MACROECONOMIC DYNAMICS IN LOW INCOME ECONOMIES:

EVIDENCE FROM MALAWI

BERTHA CHIPO BANGARA

Background & MotivationLow income countries (LICs) have certain

features different from the developed ones but important in analysis; e.g. highly dependent on foreign aid, mono-crop farming, import mostly intermediate inputs and some capital, and face foreign exchange (FX) problems (Moran 1989)

In Sub Saharan Africa (SSA), the average share of intermediate imports in total imports increased from about 30% to 50% in the 1980s while consumer goods decreased.

There is an argument that availability and cost of FX plays a crucial role in the production process and the macroeconomic performance of LICs (Senbeta, 2011, Lensink 1995, Moran, 1989).

Background &Motivation Many studies have emphasized that availability and

cost of FX influences macroeconomic activity in less income economies (e.g Agenor and Monteil, 2008; Lensink, 1995; Moran, 1989)

Stiglitz, JE, Ocampo, JA, Spiegel, S, French-Davis, RF and Nayyar, D(2006) emphasise that apart from demand constraints, supply constraints, generated by availability of capital and FX are more important in LIEs.

LIEs fail to absorb shocks due to structure of their economies which amplify than dampen the shocks

Studies that provide stylized facts on macroeconomic dynamics in LIEs such as Malawi, with acute FX constraints, have been scanty.

The World Bank defines LIEs as economies with GNI per capita of $1,025 or less.

Malawi relies heavily on tobacco exports (80% of total exports, 40% of GDP and 60% of FX earnings) and foreign aid (40% of government budget).

Imports more than it exports (negative TB always) Fixed and overvalued exchange rate for a long

time led to low FX reserves. High prices of FX at the parallel market (100%

premium). A year after 49% devaluation, FX problems still

exists. No studies on how FX constraints and Tobacco

price shock affect the macro-economy of Malawi. Studies on LIEs are done on panel level.

Why Malawi?

Figure 1: Exchange Rate and Inflation

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Research Objectives and QuestionsThe overall objective is to examine the macroeconomic dynamics of low income economies with FX constraints using Malawi as the study area . This will be done by: Estimating a small open economy model with foreign

exchange constraints and determine the dynamics of fiscal policy

Estimating the equilibrium real exchange rate (ERER), pass-through and existence of J-Curve

Analysing the propagation of price shocks of the dominant crop (tobacco) on key macroeconomic variables in Malawi

This will answer these questions Do foreign exchange constraints change the direction and

magnitude of various shocks (FP, MP, TOT, AID) in SOEs? If so, to what extent?

Is the Malawi Kwacha overvalued? Is there a high exchange rate pass-through? If so, are devaluations necessary for Malawi?

Do shocks to tobacco prices affect key macroeeconomic variables in Malawi?

Literature Review1. Theoretical Literature DSGE models are the NK version of analysing macroeconomic issues and

are the main workhorse in RBC estimations (Senbeta, 2011). However, not many studies have included features for LICs

Inclusion of features specific to LICs such as aid, high government debts and FX constraints into the RBC models with micro-foundations tend to be necessary in the analysis of LICs.

Exchange rate models with tradable and non-tradable sectors of the economy and the analysis of commodity price shocks from oil price shocks literature have been developed to suit LICs and this gives the theoretical literature for this work.

2. Empirical Literature Moran (1989), Lensink (1995); Senbeta (2011) FX DSGE; Adam et al

(2009) Aid shocks on LDCs Sichei & Eita (2006), MacDonald & Ricci (2004) → ERER on Nam and

RSA Kwalingana, Simwaka & Chiumia (2012), Kamoto (2006), Newark (2004),

Musila (2003)→ effects of FX on TB and Inflation, Mathisen (2003), ERER Deaton & Miller (1995), Raddatz (2007), Conforti, Ferrari and Sarris

(2010) Price shocks

Data Sources Study uses quarterly data (1980Q1-2012Q4) from

RBM, World Bank, IFS and NSOVariables of interest are international tobacco prices,

(TP), TOT, AID, GovtEXP, taxes, EXR and REMThe period is dictated by important macroeconomic

decisions that the country has undertaken (commercialisation of tobacco growing), structural breaks (policy regimes, exchange rate regimes and political regimes) devaluations, pegging and floatation of the kwacha

Why DSGE? Standard DSGE models assume capital and intermediate

inputs are produced domestically and remain silent on challenges in LICs e.g FX, mono-crop, aid dependence, ↑imports of inputs.

