Money supply and memory (expectation) are the main drivers of exchange rate volatility in Zimbabwe, results of research conducted on behalf of CZI and funded by Konrad Adenauer Stiftung (KAS) show.
The research, which was conducted by Dr Carren Pindiriri, also concluded that other variables such as the fiscal balance and trade openness insignificantly explain volatility of the exchange rate.
However, some components of government expenditure, in particular expenditures on capital and programmes, could also drive volatility of the exchange rate, according to research findings.
While money supply is established as a significant driver of exchange rate fluctuations, the findings show that a significant share of exchange rate fluctuation which is not a result of money supply started to ascend after the first quarter of 2019.
This shows that a significantly larger part of the exchange rate volatility after the first quarter of 2019 was not commensurate with monetary growth.
In fact, the findings show a huge residual in the exchange rate volatility-money supply relationship after the first quarter of 2019.
The research results thus demonstrate that although volatility of the exchange rate resulting from money supply subsided after the first quarter of 2019, there has been a sharp increase in volatility of the exchange rate as a result of memory or lagged exchange rate and expenditure on capital and government programmes.
“Confidence issues that emanate from bad memories about the financial sector and previous monetary policies are a key driver of exchange rate variation.
“What is, however, worth noting is that these memories emanate from some monetary shocks. Hence, monetary targeting remains central in the management of exchange rate growth and volatility in Zimbabwe,” reads part of the research report.
The main policy implication of the findings is that any slight change in money supply triggers bad memories about the past thereby fueling instability in the exchange rate.
However, the authors of the report are of the opinion that rebuilding confidence in the financial sector and in monetary policy is not a short-term activity since it takes time for economic agents to forget about the bad memories.
“It is, however, important for monetary authorities to reconstruct confidence for a better future.
“In this regard, the study recommends a continued monetary targeting supported by prudent fiscal management.”
In addition to monetary targeting, the study further recommends perpetuation and strengthening of good macroeconomic management practices. If the macroeconomic fundamentals continue to perform well and money supply growth is kept in check then the bubble experienced in the exchange rate growth since the first quarter of 2019 will disappear.
Furthermore, the study recommends strengthening of monetary institutions, in particular, independence of the central bank, in order to build the lost confidence in the banking sector.