**1. Introduction**

Malawi is a small country located in the Southern part of Africa, with a surface area of 118,484 square kilometres, total length of 853 km and a maximum width of 257 km. It is a former British colony that gained independence in 1964. Its economy is mainly dependent on agriculture which employs about 65% of the workforce in the country, and contributing about 36% to the economy's gross domestic product (GDP). More than 90% of the country's export revenues come from the agriculture sector. The sector is one of the main contributors to the country's building of inflationary pressures as it occupies the largest proportion of the country's inflation basket designed by the country's National Statistical Office (NSO).

High inflation and fluctuation in prices is not preferred as it leads to uncertainty and cost push shocks which affect the stability and performance of economies [1]. This being the case, maintaining relatively low inflation and price stability has been one of the core objectives targeted by the monetary authorities in designing and implementing monetary policy in Malawi. Before 2012, Malawi operated a de facto pegged exchange rate regime with periodic devaluations. The national currency was pegged to the US dollar and kept an overvalued exchange rate. However, in 2012 Malawi implemented a floating exchange rate regime where prices and exchange

rates move based on economic fundamentals [1]. During the same period, the country adopted an automatic fuel pricing mechanism, which together with the newly implemented floating exchange rate regime was aimed at addressing the country's balance of payments problems.

As has been the case with most developing countries in Africa, the main objective of the monetary policy in Malawi has been to achieve low and stable prices that preserve the value of the Kwacha (the local currency), and encourages investment needed to achieve sustainable economic growth and create employment as stipulated in the Reserve Bank of Malawi Act of 1989 [2]. This is because price stability enhances investors' confidence as it reduces uncertainty in an economy and, thereby creating a favorable environment for growth and employment creation. Furthermore, low inflation contributes to the protection of the purchasing power of all households, particularly the poor who have no means of defending themselves against continually rising prices. However, the implementation of such a broad mandate could be practically challenging, since some of the policy objectives could be in conflict with each other [3]. Nonetheless, monetary policy pursued by most developing countries has managed to bring down inflation over the past two decades, with significant growth being experienced in most countries in the past decade or so [4].

In Malawi, monetary policy implementation continues to be underpinned by inflation dynamics especially by the dominance of the agricultural sector activities and the country's reliance on donor funding which contributed about 40% of the country's budget before the "Cash-gate scandal"<sup>1</sup> which led to withdrawal of donor funding in 2013. With the economy's dependence on agriculture, inflation in Malawi normally improves with improved food availability and tobacco sales, mostly from April to September every year. It then accelerates with food scarcities and excessive demand for foreign exchange from October to March [5]. However, it is claimed that the country's monetary policy does not seek to address these dynamics but rather to achieve a balance between output growth and monetary aggregates as well as smoothening of exchange rate movements. With the belief that these inflation dynamics will improve over time as production structures respond to macroeconomic stability in the context of a market-determined exchange rate [2]).

large scale theft of public funds coined the "cash-gate scandal". These developments exerted inflationary pressures in the economy, with inflation hovering to as high as 37.9% by February 2013, mainly driven by food prices, especially maize prices following poor agricultural performance and depreciation of the exchange rate [2]. Furthermore, financing of the fiscal deficits in the aftermath of the scandal was done through printing of money and the issuing of government securities to the private sector. In addition, the economy suffered from the effects of a combination of droughts and floods resulting in a reduction in agricultural production leading to

*Inflation, exchange rate and interest rate dynamics, January 2001–June 2019. Source: [6].*

During this period, in May 2012, the exchange rate depreciated by 49% against the major currencies leading to a significant increase in inflation rate. As a consequence, interest rates increased to contain the inflationary pressures induced by the depreciation of the local currency, and also to contain inflationary expectations pressure accumulated over the preceding period. Furthermore, apart from the inflationary expectations arising from the continued uncertainty in the exchange rate policy, increasing food prices, especially maize prices, exacerbated the situation [2]. Inflation rates, interest rates and nominal exchange rates reached their highest levels over the period May 2012 to May 2013. Rising as high as 38%, 41% and 355 Kwacha per US/\$ respectively, the highest levels after a long time. **Figure 1** shows that after this period both inflation and interest rates begun to decline, while

