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WPS8128

Policy Research Working Paper 8128

Public Disclosure Authorized

Exchange Rate and Inflation Dynamics

in Zambia
Lionel Roger
Gregory Smith
Oliver Morrissey
Public Disclosure Authorized
Public Disclosure Authorized

Macroeconomics and Fiscal Management Global Practice Group

June 2017
Policy Research Working Paper 8128

Abstract
This paper investigates the dynamics between the exchange most important driver of the exchange rate, the fluctua-
rate and consumer price inflation in Zambia. The analy- tions it caused are associated with a low pass-through of
sis uses a structural vector autoregression, with quarterly only about 7 percent. Exchange rate fluctuations caused
data for 1995–2014 and a combination of short-run by monetary shocks come with a pass-through of up to
sign- and zero-restrictions to identify relevant global 25 percent. Food inflation is equally affected by genuine
and domestic shocks. The findings suggest that the pass- exchange rate shocks, but appears more reactive to changes
through of exchange rates to consumer prices depends in copper prices or the money supply. Historical vari-
greatly on the shock that originally caused the exchange ance decomposition shows that, across periods, the main
rate to fluctuate. Although the price of copper is the drivers of exchange rate fluctuations varied substantially.

This paper is a product of the Macroeconomics and Fiscal Management Global Practice Group. It is part of a larger effort
by the World Bank to provide open access to its research and make a contribution to development policy discussions
around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The authors
may be contacted at gsmith3@worldbank.org.

The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development
issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the
names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those
of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and
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 Exchange Rate and Inflation Dynamics
in Zambia
By LIONEL ROGER, GREGORY SMITH AND OLIVER MORRISSEY *

JEL classification numbers: E31, E52, O23

Keywords: Exchange Rate Pass-Through, Inflation, Time Series Analysis

* Roger (e-mail: lionel.roger@nottingham.ac.uk) and Morrissey (oliver.morrissey@nottingham.ac.uk): School of

Economics, University of Nottingham, University Park, Nottingham NG7 2RD. Smith: World Bank, Lusaka, Zambia and
Washington DC, USA (e-mail: gsmith3@worldbank.org).
We would like to thank the Economics Department of the Bank of Zambia and the participants of the CSAE conference
2017 in Oxford for their valuable comments. Lionel Roger’s research is supported by the UK Economic and Social
Research Council [award number 1511835].
 1. Introduction

When Zambia introduced a floating exchange rate regime in 1994, it was one of first
countries in Sub-Saharan Africa to do so. While this has been welcomed as a critical step
towards economic modernization and sound macroeconomic management, it has also created
new challenges. Being a small, open, and rather undiversified economy (copper alone accounts
for more than 70% of exports), the country is highly exposed to global shocks, potentially
inducing large and unexpected fluctuations in the value of its currency.
Recently, this potential issue surfaced with great force: Between January and August 2015,
the Zambian kwacha gradually lost about 21% of its value against the US dollar. In the ten
weeks between September and mid-November, its value plummeted by another 60%, before
partially recovering with an appreciation of 27% until the end of the year. Overall, the currency
depreciated by more than 40% in 2015. The impact on the economy was severe, especially for
consumers: the weakness of the currency abruptly fed through to consumer prices, and monthly
inflation jumped from an average of 0.7% to 6.2% in October and another 5% in November.
Overall, consumer prices had risen by 21% in 2015.
The aim of this study is to gain an understanding of the dynamics and relative importance of
the multiple factors that affect the value of the kwacha and, in turn, consumer price inflation in
Zambia. This study relates to three interrelated strands of the growing literature on
macroeconomic dynamics in Zambia: first, the determinants and dynamics of the exchange
rate; second, inflation dynamics in Zambia; and third, the interaction between the two, the
exchange rate pass-through.
From the first category of studies, a wide consensus emerges that the value of the kwacha is
exceptionally susceptible to global commodity prices, especially that of copper. This is
supported by case studies such as Muhanga, Zyuulu and Adam (2014), who focus on the short
run in an SVAR, or Bova (2009) and Chipili (2015a), who both focus on long-run cointegrating
relationships and infer an equilibrium relationship between the price of copper and the
exchange rate. Similarly, Cashin, Céspedes and Sahay (2002) test for a long-run relationship
between main export commodities and the exchange rate in a sample of 58 countries, and
conclude that the Zambian kwacha is a 'commodity currency’. Pamu (2011), however, rejects
this classification on the basis of being unable to discern a relationship between the price of
copper and the exchange rate.
While the literature on inflation in Zambia is relatively extensive, the focus of most studies
is on forecasting rather than on the identification of the underlying mechanics and main drivers
(e.g., Chipili, 2015b; Mbao, 2015). Notable exceptions include Mutoti et al. (2011), who
establish the importance of the oil price and money supply as determinants of inflation, and
Chileshe (2015), who shows that fiscal shocks can have a great impact on consumer prices.
Lastly, studies that explicitly address the link between the exchange rate and consumer
prices, and therefore investigate the exchange rate pass through (ERPT), are scarce. To the best
of our knowledge, the only study explicitly aimed at investigating this question for Zambia is
Zgambo (2015). In the framework of a structural VAR (SVAR), similar in many respects to the
one we will present, he estimates the ERPT to be between 41% and 49%. Beyond the country-
specific literature, in a seminal study concerned with estimating the determinants of ERPT in a
global sample, Choudhri and Hakura (2006) report a similar value for Zambia (an ERPT of
41% after 4 quarters).
The main novelty of this study concerns this last strand of the literature. While there is a
general consensus that a depreciation in the exchange rate should translate into increases in