DSGE models are structural, micro-founded, general equilibrium and are not vulnerable to the Lucas Critique.

Due to a decline in demand for commodity prices due to the financial crisis which decreased exports of LIEs, the suitable models to analyse these shocks are structural.

Compared to their consequences in HICs, standard models produce results contrary to outcomes when applied to LICs.

A few studies have incorporated some features of LICs in DSGE models (see for example Senbeta, 2011 (FX), Adam, O’Connell and Buffie, 2008(Aid), Peiris and Saxegaard, 2007(MP)). However, not much has been done on FX and Aid.

MethodologyA. An Estimated New Keynesian DSGE for a Foreign Exchange Constrained Small Open Economy: (4-sector model)The model is as in Senbeta (2011) and Štork (2011) but builds extensively on Gali and Monacelli (2005) to account for incomplete pass-through and habit formation. 1.Household maximize instantaneous utility

2. Firms produce tradable and non-tradable good. We explicitly model FX constraints in the non-tradable production as additional cost faced by firms in importing inputs s.t s.t and

3. Government and RBM conduct fiscal and monetary policy with Govt BC having Taxes, Aid and other sources of income

B. Estimating the Equilibrium Real Exchange Rate, and Pass-through: Does a J-Curve exist for Malawi? 1. Exchange Rate and Pass-through Johansen’s Full Information Maximum Likelihood (FIML) is used to estimate the existence

of a long-run ERER.ERER is determined by TOT, Trade and exchange restriction, Government expenditure, capital controls and technology Xt= f(REER, TOT, OPEN, INV) where Xt ix ERER, OPEN ,INV is ratio of investment to

GDP. We include FP, MP, GOVT consumption and technical progress following Mundell-Fleming.

In the short-run RER respond to these. The model is specified as: Xt = f(REER, TOT, OPEN, INV; GCON, TECP, NCF, EXSDC, Dt, D1) , TECP measured by industrial production indexwhere Dt is a seasonal dummy, D1 represents change in political regimes. We assume the vector has a VAR representation of the form:

and for VECM

2.Trade Balance (ARDL)

TB = F(Y,E/P) where Y is output level, E is exchange rate and P is domestic price level. Equation is extended as in Bahmani-Oskooee (1985) to include world income Y*, M, M*, and a lag to the exchange rate variable to assess J-curve phenomena. The linear model is:

We expect ; is either positive or negative and ,

C. Propagation of Tobacco Price Shocks in Malawi: a SVAR Approach

Since recursive analysis of VAR has controversies and validity of Cholesky factorisation is questioned when there is simultaneity problem among variables, the paper follows Christiano, Eichenbaum and Evans (1998) in using a Structural VAR assuming the shocks to tobacco price propagate in a dynamic system as:

Since the above cannot be estimated, identification requires we place restrictions on the B matrix.

One shock to tobacco prices is identified (world demand shock) ↓/↑tobacco production and prices,.

Variables to be considered M1, FXR, NFA, TOT, EX, GR and the shock is Tobacco Prices (TP). The choice of variables is dictated by the availability of data and how they react to changes in tobacco prices

We determine stationarity, causality, IRFs and variance decompositions for shocks, the long run and short run relationships through a cointegration framework

Contribution to Literature This thesis examines dynamics of macroeconomic

variables in LIEs using models adjusted for LIEs since standard econometric models generate contrary variability to what HIEs obtain

The thesis is the first study to estimate a NKDSGE model with FX constraints for Malawi.

This thesis is the first to estimate ERER, pass-through and J-Curve after the 49% devaluation of the Malawi Kwacha

Studies on Malawi on tobacco have not examined how tobacco price shocks influence macroeconomic variables of the economy and this thesis closes this research gap.

Analysis and policy recommendations that will be provided may help in implementation of policy in LIEs and assist in dampening macroeconomic shocks.

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