**2. Literature review**

A number of studies have looked at the effectiveness of monetary policy in Malawi or the effect of selected monetary policy variables on the economy, but very few (if any) have focuses on inflation in the past few years. For example, Wu [1] looked at the causal relationship between food and non-food inflation in Malawi before examining the exchange rate pass-through process to headline inflation and how it has evolved during the pre- and post-exchange rate regime change in 2012. The paper further investigates the possible drivers of headline inflation in Malawi over the period 2001–2015 [1]. However, the period 2012–2015 could not have offered longer enough time horizon for the exchange rate policy regime change implemented in 2012 to have had a significant impact on inflation. This study, with a much longer time span, covering the period 2012–2019, is expected to provide more insights on the impact of both structural and policy changes on inflation in the country. Ngalawa and Viegi [7] uses the structural vector autoregressive model to investigate the transmission mechanism through which monetary policy affects domestic prices and output growth in Malawi. The results of the study reveal that the bank rate remained a more effective measure of monetary policy than reserve money over the period of the study. The results also support the narrative that price

## *Will Malawi's Inflation Continue Declining? DOI: http://dx.doi.org/10.5772/intechopen.91764*

significantly declining to have an impact on inflation during the period January 2013 to February 2016. However, inflation in Malawi has continued to decline since early 2013, declining by 29 percentage points from 36% in February 2013 down to 9% in June 2019 (**Figure 1**). This is despite the theoretical economic fundamentals behaving to the contrary as fiscal balances widened from 1.9% of GDP in 2011 to 7.2% in 2018; and the country switched from a de facto pegged exchange rate regime to a floating exchange rate regime, leading a 33% devaluation of the local currency in 2012. Authorities' adoption of the automatic fuel pricing mechanism during the period meant that fuel prices should reflect the recent increases in global fuel prices. However, on the contrary, money supply grew at an average of 1.6% between February 2013 and September 2019, while policy rate declined from 25% in 2013 to 13.5% in 2019, theoretically easing the inflationary pressures in the

*Linear and Non-Linear Financial Econometrics - Theory and Practice*

Since Wu [1], there has been no study (to the author's knowledge) that has looked at inflation dynamics in Malawi over the period 2000–2019 as carried out in this study. However, the most recent study by Wu [1] focused mainly on the period up to 2015, investigating mainly the effects of the exchange rate regime change in 2012 and the switch to an automatic fuel pricing mechanism. This study, however, focuses on a relatively much longer period investigating the factors behind inflation movements in Malawi noting that a number of policy and structural changes have taken place over the period 2000–2019, which might not have been fully captured by Wu [1]. Authorities claim that most of these policy and structural changes have contributed to the recent continuous decline in headline inflation in the country. The main objective of this chapter is therefore to examine the factors that have led to inflation movements in the Malawian economy with a special focus on the recent continuous decline, and assessing whether it is a reflection of the performance of the country's economic fundamentals and whether it is something that will persist

The rest of the chapter is organized as follows. The next presents a brief literature review of some previous studies in the area. Section 3 presents the methodology employed in the chapter, while Section 4 presents the results of the analysis and

A number of studies have looked at the effectiveness of monetary policy in Malawi or the effect of selected monetary policy variables on the economy, but very few (if any) have focuses on inflation in the past few years. For example, Wu [1] looked at the causal relationship between food and non-food inflation in Malawi before examining the exchange rate pass-through process to headline inflation and how it has evolved during the pre- and post-exchange rate regime change in 2012. The paper further investigates the possible drivers of headline inflation in Malawi over the period 2001–2015 [1]. However, the period 2012–2015 could not have offered longer enough time horizon for the exchange rate policy regime change implemented in 2012 to have had a significant impact on inflation. This study, with a much longer time span, covering the period 2012–2019, is expected to provide more insights on the impact of both structural and policy changes on inflation in the country. Ngalawa and Viegi [7] uses the structural vector autoregressive model to investigate the transmission mechanism through which monetary policy affects domestic prices and output growth in Malawi. The results of the study reveal that the bank rate remained a more effective measure of monetary policy than reserve money over the period of the study. The results also support the narrative that price

economy.

in the short to medium term.

Section 5 concludes the chapter.

**2. Literature review**

**254**

stability remains the main objective of monetary policy in Malawi, despite revealing that monetary authorities also put emphasis on increasing economic growth and employment in the country. The results show also that the responses of exchange rate changes to monetary policy are stronger than those of consumer prices, suggesting that monetary factors may not be the dominant determinants of inflation in Malawi.

As is the case with Ngalawa and Viege [7], Mangani [8] examines the effectiveness of monetary policy in Malawi, but using bank rate and reserve money as measures of monetary policy stance, while using lending rate and broad money as intermediate targets. The results show that changes in the bank rate have an instantaneous impact on the lending rate and also the results reveal that the lending rate had an impact on changes in money supply. However, it was further observed that these effects were hardly transmitted to prices, indicating the ineffectiveness of the Keynesian interest rate view of the monetary policy transmission mechanism [8]. The results showed also that changes in exchange rate and money supply had a significant impact on prices, which is contrary to the classical view of the policy transmission mechanism, while the exchange rate itself was in turn affected by changes in money supply. Hence, it could be argued that the changes in consumer prices are more attributable to the exchange rate channel of the monetary policy transmission mechanism. However, further analysis shows that monetary policy played no role in the effects of the exchange rate movements on domestic prices over the period under study.