2
consumer prices as imported goods become more expensive, the extent of this effect – the
ERPT – can be difficult to quantify.1 Moreover, as some recent contributions point out, the
ERPT need not be the same for all the shocks that drive the exchange rate (Shambaugh, 2008;
Forbes et al., 2015): A depreciation caused by global market conditions may be associated with
very different price dynamics than the same depreciation caused by, for instance, expansionary
monetary policy by the domestic central bank. The focus of our paper is then to disentangle the
dynamics between the exchange rate and consumer price inflation, and to explore the possibility
of a differential ERPT depending on the shock that originally caused the exchange rate to move.
To this end, we identify six shocks to key variables of the Zambian economy (namely shocks
to the copper price, external interest rate, output, domestic money supply, exchange rate and
inflation) using sign- and zero-restrictions in the framework of an SVAR. Since its introduction
by Sims (1980), Blanchard and Watson (1986) and Bernanke (1986), this method has found
thousands of applications in empirical macroeconomics. The most common identification
scheme remains a triangular Cholesky decomposition, which reduces the number of free
parameters exactly to the point where the system is just-identified. This approach, however,
often implies assumptions that are hard to justify, and the results may be susceptible to the
ordering of the variables. Uhlig (2005) suggests to address this using economically plausible
but less restrictive sign restrictions on the impulse response functions, which can be estimated
in a Bayesian VAR. His ‘agnostic’ approach has since inspired hundreds of papers to adopt
similar methodologies. However, Baumeister and Hamilton (2015, henceforth BH) show that
statistical models that appear to be ‘agnostic’ at first can in fact be heavily influenced by the
priors imposed by the researcher, even if they were originally designed to be uninformative,
that is, designed to have little impact on the results. Indeed, they show that there can be
situations where results may be driven solely by the priors unintentionally imposed by the
researcher. BH suggest to impose informative priors on economically interpretable parameters
instead, where the prior values can, for instance, be derived from earlier empirical literature or
from theory. We acknowledge their argument but note that, especially in larger VARs and for
less studied economies and questions, there may simply not exist conceptually similar estimates
for the relevant parameters, and that the parameters of theoretical models can rarely be directly
mapped to the empirical model. In order to obtain sensible priors nonetheless, we therefore first
estimate short-run elasticites using a conventional Cholesky decomposition, and then feed these
into our Bayesian VAR as priors.
The remainder of this paper proceeds as follows: Section 2 discusses relevant aspects of the
institutional and historical background in Zambia. Section 3 lays out our methodology and
discusses the underlying assumptions. Section 4 describes the data, its basic time series
properties, and any transformations. Section 5 presents the results, and Section 6 discusses the
turbulence of late 2015 with respect to the results. Section 7 concludes.

2. Background

Zambia is a small, open commodity-dependent economy and regularly faces challenges

from supply shocks. These include shifts in the global copper price, rain-fed agricultural
outputs, hydro-electric generation output, and the global price of fuel. It has been a copper
producer since prior to its independence in 1964, but from the early 1970s production fell

1
For an excellent and comprehensive overview of the theoretical and empirical literature on the exchange rate pass-
through in developing and emerging markets see Aron et al. (2014).

3
considerably. Nationalization in 1973 and low prices hampered investment in the sector until
the 2000s. Fresh investment followed privatization and higher copper prices in the mid-2000s
supported a doubling of copper production between 2004 and 2014. The boost to the economy
from the copper industry was also complemented by better macroeconomic fundamentals in
the 2000s. For example, Zambia maintained a fairly low level of inflation, judged by its
historical standards, and substantial debt relief improved investors’ perception of the country
after it qualified for the Heavily Indebted Poor Countries (HIPC) initiative in 2005. These
factors supported the expansion of the economy and annual GDP growth, which averaged 7.4%
between 2004 and 2014. As the production of copper increased and the economy prospered,
much larger foreign exchange inflows followed from the mining sector. Added to this in the
late 2000s were inflows from large Chinese infrastructure lending and from 2012 in the form
of large commercial Eurobonds placements (2012, 2014 and 2015).
Since the introduction of a floating exchange rate in 1994, the primary objective of the

Figure 1: Key variables from 1995 to 2015 (monthly data)

central bank has been to maintain price stability. In the foreign exchange market, its only role
has been to intervene in order to reduce volatility and manage exchange rate stability. Key
characteristics of Zambia’s foreign exchange markets are that they are ‘thin’, in the sense that
there is not much trading, and that markets are dominated by few players (notably the large
mining firms, the commercial banks, and the Bank of Zambia). There are often times of low
trading volume, when large players are not trading and the exchange rate is fairly stable. The
participants that are large relative to the level of transactions can exert influence over the
exchange rate, sometimes by the timing of their transactions, even if they do not intend to.
In 2014 and 2015 the economy experienced several shocks including a further decline in
copper prices and after nearly a decade of running a trade surplus, the external account fell into
deficit in December 2014. The initial consequence was a steady depreciation of the kwacha
during the first half of 2015. In August of that same year the confidence of the economy was

4
eroded further as a power crisis began to impact all sectors of the economy, and the trade deficit
accelerated. Between August and November, the currency depreciated by 60% in what appears
to have been an instance of market panic. Some gains were recovered in 2016 following much
tighter monetary policy, but at the end of 2016 the kwacha remained substantially weaker than
prior to the shock. The depreciation of the currency abruptly fed through to consumer prices
between September and November 2015, lifting annual inflation from less than 8% in the
preceding years to more than 20% in 2015. Section 6 will discuss this episode with what can
be inferred from our results.
Figure 1 traces some key macroeconomic variables relevant to our narrative (the exchange
rate, the copper price and consumer prices) since 1995, after the introduction of the floating
exchange rate regime in 1994 and at the start of our sample period (see Section 4). Before
proceeding to the econometric analysis, it is worth relating some of the key changes in the data
to the institutional context outlined above. First, notice the changing patterns in the
development of the exchange rate (expressed throughout this article in USD/ZMW, such that a
decrease corresponds to a depreciation).2 In the earlier periods (top panel) it seems to be moving
rather independently of the copper price (expressed in USD per metric ton). It is only after
2005, when investment and copper production increased, that the two variables began to
noticeably move together. Second, this coupling coincides with a strong appreciation following
scaled-up debt relief under the HIPC initiative in 2005. To be sure, this appreciation precedes
the increase in the copper price around the same time; later it appears the sequence is reversed
(changes in the copper price precede those in the exchange rate), consistent with the
interpretation that copper became a stronger determinant of the exchange rate after the sector
had attracted investment and gained importance. Lastly, while consumer prices (CPI) and the
exchange rate do generally appear to be trending in the same direction in most periods, prices
do not react to exchange rate fluctuations in any obvious manner. This does not apply to the
end of 2015, when a sharp depreciation comes with an equally sharp increase in inflation, an
observation that will be further discussed in Section 6.

3. Methodology

Subsection 3.1 outlines the general form of the structural VAR employed and discusses the
central problem of identifying the relevant shocks. Drawing from recent methodological
advancements, especially Baumeister and Hamilton (2015) and building on Uhlig (2005), we
avoid enforcing a fully identified structure on our system, and instead rely on a combination of
sign- and zero-restrictions to achieve set identification in an under-identified system. This
allows us to relax a common, but in our view overly strong (and as our results will show,
influential), assumption about the contemporaneous interaction of the exchange rate and
inflation, which our specification will allow to take place in either direction.
As our system is under-identified, estimation will be carried out in a Bayesian framework.
This raises the critical issue of selecting sensible priors. As Baumeister and Hamilton (2015)
point out, these can be highly influential even where they are designed for opposite (supposedly
flat priors). Priors therefore need to be chosen with corresponding care, and reported in a
transparent manner. Subsection 3.2 will discuss and make explicit our choices in this respect.

