In this study, we proffer that the relationship between inflation and dollarization is asymmetric. In essence, countries react differently to changes in the inflation and exchange rate volatility (ERV) episodes. As such, it is important for studies to consider the role of heterogeneity when issues of dollarization are raised. Previous studies have not done so.
Previous studies have argued for the importance of structural breaks in exchange rate dynamics. This paper seeks to address the issue of hypothesized asymmetry through the use of the nonlinear autoregressive distributed lags (NARDL) approach proposed by Shin et al (2014). To test for structural break(s), we rely on the Bai-Perron (2003) test.
Four yardsticks were used to select our scope: (i) high levels of dollarization and ERV (Sierra Leone); (ii) low levels of dollarization and ERV (South Africa); (iii) high level of dollarization and low level of ERV (Togo); and (iv) low level of dollarization and high level of ERV (Burundi). Our methodology decomposes the variable of interest into depreciation and appreciation of ERV.
The objectives of this study are in two variants. The first relates to seeking a plausible explanation for the occurrence of a ratchet effect based on the assumption of the important role of asymmetric characteristics of the selected Sub-Saharan African countries. The second objective would be to validate if the result is sensitive to structural breaks. The objectives of this study add novelty and value to the existing stock of knowledge.
It is anticipated that there is a short-run asymmetric effect on dollarization in Sierra Leone, South Africa and Burundi. In the case of Togo, we found a symmetric effect. However, having accounted for breaks, asymmetry became evident in both the short- and long-run. These results are sensitive to changes in data frequencies and robust to alternative measure of volatility.