Continued exchange rate depreciation and relatively tight monetary policy have further resulted into inflationary pressures, exacerbated by the substantial increase in government domestic borrowing due to donor suspension of direct budget support to the Malawi Government due to the Cashgate scandal [2]. This raised domestic financing requirements by government, hence creating more liquidity in the economy. This also heightened pessimistic inflation expectations by the public and precipitated exchange rate depreciation. These developments led to an increase in money supply growth and inflation [2]. It should also be noted that despite the continued decline in the global oil prices during the period, its impact has not fully been translated into the Malawian economy because the automatic pricing mechanism on energy prices adopted since 2012 has not consistently been reflecting this decline [2]. Food prices especially maize during the harvesting seasons were also not

a sharp increase in food inflation [1].

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

**Figure 1.**

**253**

the exchange rate continued to depreciate.

**Figure 1** shows that interest rates reached as high as 52% in 2000, mainly driven by increased deficit financing as the IMF stopped aid disbursements due to corruption concerns in December 2000, and many individual donors followed suit, resulting in an almost 80% drop in Malawi's development budget. The continued deficit financing led to an increase in liquidity in the economy, exerting pressure on both interest rates and domestic prices. Since then both interest rates and inflation declined significantly due to improved fiscal management and increased real growth, with interest rates, inflation, money supply and GDP growth averaging 24.3%, 10.9%, 1.9% and 6.3% respectively over the period 2005–2009.

However, since 2005, Malawi enjoyed price stability as inflation declined from 16% to 7.2% in March 2011. Overall, inflation remained moderate and in single digits since 2007, mainly due to a relentless adherence to a tight monetary policy, heavily buttressed by fiscal discipline and stable exchange rate up-to January 2012 when it jumped to 10.3% (**Figure 1**). However, inflation remained persistently high since 2012, mainly due to the country's switch from a fixed to a floating exchange rate regime, which led to a sharp depreciation of the exchange rate which was further exacerbated by the withdrawal of external budget support following the

<sup>1</sup> "Cashgate" is a financial scandal involving looting, theft and corruption that happened at Capital Hill the seat of Government of Malawi.

#### **Figure 1.**

rates move based on economic fundamentals [1]. During the same period, the country adopted an automatic fuel pricing mechanism, which together with the newly implemented floating exchange rate regime was aimed at addressing the

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

As has been the case with most developing countries in Africa, the main objective of the monetary policy in Malawi has been to achieve low and stable prices that preserve the value of the Kwacha (the local currency), and encourages investment needed to achieve sustainable economic growth and create employment as stipulated in the Reserve Bank of Malawi Act of 1989 [2]. This is because price stability enhances investors' confidence as it reduces uncertainty in an economy and, thereby creating a favorable environment for growth and employment creation. Furthermore, low inflation contributes to the protection of the purchasing power of all households, particularly the poor who have no means of defending themselves against continually rising prices. However, the implementation of such a broad mandate could be practically challenging, since some of the policy objectives could be in conflict with each other [3]. Nonetheless, monetary policy pursued by most developing countries has managed to bring down inflation over the past two decades, with significant growth being experienced in most countries in the past