2
We apply the 2013 redenomination of the kwacha retroactively throughout the series for consistency, that is, we divide
older values by 10,000 to have a consistent series.

5
 3.1. Identification

We estimate the macroeconomic dynamics of interest in the framework a vector

autoregression of the following form (using the notation of Ramey (2016) and Stock and
Watson (2016)):

( ) = , (1)

Where is a vector of reduced form VAR innovations, that is, the observed residuals as
obtained when forecasting based on its lagged values. We make the usual assumptions that
these innovations have a zero mean, constant variance, and are uncorrelated with each other.
Furthermore, ( ) is a lag polynomial of the form ( ) = − ∑ , where is the lag
operator, shifting values by lags. It effectively applies weights to each lag and element of
in order to explain its current values, short of the innovations .
However, the idea of a structural VAR is specifically to represent in terms of structural
shocks that are unexpected, exogenous disturbances to the system, in order to identify the
effect of unexpected changes in each of the variables, and to subsequently compute parameters
of interest such as impulse response functions and variance decompositions. The SVAR
assumes that these structural shocks are related to the VAR innovations in the following
way:

= , (2)

Where the matrix describes the contemporaneous relationships between the structural
shocks and the reduced form VAR residuals , or how an exogenous shock to any variable
will affect each of the variables in within the period. 3 We will normalize it such that the
structural shocks have unit effect, that is, its diagonal elements are unity (an exogenous shock
to a given variable will translate one to one into a change of that variable). Without any further
restrictions however, the system is unidentified and there exists an infinite number of parameter
combinations in that are equally consistent with the observed data. The challenge is then to
impose some structure that will allow us to uncover the parameters of , and therefore the
impact of each of the individual shocks onto the system.
This leads us to the critical issue of identification, which sets our study apart from most of
the previous literature (that on Zambia in particular), much of which relies on a Cholesky
decomposition first suggested by Sims (1980) and still common in the exchange rate and
monetary literature (with respect to Zambia, recent examples include Muhanga et al. (2014)
and Zgambo (2015)). For all its benefits (most importantly, pinpointing parameters by just-
identifying the system), this comes at the cost of substantial rigidity and requires the researcher
to impose strong assumptions on the economic mechanisms that are being investigated. Our
approach will therefore build on more recent developments in the literature, which has
increasingly moved away from strict just-identified systems towards more flexible
specifications; specifically, we will rely on a combination of sign- and zero-restrictions in a
fashion similar to Uhlig (2005). The general idea here is to restrict parameter combinations to
the set of those that are consistent with fundamental macroeconomic principles, instead of

3
In the literature using a Cholesky decomposition, matrix is commonly referred to as . We stick to the Ramey (2016)
and Stock and Watson (2016) notation to facilitate reference to their excellent discussion of the matter.

6
imposing so many (but potentially unwarranted) restrictions that only one combination remains
possible. We also acknowledge recent improvements on the Uhlig (2005) approach, and in
particular we use the Baumeister and Hamilton (2015) methodology in order to avoid the undue
impact of supposedly uninformative priors (see Section 3.2).
Consider now the following general set of equations that describe the relationship between
the variables in our system, which are chosen in line with the literature on exchange rates and
inflation. The model is limited to six variables: the US Federal Funds rate (to represent the
external interest rate), the international price of copper, domestic money supply, the domestic
output gap, the exchange rate and consumer price inflation (the choice and details of the
variables will be discussed in more detail in section 4, and the assumptions underlying this
structure below):

= ,
= Φ + ,
= + + ,
(3)
= + + + ,
= + + + + + ,
= + + + + + , .

More concisely, we can represent the dynamic behavior of this system in matrix notation as:

= Φ( ) + Ω (4)

where Φ( ) = Φ + ∑ Φ : The structural coefficients in system (3) are captured in the

contemporaneous matrix Φ , while the dynamics of additional lags are captured in the matrices
Φ . The ’s are now the structural shocks we will aim to identify, entering the system as
determined by matrix Ω. We follow common practice in assuming that each structural shock
only enters one equation, or Ω = .
As outlined above, our identification strategy will rely on imposing structure on in order
to identify the contemporaneous relationship defined in (2). The combination of sign- and zero-
restrictions we employ takes the form:

1 0 0 0 0 0
1 0 0 0 0
1 0 0 0
= (5)
1 0 0
1
1

This specification is similar to a Cholesky decomposition, but it relaxes the restrictions on

the contemporaneous interactions on our main variables of interest, inflation and the exchange
rate. Instead, we impose a number of sign restrictions on the parameters, indicated by the
superscripts ‘‒’ and ‘+’. More specifically, this specification reflects three types of
assumptions:

7
 1. Small economy: The domestic macroeconomic variables in Zambia are assumed to have
no contemporaneous impact on the two global variables in the system, the US Federal
Funds rate and copper prices. Given the importance of copper as an export in Zambia,
the latter may seem restrictive; however, Zambia only accounts for about 2% of the
global copper production.
2. Delayed responses: Monetary policy is assumed to react only with a delay to developments
in the economy. This assumption is commonly made and rooted in the observation that
information on macroeconomic variables typically becomes available only with a lag.
Similarly, output is typically observed to react to changes in other variables only with a
lag. The ordering above implies that output may respond to monetary policy
contemporaneously, but not vice versa. Note that a few studies have made the opposite
assumption in the past and constrained GDP to only react with a lag based on the
argument that it is a notoriously slow variable; in a robustness check, we changed the
order and the results were robust to this choice.
3. Sign restrictions: We impose sign restrictions on contemporaneous parameters where we
deem this choice consistent with a broad range of macroeconomic theories. Specifically,
the exchange rate is constrained to depreciate (if anything) as the fed funds rate increases,
as broad money increases, and as domestic inflation increases. Similarly, we constrain
the contemporaneous impact of an exchange rate appreciation on prices to be negative
or zero, thus excluding parameter combinations that would imply a negative ERPT at
impact. Further, the contemporaneous reaction of output to an increase in copper prices
is assumed to be positive or zero, as well as that of inflation to an expansionary monetary
shock.

