MACROECONOMIC DYNAMICS

IN LOW INCOME ECONOMIES:

EVIDENCE FROM MALAWI
BERTHA CHIPO BANGARA

Background & Motivation

Low income countries (LICs) have certain
features different from the developed ones but
important in analysis; e.g. highly dependent on
foreign aid, mono-crop farming, import mostly
intermediate inputs and some capital, and face
foreign exchange (FX) problems (Moran 1989)
In Sub Saharan Africa (SSA), the average share
of intermediate imports in total imports
increased from about 30% to 50% in the 1980s
while consumer goods decreased.
There is an argument that availability and cost of
FX plays a crucial role in the production process
and the macroeconomic performance of LICs
(Senbeta, 2011, Lensink 1995, Moran, 1989).

Background &Motivation

Many studies have emphasized that availability and cost

of FX influences macroeconomic activity in less income
economies (e.g Agenor and Monteil, 2008; Lensink,
1995; Moran, 1989)
Stiglitz, JE, Ocampo, JA, Spiegel, S, French-Davis, RF
and Nayyar, D(2006) emphasise that apart from demand
constraints, supply constraints, generated by availability
of capital and FX are more important in LIEs.
LIEs fail to absorb shocks due to structure of their
economies which amplify than dampen the shocks
Studies that provide stylized facts on macroeconomic
dynamics in LIEs such as Malawi, with acute FX
constraints, have been scanty.
The World Bank defines LIEs as economies with GNI per
capita of $1,025 or less.

Why Malawi?
Malawi relies heavily on tobacco exports (80% of
total exports, 40% of GDP and 60% of FX earnings)
and foreign aid (40% of government budget).
Imports more than it exports (negative TB always)
Fixed and overvalued exchange rate for a long time
led to low FX reserves.
High prices of FX at the parallel market (100%
premium).
A year after 49% devaluation, FX problems still
exists.
No studies on how FX constraints and Tobacco
price shock affect the macro-economy of Malawi.
Studies on LIEs are done on panel level.

Figure 1: Exchange Rate and

Inflation

The overall objective is to examine the macroeconomic

dynamics of low income economies with FX constraints using
Malawi as the study area . This will be done by:
Estimating a small open economy model with foreign
exchange constraints and determine the dynamics of fiscal
policy
Estimating the equilibrium real exchange rate (ERER), passthrough and existence of J-Curve
Analysing the propagation of price shocks of the dominant
crop (tobacco) on key macroeconomic variables in Malawi

Research Objectives and Questions

This will answer these questions

Do foreign exchange constraints change the direction and
magnitude of various shocks (FP, MP, TOT, AID) in SOEs? If
so, to what extent?
Is the Malawi Kwacha overvalued? Is there a high exchange
rate pass-through? If so, are devaluations necessary for
Malawi?
Do shocks to tobacco prices affect key macroeeconomic
variables in Malawi?

Literature Review
1. Theoretical Literature
. DSGE models are the NK version of analysing macroeconomic issues and
are the main workhorse in RBC estimations (Senbeta, 2011). However,
not many studies have included features for LICs
. Inclusion of features specific to LICs such as aid, high government debts
and FX constraints into the RBC models with micro-foundations tend to
be necessary in the analysis of LICs.
. Exchange rate models with tradable and non-tradable sectors of the
economy and the analysis of commodity price shocks from oil price shocks
literature have been developed to suit LICs and this gives the theoretical
literature for this work.
2. Empirical Literature
. Moran (1989), Lensink (1995); Senbeta (2011) FX DSGE; Adam et al
(2009) Aid shocks on LDCs
. Sichei & Eita (2006), MacDonald & Ricci (2004) ERER on Nam and RSA
. Kwalingana, Simwaka & Chiumia (2012), Kamoto (2006), Newark (2004),
Musila (2003) effects of FX on TB and Inflation, Mathisen (2003), ERER
. Deaton & Miller (1995), Raddatz (2007), Conforti, Ferrari and Sarris
(2010) Price shocks

Data Sources
Study uses quarterly data (1980Q1-2012Q4) from
RBM, World Bank, IFS and NSO
Variables of interest are international tobacco prices,
(TP), TOT, AID, GovtEXP, taxes, EXR and REM
The period is dictated by important macroeconomic
decisions that the country has undertaken
(commercialisation of tobacco growing), structural
breaks (policy regimes, exchange rate regimes and
political
regimes) devaluations,
pegging and
floatation of the kwacha