In Malawi, monetary policy implementation continues to be underpinned by inflation dynamics especially by the dominance of the agricultural sector activities and the country's reliance on donor funding which contributed about 40% of the country's budget before the "Cash-gate scandal"<sup>1</sup> which led to withdrawal of donor funding in 2013. With the economy's dependence on agriculture, inflation in Malawi normally improves with improved food availability and tobacco sales, mostly from April to September every year. It then accelerates with food scarcities and excessive demand for foreign exchange from October to March [5]. However, it

is claimed that the country's monetary policy does not seek to address these dynamics but rather to achieve a balance between output growth and monetary aggregates as well as smoothening of exchange rate movements. With the belief that these inflation dynamics will improve over time as production structures respond to macroeconomic stability in the context of a market-determined exchange rate [2]). **Figure 1** shows that interest rates reached as high as 52% in 2000, mainly driven by increased deficit financing as the IMF stopped aid disbursements due to corruption concerns in December 2000, and many individual donors followed suit, resulting in an almost 80% drop in Malawi's development budget. The continued deficit financing led to an increase in liquidity in the economy, exerting pressure on both interest rates and domestic prices. Since then both interest rates and inflation declined significantly due to improved fiscal management and increased real growth, with interest rates, inflation, money supply and GDP growth averaging

24.3%, 10.9%, 1.9% and 6.3% respectively over the period 2005–2009.

However, since 2005, Malawi enjoyed price stability as inflation declined from 16% to 7.2% in March 2011. Overall, inflation remained moderate and in single digits since 2007, mainly due to a relentless adherence to a tight monetary policy, heavily buttressed by fiscal discipline and stable exchange rate up-to January 2012 when it jumped to 10.3% (**Figure 1**). However, inflation remained persistently high since 2012, mainly due to the country's switch from a fixed to a floating exchange rate regime, which led to a sharp depreciation of the exchange rate which was further exacerbated by the withdrawal of external budget support following the

<sup>1</sup> "Cashgate" is a financial scandal involving looting, theft and corruption that happened at Capital Hill

country's balance of payments problems.

decade or so [4].

the seat of Government of Malawi.

**252**

*Inflation, exchange rate and interest rate dynamics, January 2001–June 2019. Source: [6].*

large scale theft of public funds coined the "cash-gate scandal". These developments exerted inflationary pressures in the economy, with inflation hovering to as high as 37.9% by February 2013, mainly driven by food prices, especially maize prices following poor agricultural performance and depreciation of the exchange rate [2]. Furthermore, financing of the fiscal deficits in the aftermath of the scandal was done through printing of money and the issuing of government securities to the private sector. In addition, the economy suffered from the effects of a combination of droughts and floods resulting in a reduction in agricultural production leading to a sharp increase in food inflation [1].

During this period, in May 2012, the exchange rate depreciated by 49% against the major currencies leading to a significant increase in inflation rate. As a consequence, interest rates increased to contain the inflationary pressures induced by the depreciation of the local currency, and also to contain inflationary expectations pressure accumulated over the preceding period. Furthermore, apart from the inflationary expectations arising from the continued uncertainty in the exchange rate policy, increasing food prices, especially maize prices, exacerbated the situation [2]. Inflation rates, interest rates and nominal exchange rates reached their highest levels over the period May 2012 to May 2013. Rising as high as 38%, 41% and 355 Kwacha per US/\$ respectively, the highest levels after a long time. **Figure 1** shows that after this period both inflation and interest rates begun to decline, while the exchange rate continued to depreciate.

Continued exchange rate depreciation and relatively tight monetary policy have further resulted into inflationary pressures, exacerbated by the substantial increase in government domestic borrowing due to donor suspension of direct budget support to the Malawi Government due to the Cashgate scandal [2]. This raised domestic financing requirements by government, hence creating more liquidity in the economy. This also heightened pessimistic inflation expectations by the public and precipitated exchange rate depreciation. These developments led to an increase in money supply growth and inflation [2]. It should also be noted that despite the continued decline in the global oil prices during the period, its impact has not fully been translated into the Malawian economy because the automatic pricing mechanism on energy prices adopted since 2012 has not consistently been reflecting this decline [2]. Food prices especially maize during the harvesting seasons were also not 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 economy.

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

As is the case with Ngalawa and Viege [7], Mangani [8] examines the effective-

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

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

ness 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

in Malawi.

over the period under study.

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

market system.

**255**

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 in the short to medium term.

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 Section 5 concludes the chapter.