3.2. Priors

As our system is not fully identified as in the pure Cholesky case, we follow the literature in
taking a Bayesian approach in order to estimate the VAR. Crucially, this requires us to select
priors. As shown by Baumeister and Hamilton (2015), seemingly uninformative priors (e.g.,
the commonly used Haar prior) can effectively be very influential, in a manner that is neither
intended, understood, or related in any intuitive way to the underlying economic meaning. This
can be the case when the outcome of interest (e.g., the impulse response function) is a non-
linear transformation of the parameters the priors are imposed on. Instead, they suggest to
formulate informative priors directly on parameters with an intuitive economic interpretation,
in our case on the contemporaneous coefficients in matrix . We will follow their approach,
and use their numerical algorithm to obtain our results.
This poses the fundamental challenge of finding sensible prior values, that is, expectations
about the values of the contemporaneous elasticities between the variables included in our
system. In fact, we found it impossible in the present study to base all our priors on results of
the earlier literature, which would be the obvious way to proceed. This is the case for a number
of reasons: First, reporting conventions make it difficult to draw from earlier studies. It is not
common for the empirical literature to report the contemporaneous coefficients making up the
matrix . For instance, Muhanga et al. (2014), even though they study the same country with
a similar research question and a comparable set of variables, only report their results in the
form of impulse response functions, and thus do not offer a starting point for our priors.
Second, the size of our VAR complicates the search for priors. With an increasing number of
parameters (we estimate 16 contemporaneous parameters), it becomes increasingly difficult to

8
find sensible priors for each of them that would be conceptually similar and could reasonably
be expected to apply to Zambia.
Third, there is little guidance by theory in the choice of priors. The theoretical literature is
generally not parameterized in a way that suggests any particular amplitudes for the coefficients
in our empirical model. To illustrate this, consider Baldini et al. (2012), who develop a DSGE
model to analyze monetary policy in Zambia. While conceptually and contextually close to our
study, and very transparent about the parameters applied and derived, none of the macro-
parameters of interest here correspond to those employed in their model (which by construction
roots the dynamics in deep parameters at the micro level).
In order to obtain sensible priors, we take the following approach. Instead of collecting or
deriving coefficients from earlier literature, we generate our own priors from a more traditional
approach (as if there was previous literature sufficiently consistent with our study). We start by
estimating the model using a conventional Cholesky decomposition, thereby obtaining results
based on more restrictive assumptions as typically made in the earlier literature. We then feed
the resulting estimates as the prior modes into the system described earlier. Thus, we take
traditional estimates with all their shortcomings as a first guess, and then use algorithms to
improve on them.
Note that – given our structure of choice described above – it is not possible to estimate
and simultaneously. In order to obtain prior modes for both, we estimate the system twice,
once as described above, and then reversing the order of the last two variables (exchange rate
and inflation). All other parameters are those obtained from the estimation with the order as
described throughout the article (exchange rate before inflation). Beyond the mode, in order to
complete the specification of our priors, we need to specify the nature of our prior distribution
(as the parameters are inherently treated as random variables). In line with Baumeister and
Hamilton (2015), we formulate the priors on the parameters in as student t distributions with
three degrees of freedom, and a scale parameter of 0.6 reflecting moderate confidence in our
prior modes. Appendix A explicitly reports the prior modes.

4. Data

We use quarterly data from 1995:2 to 2014:4. This corresponds to a period of relative
stability in the Zambian economy, and a regime of flexible exchange rates since 1994.
Furthermore, we only have data on the output gap starting from 1995, the first quarter of which
drops out as we take first differences. We deliberately exclude the tumultuous year 2015 from
the main analysis as it exhibits extreme developments that are likely to dominate and distort
our baseline estimations.
We obtain the price of copper from the IMF’s Primary Commodity Price database; the
Federal funds rate, the nominal USD/ZMW exchange rate (expressed such that a decrease
corresponds to devaluation) and the Zambian CPI from the IMF’s International Financial
Database; Broad Money (M2) from the Bank of Zambia’s fortnightly statistics; and an internal
estimate of the output gap kindly provided to us by the Bank of Zambia. All series are originally
obtained at a monthly frequency and averaged over quarters, except for the output gap which
was provided to us at quarterly frequency.
Figure 2 plots all variables in levels (solid lines) and in log differences (dashed lines). All
series, except for the output gap (especially in early periods) resemble non-stationary series;
the differenced series however appear stationary. This is confirmed by Augmented Dickey-

9
Fuller tests reported in Appendix A. As our study focusses on relatively short time horizons,
we will restrict our attention to the differenced series.
Specifically, we use the log-difference (multiplied by 100) of the copper price, money, the
exchange rate and the consumer price index, so as to measure percentage changes between
quarters. The Federal Funds rate, already expressed in percentages, will be included in first
differences, therefore reflecting changes in percentage points. The output gap is expressed in
percentage deviations from potential output and will be included as obtained. Furthermore, we
de-trend the consumer price and money series.

10
 10000

.4

1
6.00
.2
8000

0
USD / metric ton

4.00
log difference

log difference
0
6000

Percent

−1
−.2
4000

2.00
−.4

−2
2000

−.6

0.00

−3
1995 2000 2005 2010 2015 1995 2000 2005 2010 2015

(a) Copper price (b) Fed funds rate

10
.2

6
40

Percent deviation from potential output

.15

4
30

5
Billions of ZMW

log difference

log difference
.1

2
20

.05

0
10

0
−.05

−5

−2
0

1995 2000 2005 2010 2015 1995 2000 2005 2010 2015

(c) Money (M2) (d) Output gap

200
1.5

.15
.2
.1

150
Index (2009=100)

.1
1

log difference

log difference
USD/ZMW

100
−.1

.05
.5

50
−.2
−.3
0

1995 2000 2005 2010 2015 1995 2000 2005 2010 2015

(e) Exchange rate (f) Consumer Price Index

Notes: The solid lines describe the variables in levels and native units (see left y-axis), the dashed lines indicate are the
first differences of the logarithm of these series. The dotted vertical line at the beginning of 2015 indicates the end of the
sample period used for our main specification. See main text for further transformations applied to the series.

