Determinants of Inflation in a Dollarized Economy: The Case of Zimbabwe

Adverse inflationary pressure has been a persistent feature of the Zimbabwean economy under a dollarized regime, which was adopted in January 2009. Since the beginning of 2012, the country’s annual inflation has been on a downward trend, initially exhibiting characteristics of disinflation and subsequently deflation. This paper seeks to shed some light on the determinants of inflation in Zimbabwe under dollarization. The study applies a single error correction model (ECM) to investigate possible short and long-run determinants of Zimbabwe’s overall, food and nontradables' consumer price indices (CPIs) for the period January 2010 to December 2015. The main findings are that the country’s long-run price level is influenced by changes to the South African Rand/US Dollar exchange rate and South African inflation given the high trade linkages between the two countries, mainly dominated by Zimbabwe’s imports of raw materials, and intermediate and consumer goods from that country. On the other hand, domestic fuel price movements have an impact on the country’s price level as it imports all its fuel. In order to avert a deflationary spiral, authorities need to mobilize significant domestic public, private-sector and international funding in order to increase the capital stock, refurbish the existing infrastructure and invest in new infrastructure projects in order to increase the country’s potential output.