile. During the past two years, the modest growth in per capita income has not been sufficient to make a significant impact on poverty reduction. Poverty is estimated to have increased, largely due to weaker growth in per capita GDP and higher food prices, further eroding the purchasing power of households.
Furthermore, the weak growth in the services sector, particularly in tourism, has restrained The Gambia’s economic progress, and diminished the foreign exchange earnings potential of the Interbank Market. Although there was an increase in the number of tourist arrivals during the last Tourist Season, it was not at pre Covid-19 levels, and not sufficient enough to offset the sluggish growth in other subsectors. In addition, trade disruptions and negative terms of trade have weighed on the economy, as the country is a net oil and commodities (food) importer and recorded negative terms of trade in 2022.
Given the country’s high dependence on imports of food items and fuel, the lack of import substituting industries, and weak agricultural production coupled with low level of exports, the inflation outlook in the near term will remain a real challenge for the Monetary Authorities, especially given that the current level of inflation is still far from the Policy Objective of 5 percent, hence the specter of higher interest rates looms in the near future, thus higher cost of borrowing and doing business which poses negative consequences for GDP growth and employment. There is little doubt that the current combination of high interest rates and high inflation will deter investment significantly over the short and medium term horizon.
Notwithstanding this outlook, both the IMF and World Bank forecast that, looking ahead, the economic outlook for The Gambia remains favorable, with GDP projected to grow by 5.5 % over the period 2023-2025. Growth is expected to be supported by increased economic activity across sectors, particularly in the tourism industry, construction, agriculture and telecoms services sector.
A first and important finding is that there is strong and robust evidence concerning the long-term relationship between money and prices, based on data collected for many West African countries over long periods of time. One such study, which estimates this relationship on the basis of a methodology that should make the estimates independent of country-specific events and of the sample period, finds that the correlation between inflation and the growth of money is close to 1, as suggested by theory. The existence of a strong and stable long-term relationship between inflation and money growth is documented by many other studies, including a number of major studies conducted by the West African Monetary Institute (WAMI) based on data from West African Central Banks and the BCEAO. It is also interesting to note that the relationship between inflation and money growth is particularly close for high-inflation countries such as The Gambia. These findings are, of course, important and consistent with theory. But because robust correlations and long-term relationships need not imply causality, and because we are also interested in the links between money and prices over shorter time periods, we have to examine other types of evidence.
IV. The conduct of Monetary Policy
What do all these issues imply for the Central Bank’s choice of monetary policy strategy and the conduct of its monetary and exchange rate policy? There is one logical conclusion, based on theoretical considerations, the empirical evidence and the current state of analytical tools: the sensible approach to assessing the outlook for and the risks to price stability over all pertinent horizons, but especially over the more policy-relevant medium term, is to analyze and combine all available information in a conceptually appropriate and consistent manner. This conclusion is further supported by the nature and extent of the uncertainty faced by policy-makers:
o uncertainty about the impact of ongoing processes, such as technological advances and financial innovations with the increasing use of fintech in the money transfer business;
o the associated uncertainty concerning the estimated values of key economic concepts, such as the economy’s potential growth rate, the neutral real rate of interest or the non-inflationary rate of unemployment;
o uncertainty about the way in which economic agents form expectations;
o uncertainty relating to the robustness and completeness of the estimated quantitative approximations of the theoretical paradigms that may be employed in policy analysis; and
o uncertainty about the accuracy of data, especially on a real-time basis.
And needless to say, uncertainty was heightened – for the Central Bank of The Gambia – during the transition from the ingerence of the Jammeh era into the operations of the Bank, to the position whereby today the Bank gained real independence to conduct monetary policy. For such a laudable effort in repositioning the Bank, indeed homage is due to the brilliant and intelligent Management that has largely restored confidence and credibility to the Bank. Taking all of these issues into account, the choice of our policy strategy – employing both economic and monetary analyses, and using the latter to cross-check over the medium- and long-term, the assessment resulting from the former – is the right one. It has served us well.
According to my experience as a Senior Officer of the Bank, having worked with most of the present-day Research Staff, I know that the methodology of monetary analysis carried out at the Bank has evolved over time, and is fairly comprehensive, going beyond the standard assessments based on the quantity theory of money and the stability of money demand. It employs a variety of tools in a manner that is not mechanical but combines judgment and analytical rigor in reaching a money-based assessment of the risks to price stability.
There is, however, more work to be done towards deepening and refining our monetary analysis framework. This will involve not only improving the pertinent analytical tools and examining more thoroughly developments in the components and counterparts of money, but also a more comprehensive use of the signals contained in money data to extract information on the current state of the economy, and which can be useful for forecasting inflation.
V. Concluding Remarks
According to an old saying, “The best advice about money is not to talk about it”. Well, I obviously did not heed this advice, as I have talked about money quite extensively in this article. But I felt it necessary to treat “money” comprehensively in my remarks, because it is money – according to an ancient sage – that “holds all things together”. Around 330 B.C., Aristotle recognized that “all goods must therefore be measured by some one thing […] that holds all things together.” He emphasized that “Money has become a sort of representative of demand by convention; […] it exists not by nature, but by law. And it is in our power to change it and make it useless.” In modern democracies, the power – and the responsibility – to ensure that money retains its value is vested in independent Central Banks.
BSc. Economics, BSc. Accounting, Certified Management Accountant
Masters in Economics & Finance,
Former director (Foreign Exchange Department) Central Bank of The Gambia.