Figure 2: Variables in levels and log differences

11
 5. Results

We discuss our results in three steps. First, we present the basic impulse response functions
of our main variables of interest, the exchange rate and inflation. These indicate a strong
dependence of the exchange rate on copper, as well as a moderate effect of the exchange rate
on price levels. Second, we report variance decompositions over the sample periods in order to
isolate the most important contributing factors on each of the variables, and the evolution of
this pattern over time. Third, we analyze whether there is a differential ERPT depending on the
shock that drives the exchange rate fluctuation, following Forbes et al. (2015). We further
investigate whether and to what extent food and non-food inflation are affected differently, and
also report differential ERPTs obtained using the respective disaggregated CPIs.
5.1 Impulse response functions

Figure 3 depicts the cumulative impulse response functions (IRF) for the exchange rate as a
reaction to a 1% positive shock in the other variables. The solid line reports the pointwise mean
IRF, which is the recommended point estimate to be reported given a linear loss function
(Baumeister and Hamilton, 2015). The dashed lines depict the 68th and 90th percentiles of the
estimated IRFs (following the Bayesian convention of credible intervals, in lieu of frequentist
confidence intervals).
Panel (a) summarizes one of the key results of this exercise: the exchange rate reacts strongly
and quickly to an increase in copper prices. The mean response suggests that, at impact (within
the quarter), an unanticipated 1% rise in copper prices leads to an exchange rate appreciation
of 0.2%. The exchange rate continues to markedly appreciate for the next two quarters, up until
0.4%, and then stays at roughly that level. This is slightly lower than the 4.8% appreciation
following a 10% increase in copper prices in the long run reported by Chipili (2015), although
this estimate is within the bounds of the 68% interval.
An expansionary monetary shock of 1% (panel (c)) is estimated to induce a marked
depreciation of about 0.7% within the quarter, reaching its peak in the next quarter at 0.9%.
The point estimates suggest a slight overshooting here, and the persistent effect is of about
0.8%. Note that after three quarters, the estimates become less confident to the point where a
zero effect cannot be excluded based on the 90% credible interval.

12
 0.9 17.1
0.8 14.3
0.7 11.5
0.6 8.7
0.5
5.9
0.4
3.1
0.3
0.3
0.2
-2.5
0.1
0 -5.3
-0.1 -8.1
-0.2 -10.9
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8

(a) Copper prices (b) Fed funds rate

0.1 1.3
1.1
-0.1
0.9
-0.3
0.7
-0.5
0.5
-0.7
0.3
-0.9
0.1
-1.1 -0.1
-1.3 -0.3
-1.5 -0.5
-1.7 -0.7
-1.9 -0.9
-2.1 -1.1
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8

(c) Monetary (expansionary) (d) Output gap

1.3
0.8
0.3
-0.2
-0.7
-1.2
-1.7
-2.2
-2.7
-3.2
-3.7
0 1 2 3 4 5 6 7 8

(e) CPI

Figure 3: Response of the exchange rate to a 1% shock to key variables

The third most salient driver is domestic prices, reported in panel (e). Although the estimates
are too imprecise for any stark conclusions, the point estimates suggest a contemporaneous
depreciation of about 0.8% following a 1% inflationary shock to CPI. The median response
suggests a peak depreciation at about 1.4% after one quarter, which then levels off at about
0.9% after five quarters. This is evidence that our decision to leave the contemporaneous impact

13
of inflation on the exchange rate unrestricted was well-warranted; restricting it to zero would
have forced the intercept of this IRF to be zero, and exerted great but possibly undue effect on
our estimates of the exchange rate pass-through, discussed below.
The effect of the output gap and the fed funds rate, panels (b) and (d), are ambiguous and
estimated with little precision.

14
 0.2
1.9
0.16
1.3
0.12
0.7
0.08
0.1
0.04
-0.5
0
-1.1
-0.04
-1.7
-0.08 -2.3
-0.12 -2.9
-0.16 -3.5
-0.2 -4.1
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8

(a) Copper prices (b) Fed funds rate

0.3
0.4
0.2
0.3

0.1
0.2

0.1 0

0 -0.1

-0.1 -0.2

-0.2 -0.3
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8

(c) Monetary (expansionary) (d) Output gap

0.2
0.15
0.1
0.05
0
-0.05
-0.1
-0.15
-0.2
-0.25
-0.3
0 1 2 3 4 5 6 7 8

(e) Exchange rate

Figure 4: Response of consumer prices to a 1% shock to key variables

Figure 4 is identical in notation and plots the responses of consumer prices to 1% shocks to
any of the other variables. The general picture here is that consumer prices do not react very

15
strongly to the other macro variables, at least based on the short run dynamics analyzed in our
framework.
The most pronounced effect comes from monetary shocks (panel (c)): While a monetary
expansion does not have much of an impact contemporaneously, after two quarters, a 1%
monetary shock is estimated to induce a 0.2% increase in prices.
Panel (e), reporting the response of CPI to a shock in the exchange rate – the ERPT to
consumer prices – reveals a very moderate response of consumer prices to changes in the
exchange rate based on the short run dynamics. At impact, there is no evidence for an increase
in consumer prices. While the precision of the estimate is very low given the small amplitude
of the effect, the median IRF suggests a steady decrease (increase) in prices following an
unanticipated appreciation (depreciation) of the exchange rate. The dynamics settle down after
four quarters, after consumer prices have decreased (increased) by about 0.07%.
Our estimates therefore imply an ERPT to consumer prices of 7% after four quarters. This is
very low compared to other estimates in the literature. The corresponding figures obtained by
Zgambo (2015) range between 41% and 49%, although this is reduced to 20% when focusing
on a more recent period (2004-2014) characterized by lower inflation. Choudhri and Hakura
(2006) estimate an ERPT to domestic prices in Zambia of 15% at impact, and 41% after four
quarters. The average pass-through after four quarters they obtain for developing countries is
24% (although with some notable exceptions, like 9% in Burundi, and -1% in Colombia).
It is worth emphasizing that, besides other important methodological differences in their
study, Choudhri and Hakura (2006) study the period 1979-2000 which overlaps with our
sample for only five years. The discrepancy is somewhat consistent with the main point of their
paper: low inflation is associated with a low pass-through. In our sample period, Zambian
inflation is much lower than in earlier decades, averaging 18% per annum over 1995-2014
compared to 71% per annum during 1986-2000 (World Bank, 2016). Our results may therefore
reflect a genuine increase in the resilience of the Zambian economy until 2014.
A second factor is our decision to leave the initial impact of inflationary shocks on the
exchange rate, , unrestricted. Estimating the same set of equations with full identification
through a classical Cholesky decomposition ( = 0, no sign restrictions) leads to a higher
ERPT estimate of 9% at impact and about 15% after four quarters. This is indeed what much
of the previous ERPT literature has been doing, suggesting that some of the results are inflated
as causality was constrained to go from exchange rates to prices.
5.2 Historical decomposition

Figure 5 and Figure 7 describe the historical contributions of each of the shocks to the
changes in the exchange rate and consumer prices. The red line is the observed value of the
respective (de-trended) series, expressed in quarter to quarter changes. The colored bars
indicate the contribution of each of the shocks to this value over the eight periods (two years)
prior to the indicated date, computed from the median IRFs discussed in the previous section.
These illustrate the decompositions reported in Table 1, which shows that money supply (M2)
and the copper price account for most of the variation in exchange rates, and M2 is usually the
more important factor (except for 1996-99 and 2008-11). The lower panel shows that the output
gap, money supply and the copper price account for most of the variation in exchange rates
(their relative importance varies, which M2 generally becoming more important over time).
The role of domestic inflation as a driver of the exchange rate appears to have steadily declined,
from 19% in 1996-99 to 6% in 2012-14.