Why DSGE?
Standard DSGE models assume capital and intermediate
inputs are produced domestically and remain silent on
challenges in LICs e.g FX, mono-crop, aid dependence,
imports of inputs.
DSGE models are structural, micro-founded, general
equilibrium and are not vulnerable to the Lucas Critique.
Due to a decline in demand for commodity prices due to the
financial crisis which decreased exports of LIEs, the
suitable models to analyse these shocks are structural.
Compared to their consequences in HICs, standard models
produce results contrary to outcomes when applied to LICs.
A few studies have incorporated some features of LICs in
DSGE models (see for example Senbeta, 2011 (FX), Adam,
OConnell and Buffie, 2008(Aid), Peiris and Saxegaard,
2007(MP)). However, not much has been done on FX and
Aid.

Methodology
A. An Estimated New Keynesian DSGE for a Foreign Exchange
Constrained Small Open Economy: (4-sector model)
The model is as in Senbeta (2011) and tork (2011) but builds
extensively on Gali and Monacelli (2005) to account for incomplete
pass-through and habit formation.
1.Household maximize instantaneous utility
2. Firms produce tradable and non-tradable good. We explicitly model
FX constraints in the non-tradable production as additional cost faced
by firms in importing inputs
s.t s.t and

3. Government and RBM conduct fiscal and monetary policy

with Govt BC having Taxes, Aid and other sources of income

B. Estimating the Equilibrium Real Exchange Rate, and

Pass-through: Does a J-Curve exist for Malawi?
1. Exchange Rate and Pass-through
. Johansens Full Information Maximum Likelihood (FIML) is used to estimate the existence
of a long-run ERER.
ERER is determined by TOT, Trade and exchange restriction, Government expenditure,
capital controls and technology
. Xt= f(REER, TOT, OPEN, INV) where Xt ix ERER, OPEN ,INV is ratio of investment to
GDP.
. We include FP, MP, GOVT consumption and technical progress following Mundell-Fleming.
In the short-run RER respond to these. The model is specified as:
Xt = f(REER, TOT, OPEN, INV; GCON, TECP, NCF, EXSDC, Dt, D1) , TECP measured by
industrial production index
where Dt is a seasonal dummy, D1 represents change in political regimes. We assume the
vector has a VAR representation of the form:
and
for VECM
2.Trade Balance (ARDL)
. TB = F(Y,E/P) where Y is output level, E is exchange rate and P is domestic price level.
Equation is extended as in Bahmani-Oskooee (1985) to include world income Y*, M, M*,
and a lag to the exchange rate variable to assess J-curve phenomena. The linear model is:
We expect ; is either positive or negative and ,

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

Approach
Since recursive analysis of VAR has controversies and validity
of Cholesky factorisation is questioned when there is
simultaneity problem among variables, the paper follows
Christiano, Eichenbaum and Evans (1998) in using a Structural
VAR assuming the shocks to tobacco price propagate in a
dynamic system as:
Since the above cannot be estimated, identification requires we
place restrictions on the B matrix.

One shock to tobacco prices is identified (world demand shock)

/tobacco production and prices,.
Variables to be considered M1, FXR, NFA, TOT, EX, GR and the
shock is Tobacco Prices (TP). The choice of variables is dictated
by the availability of data and how they react to changes in
tobacco prices
We determine stationarity, causality, IRFs and variance
decompositions for shocks, the long run and short run
relationships through a cointegration framework

Contribution to Literature

This thesis examines dynamics of macroeconomic

variables in LIEs using models adjusted for LIEs since
standard econometric models generate contrary
variability to what HIEs obtain
The thesis is the first study to estimate a NKDSGE
model with FX constraints for Malawi.
This thesis is the first to estimate ERER, pass-through
and J-Curve after the 49% devaluation of the Malawi
Kwacha
Studies on Malawi on tobacco have not examined how
tobacco price shocks influence macroeconomic
variables of the economy and this thesis closes this
research gap.
Analysis and policy recommendations that will be
provided may help in implementation of policy in LIEs
and assist in dampening macroeconomic shocks.

THANK
YOU