Jombo et al. [9] employs the augmented Phillips curve and vector autoregressive approaches to estimate the exchange rate pass-through to domestic inflation in Malawi over the period 1990–2013. The results show that exchange rate movements had a modest impact on domestic prices. However, it is argued that the dynamic exchange rate pass-through elasticity of 0.2 signifies that exchange rate still stood as a potential important source of inflation over the period of the study, hence the need for monetary authorities to pay attention to its movements. Mwabutwa et al. [10] uses the time varying parameter (TVP) VAR model with stochastic volatility that allows for the capturing of the variation of macroeconomic structure and changes in the transmission mechanism overtime, to examine the impact of bank rate, exchange rate and private credit shocks on output and price level. The model is used to simulate the impulse responses of output and price levels to financial and monetary policy shocks. The results reveal that by demarcating the analysis to focus on the period before and after financial reforms carried out between 1988 and 1994. The results indicate that changes in the transmission mechanism became clearer only after 2000, with monetary policy transmission performing in tandem with economic theory predictions without price surprises in the period after reforms especially after 2000, while it performed with price surprises in the period before the financial reforms carried out between 1988 and 1994. However, the results found a weak transmission mechanism through the credit channel especially through loans supply, calling for more financial strategies to improve the credit market system.

As per the results of other studies mentioned earlier, the findings from both Mangani [11] and Ngalawa [12] show that an increase in money supply leads to a decrease in price levels, which contradicts with the conventional monetary policy theory of inflation in Malawi, where an increase in money supply leads to an increase in price levels. In fact, in most of the periods an increase in money supply is associated with periods of falling inflation most of the times. In addition, and in line with the findings of Jombo et al. [9], these studies also reveal that while lending rate instantaneously responds to bank rate adjustments and though the lending rate somewhat influences money supply, the effects are hardly transmitted to prices. So they also observe that the Keynesian interest rate view of the monetary policy transmission mechanism does not apply to Malawi. Interest rates are found to affect inflation through the cost of production effect rather than through money supply effects. Also as is the case with Mangani [8] and Jombo et al. [9], these studies show that exchange rates have a much stronger effect on price levels in Malawi, reflecting the country's high level of openness and import dependence, making it highly vulnerable to foreign reserve situation due to the country's reliance on a narrow range of sources, most notably foreign aid and tobacco exports [13]. Matchaya [14] looks at the possible sources of inflation in Malawi and finds out that changes in money supply, exchange rates, past values of inflation, recessions and booms were the main determinants of inflation. These results are further supported by the findings from Simwaka et al. [15] where the results indicate that monetary and supply side factors drove inflation in Malawi over the period January 1995–March 2011. The study finds that money supply growth, exchange rate adjustments and decreases in output growth had a significant positive impact on inflation over the period. This result is also supported by Lungu et al. [16] which found that output gap has a negative impact on inflation over the period to some extent signifying the dominance of food prices in the consumer price index in Malawi.

interest rates and money growth rates are also expected to be positively correlated because of the positive correlation between average inflation rates and average

Fiscal deficits are one of the main factors that have been exerting inflationary pressures in most African countries. Especially when a country implements a regime of fiscal dominance or active fiscal policy, and passive monetary policy where monetary policy adjusts to deliver the level of seignorage required to balance the government's intertemporal budget [18]. In this case, the monetary authority is forced to generate enough seigniorage to satisfy the intertemporal budget balance condition. This will have an effect on prices and inflation since the changes in

An increase in the bank rate by the monetary authorities induces a rise in short term rates such as interbank rate and treasury bill rates which have an impact on other long-term lending rates. As a result of the rise in lending rates, both households and firms reduce their consumption and investment expenditures respectively, as real cost of borrowing increases. Households will mostly reduce their expenditures on consumption of luxury or durables goods due to the increased costs of borrowing. This leads to a decline in aggregate demand and consequently easing the inflationary pressures in the economy (see [20–22] among others for more details). Furthermore, when domestic interest rates increase relative to foreign interest rates, assuming uncovered interest rate parity, domestic currency depreciates in order to maintain equilibrium in the foreign exchange market of the domestic economy. This expected future depreciation induces an initial appreciation of the domestic currency making domestically produced goods more expensive than foreign-produced goods. Hence leading to a decline in net exports and aggregate demand as well as inflationary pressures. Also, the rise in domestic interest rates above foreign interest rates could also attract capital inflows, leading to an appreciation of the local currency. Thus, the precise impact of changes in exchange rate

The general form of the model to be estimated can be represented as:

the output gap,*et* is the nominal exchange rate, and *εt*is the error term. It is important to note that there could theoretically be interrelationships between the chosen explanatory variables in the model hence having an impact on inflation through different channels. For instance, based on the conventional real interest

impact on inflation. The exchange rate would have a direct impact on domestic prices through its impact on the cost of imported goods and through wages, but also

Since the objective of the chapter is to examine the drivers of inflation both in the short- and the long-run, the ARDL framework is deemed appropriate for this analysis because of the advantages it has over other methodologies. Contrary to the traditional error correction methodology, where it is imperative to carry out and establish the stationarity of the variables to be used in the short- and long-run analysis to establish their order of integration, the ARDL methodology, while

indirectly through its impact on output and net exports, hence affecting the inflation rate.<sup>3</sup> In this regard, this calls for caution in taking care of instances of

*;*ð Þ *et ;*ð Þ *mt yt*

where *inft* is the inflation rate, *it* is the interest rate, *fdt* is the fiscal deficit, *yt* is

<sup>þ</sup> *<sup>ε</sup><sup>t</sup>* (1)

and hence having an

*inft* ¼ *f m*ð Þ 2*<sup>t</sup> ; i*ð Þ*<sup>t</sup> ; fdt*

rate channel, interest rates could affect the output gap *yt*

autocorrelation and heteroscedasticity in the model.

money supply growth rates [18].

*Will Malawi's Inflation Continue Declining? DOI: http://dx.doi.org/10.5772/intechopen.91764*

may be uncertain.

<sup>3</sup> See [23] for more details.

**257**

seignorage affect the current and future money supply.