16
 1996q2- 2000q1- 2004q1- 2008q1- 2012q1-
1999q4 2003q4 2007q4 2011q4 2014q4
Exchange rate Fed 3% 8% 9% 6% 3%
Copper 22% 13% 16% 29% 15%
M2 15% 24% 24% 20% 31%
Output Gap 9% 10% 9% 4% 6%
Exchange Rate 30% 32% 33% 32% 40%
CPI 19% 13% 8% 8% 6%

Fed 2% 4% 5% 6% 1%
Copper 10% 6% 13% 23% 14%
M2 7% 15% 18% 20% 24%
CPI

Output Gap 21% 21% 15% 10% 21%

Exchange Rate 5% 3% 8% 6% 6%
CPI 55% 51% 41% 35% 34%
Notes: The first panel reports the contribution of each variable to the fluctuations of the
exchange rate averaged across quarters within five sub-periods. The second panel reports the
same information for fluctuations in CPI.
Table 1: Historical variance decomposition of exchange rate and price fluctuations

Figure 5 illustrates these results for the exchange rate and depicts the year by year variation.
It is apparent that the factors contributing to exchange rate fluctuations have varied quite
substantially over time, but also that the amplitude of the shocks – and therefore that of the
exchange rate fluctuations – has declined since about 2009. The graph also offers insights about
the nature of individual fluctuations. For instance, the early 2000s saw a number of stark
movements in the exchange rate, with money appearing to be the main driver. The strong
appreciation in 2005, corresponding to the debt relief under the HIPC initiative, enters mainly
as a genuine exchange rate shock. While the proportional contribution of the price of copper
appears rather moderate over much of the sample period, the abrupt depreciation in 2009
illustrates its potential importance, as it accounts for about two-thirds of the variation. The
variety of the drivers of these shocks further underlines the importance of our research question,
whether the ERPT will vary with the underlying economic shock that originally caused the
exchange rate to move.
20

10

-10

-20

Copper Fed Money Output gap Exchange rate CPI

-30
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Figure 5: Historical decomposition of changes in the exchange rate (USD/ZWA)

Figure 6 decomposes changes in consumer prices in the same way. As expected from the low
amplitude of the IRFs presented in section 5.1, the contribution of the other variables in our

17
system to changes in CPI appears to be relatively limited, and much of the variance is attributed
to price shocks that are exogenous to our system. However, as fluctuations decline over time,
it is apparent from Table 1 that the role of our macro-variables is increasing towards the end
of the period: over the sample period, the role of genuine price shocks steadily decreases from
55% in 1996-99 to 34% in 2012-14. A few factors have a notable impact in certain periods.
This is the case for the fluctuations in output, especially in periods before 2002. Contractionary
monetary shocks contributed to slowdowns in inflation in 2001 and in 2006. While copper
prices do not play a prominent role in determining inflation in the first half of the sample period,
it becomes more important in the late 2000s. This is plausible, as both copper production as
well as prices were significantly higher in later periods (see Section 2).
5

Copper Fed Money Output gap Exchange rate CPI

-5
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Figure 6: Historical decomposition of changes in Zambian consumer prices

5.3 Differential exchange rate pass-through

We will now examine the extent to which different shocks that affect the exchange rate entail
different reactions of consumer prices. Our approach is similar to Forbes et al. (2015), in that
we use the ratio of the IRF of CPI over the IRF of the exchange rate for a shock to any given
variable. These estimates therefore indicate the change in consumer prices induced by a shock
that leads to a 1% appreciation in the exchange rate in any period. The interpretation is then
slightly different to the IRFs reported in section 5.1. These traced the effect of a shock that
causes a 1% appreciation at impact. The measures reported here are computed for a shock that
causes a 1% appreciation in the period itself. For instance, in order for a shock to the copper
price to lead to an exchange rate appreciation of 1% at impact, it needs to have an amplitude of
1%/0.2 = 5% (see Figure 3). But the shock takes some time to fully deploy its effect on the
exchange rate; a copper price shock that leads to an appreciation of 1% after four quarters
therefore only needs to have an amplitude of 1%/0.4 = 2.5%.
Note also that the direction of the original shocks we consider in this section need not be
identical to that discussed in section 5.1 when describing the IRFs. Specifically, Figure 7 reports
the result of a contractionary monetary shock (reducing inflation), while our previous
discussion as well as Figure 4 were based on expansionary shocks (increasing inflation). This
is because we consider shocks that lead to an exchange rate appreciation, which for money
needs to be a contractionary one.

18
 Since in section 5.1 we established that both the fed funds rate and the output gap had little
discernible effect on the exchange rate, we focus on shocks to copper prices, money and the
exchange rate itself.4

0.1
0.05
0
-0.05
-0.1
-0.15
-0.2
-0.25
-0.3
-0.35 Copper Money Exchange rate

0 1 2 3 4 5 6 7 8

Figure 7: Pass through to consumer prices for different shocks

Horizon 0 1 4 8
Copper 0.06 -0.02 -0.03 -0.04
Money -0.03 -0.14 -0.21 -0.22
Exchange rate -0.02 -0.03 -0.05 -0.05
Table 2: Pass through for different shocks and time horizons

Figure 7 plots the results. First, note that for a shock to the exchange rate, the effect is even
slightly lower than that reported in section 5.1. This is because a shock that raises the exchange
rate by 1% at impact still raises it in the subsequent periods; effectively, Figure 7 refers to
smaller exchange rate shocks in all periods after impact.
A 1% increase in the exchange rate caused by a shock to copper prices comes with an increase
in consumer prices of 0.05%, implying a negative pass-through at impact of about -5%. This
may reflect aggregate demand effects related to the stimulus to the copper industry (increased
employment, rents). The effect is reversed in later periods, with a pass through between 5%
and 8% in the following quarters.
Finally, monetary shocks are associated with by far the strongest pass-though: exchange rate
fluctuations that are caused by a monetary shock are estimated to translate into consumer prices
with an ERPT of about 25% after three quarters, with a lasting effect of about 23%. This is
particularly relevant in the view of the results from the historical variance decomposition in
section 5.2, which indicate that, while the variation of the exchange rate has markedly declined
overall, it has recently increasingly been driven by monetary shocks. The remaining exchange
rate fluctuations may therefore be disproportionately associated with consumer prices. Note
however that this is more than offset by the smaller amplitude of the fluctuations in general.

4
The latter may seem redundant, as conceptually it is very similar to the exchange rate pass-through already quantified
above. Because of calculation in each period, and because an exchange rate shock that raises it by 1% in the first period may
(and does) have a different effect in the second period, it is not identical.

19
 5.4 Food versus non-food inflation

0.1
0.05
0
-0.05
-0.1
-0.15
-0.2
-0.25
-0.3
-0.35 Copper Money Exchange rate

0 1 2 3 4 5 6 7 8

0.1
0.05
0
-0.05
-0.1
-0.15
-0.2
-0.25
-0.3
-0.35 Copper Money Exchange rate

0 1 2 3 4 5 6 7 8

Figure 8: Differential ERPTs for non-food (top) and food (bottom) inflation

We further repeat the previous exercise with disaggregated measures of inflation, that is, we
repeat the entire analysis as outlined previously, replacing only the overall CPI series with the
food and non-food CPI respectively. Appendix A also reports the priors employed in this
additional exercise, which we derived for each CPI category separately in the same manner as
the one employed previously and described in section 3.1. For the sake of conciseness, we
restrict our discussion to the differential exchange rate pass-through; a document containing all
the graphs from the results section for the alternative CPI measures can be provided by the
authors upon request.
Figure 8 then summarizes the differential pass-through, with an interpretation identical to
that of Figure 7. For genuine exchange rate shocks, the difference appears to be only marginal
with an ERPT of about 5%. As for monetary and copper price shocks, there seems to be a
marked difference between food and non-food inflation. Non-food inflation (top panel) appears
almost indifferent to the exchange rate fluctuations induced by copper price shocks, and

20
exhibits a pass-through of about 15% for fluctuations driven by monetary shocks, as opposed
to nearly 25% in the case of overall inflation (previous section). In fact, the exercise suggests
that the overall pass-through is overwhelmingly driven by food prices (bottom panel).
Exchange rate fluctuations induced by copper prices come with a pass through of up to 10%,
those resulting from monetary shocks with up to 33%. This corroborates the finding of a higher
ERPT for food items in Zgambo (2015).
To some extent, this may appear puzzling as food items are typically sourced domestically
(with most of the labor force working in agriculture), and often produced on small scale farms
that do not tend to employ large amounts of imported inputs. Possible explanations could be
lower menu costs in the often informal market for food items, or the fact that processed food
items are almost exclusively imported. The latter would additionally increase in relevance if
there existed an urban bias (or a bias towards formal food vendors such as supermarkets) in the
CPI figures, as this is where imported food items prevail. We leave this as an open question for
future research.

6. Exchange rate and price shocks 2015

In order to investigate the dynamics of the kwacha exchange rate and its interaction with
consumer prices, we deliberately excluded the periods after 2015 from our estimations, as the
amplitude of these events means that they would have exerted undue influence on our parameter
estimates. Having established the dynamics in arguably normal times, we will conclude our
analysis by quantifying the extent to which the variables deviated from their econometrically
expected behavior in late 2015. To this end, we compute the predicted values for each period
up until 2015, therefore extending beyond our original sample period but using the parameters
derived from the original sample period.
Error! Reference source not found. plots the predicted series against the observed values
since 2009. In the first six years, the difference between the observed exchange rate fluctuations
and the predicted series is on average below 4% (top panel). However, the fundamentals
included in our model fail to predict or explain the massive depreciation in late 2015. For the
last quarter of 2015, it would have predicted a depreciation of 7%, while the kwacha actually
depreciated by almost 30%, a discrepancy of 23 percentage points.
An even more striking discrepancy arises between the observed and predicted CPI series
(Figure 9, bottom panel). Mainly due to a general economic downturn, as captured in the Output
gap, that counteracts the inflationary pressures arising from the depreciation, consumer prices
(adjusted for the trend) were expected to stay stable (-0.1) according to the model in the last
quarter of 2015. Instead, monthly inflation shot up by an unexpected 9.6%.
These discrepancies point towards dynamics that are substantially out of the ordinary, taking
the preceding two decades as a benchmark. In view of the abruptness and peculiarity of the
events, it should be emphasized that a narrative case study is needed in order to understand the
mechanisms that led up to the sweeping currency depreciation and price inflation. While this is
not the scope of our paper, our discussions with policy makers and private stakeholders
suggested the following aspects were key in understanding the abrupt currency depreciation:

21
 Figure 9: Predicted and observed changes in exchange rate (top) and CPI (bottom)

- Thin market: The currency market in Zambia is very thin and dominated by a few
large players, most notably mining companies, the central bank, and some private
banks. Individual transactions can have a great weight in the determination of the
market exchange rate, something that is perpetuated as such transactions work as a
signal for other market participants.
- Trade deficit: In December 2014, Zambia’s balance of trade turned negative after
nearly a decade of surpluses. In the first half of 2015, there was a widespread
apprehension among currency traders that the negative trade balance would persist or
worsen. This was confirmed by the government in late August, inducing a sharp and
sudden depreciation.
- Breakdown of price revealing mechanisms: In an attempt to limit speculative and
panic behavior, authorities closed the conventional foreign exchange market, where
offers could openly be published and observed by participants. Contrary to the original
intention, this effectively led to a breakdown of price revealing mechanisms and
nurtured suspicions among market participants that authorities were artificially

22
 keeping the exchange rate from dropping to its ‘true’ value. This turned into a self-
fulfilling prophecy, and the actual rate consequently dropped to excessively low
levels, reaching a low of 14 ZMW/USD on November 10.
- Delayed policy response: The central bank remained passive in terms of monetary
policy at first; at least in part because of the factors described above, the developments
only took up more pace instead of settling. When authorities substantially tightened
monetary policy in mid-November, the exchange rate rapidly stabilized, as did
inflation.

The fact that consumer price inflation so markedly increased in line with the exchange rate
depreciation during this episode may seem at odds with the finding of a relatively low overall
exchange rate pass-through.5 It is also not the case that the exchange rate fluctuations were
driven by monetary shocks, which, based on our results, would explain part of the higher pass-
through. We conjecture that this is related to the following factors:

- Confounding factors: The currency crisis coincided with poor harvests in the
agricultural sector, independently driving food price increases.
- Size non-linearities: It is often conjectured that small changes in the exchange rate
may translate into prices differently than large changes in the exchange rate (e.g., Aron
et al., 2014), for several reasons. First, menu costs may imply that producers and
retailers absorb small changes in the exchange rate through their profit margins, and
will only adjust prices once a certain threshold has been surpassed. A large
depreciation such as in late 2015 would then surpass these thresholds across sectors
and firms, leading to a larger ERPT. Similarly, in times of large exchange rate
fluctuations, retailers pay increased attention to the exchange rate and may adjust
prices at a higher frequency. Anecdotal evidence suggests that this was the case during
2015, with some retailers informally declaring prices in USD, and converting them
into kwachas based on the daily exchange rate for every purchase. This practice
mechanically leads to a complete ERPT for these transactions.

7. Conclusions

We investigated the dynamics of the exchange rate and its interaction with consumer prices
in Zambia in a structural VAR framework, identifying shocks with a combination of
theoretically plausible zero-restrictions and sign-restrictions. Crucially, we imposed minimal
restrictions on the interaction between these two key variables. Furthermore, we explored the
possibility of differential pass-through depending on which shock originally caused the
exchange rate to fluctuate, and disaggregated these results into food and non-food items.
Finally, we used our results and qualitative evidence to put into context the tumultuous period
of late 2015.
Our findings suggest that the pass-through from the exchange rate to consumer prices is
relatively moderate for genuine exchange rate shocks; we estimate a 10% depreciation to induce

5
To obtain an order of magnitude, a back of the envelope calculation using monthly exchange rates and price data between
August and November 2015 data would suggest that a 60% depreciation came with an approximate 20% of additional
inflation (when adjusting for a baseline inflation of about 7%), implying an ERPT of more than 30% in the short run. This is
in contrast to about 7% suggested by our estimates.

23
an increase in consumer prices of ca. 0.7% after one year, corresponding to an ERPT of 7%.
This is substantially less than what other studies typically find for small, low income countries,
and far below the 41% estimated for Zambia by Choudhri and Hakura (2006). This is likely
due to two factors. First, unlike much of the comparable literature, we do not impose any
directionality on the contemporaneous relationship between the exchange rate and inflation.
When doing so, our estimates of the ERPT are more than doubled. Second, we study more
recent periods where Zambia has maintained a fairly low level of inflation judged by historical
standards. It is a well-established finding that countries with lower inflation typically have a
smaller ERPT, and Zambia may indeed have successfully reduced its vulnerability to global
shocks in this respect.
Variance decomposition suggests that the main drivers of exchange rate fluctuations are, as
suggested by much of the earlier literature, copper prices and the money supply. The relative
importance of these factors has varied over time; while money supply has typically accounted
for the largest share of the fluctuations, copper was relatively more important in the period
2008-11. The role of inflation in the determination of the exchange rate declined throughout
the sample period.
We further investigated whether the ERPT varies with the shock that initially caused the
exchange rate to fluctuate. Our findings suggest that, as opposed to exchange rate fluctuations
caused by copper shocks or genuine exchange rate shocks, those fluctuations going back to
monetary shocks are associated with a much larger pass-through of about 25%. When
considering only food inflation, this figure is even higher with up to 33%. Our findings
therefore suggest that, if consumer prices – especially food prices – are the outcome of interest,
monetary policy must be conducted with great care, in the sense that counteracting exchange
rate fluctuations with monetary interventions may have substantial repercussions on consumer
prices.
Lastly, we show that the extent of the sharp depreciation of the exchange rate, as well as the
steep increase in consumer prices in late 2015 cannot be explained from the underlying
fundamentals included in our system. Instead, we suggest a narrative of market panic paired
with non-linearities in the ERPT, and outline the core aspects: thin markets, a deteriorated
balance of trade, the breakdown of price revealing mechanisms, and a delayed policy response.
We suggest that a dedicated case study is required in order to provide a satisfactory narrative
of this episode, and leave this as a fruitful topic for further research.

24
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 APPENDIX

Appendix A: Prior values of contemporaneous matrix H

Shock
Exchange
CPI type Fed Copper Money Output Price
rate
All
Fed funds rate Non-Food 1 0 0 0 0 0
Food
All 8.52
Copper Non-Food 9.42 1 0 0 0 0
Food 8.53
All -2.65 -0.04
M2 Non-Food -2.53 -0.04 1 0 0 0
Food -2.47 -0.04
All -0.49 0.03 -0.02
Output Gap Non-Food 0.05 0.03 -0.03 1 0 0
Food -0.64 0.04 0.00
All -1.77 0.21 -0.76 0.28 -0.85
Exchange rate Non-Food -2.98 0.22 -0.79 0.16 1 -1.30
Food -1.67 0.18 -0.77 0.34 -0.47
All -0.11 0.02 -0.07 0.04 -0.09
Inflation Non-Food 0.25 0.02 -0.04 0.05 -0.11 1
Food -0.55 0.03 -0.11 0.08 -0.09
Notes: Priors reported in bold are subject to a sign restriction. The respective sign can be inferred from the reported value of
the prior. The priors are obtained from just-identified Cholesky decompositions as described in section 3.1.

Appendix B: Augmented Dickey Fuller tests for a unit root

Intercept Trend t-statistic 5% CV p-value

Level yes no -1.11 -2.90 0.71
Copper price
1st Diff no no -3.71 -1.95 0.00
Level no no -1.50 -1.95 0.13
Fed funds rate
1st Diff no no -2.97 -1.95 0.00
Level yes yes 3.47 -3.47 1.00
Money
1st Diff yes no -3.20 -2.90 0.02
Output gap Level no no -3.98 -1.95 0.00

26
 1st Diff no no -6.34 -1.95 0.00
Level yes yes -1.77 -3.47 0.71
Exchange rate
1st Diff yes no -4.37 -2.90 0.00
Level yes yes -2.53 -3.47 0.31
CPI
1st Diff yes yes -5.29 -3.47 0.00
Notes: All tests have been carried out with trends and intercept where the graphs in section 4 suggested their
relevance, and removed when they turned out insignificant in the Dickey Fuller regression. The tests in first
differences were carried out with the log differenced series as this corresponds to the series eventually included
in out estimation for most variables. The exception is the output gap, where logs cannot be taken because of
negative values. All results refer to a test with 4 lags of the variable for consistency with the main analysis.

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