Exchange Rate Policy and Price Determination in Botswana

"The dominant influence of South African goods on the Botswana CPI basket leads to the expectation that South African prices have a significant role in determining prices in Botswana. This paper examines Botswana's price and inflation relationships and their interaction. Cointegration analysis is used to develop a dynamic error correction model that establishes the link between long-run equilibrium prices and short-run inflation. Results show that the exchange rate (and South African prices), rather than money, are cointegrated with prices, supporting theoretical predictions of a dominant long-run equilibrium relationship between prices and the exchange rate in a pegged exchange rate regime with capital controls. In the short run, both domestic prices and imported inflationary pressures determine growth in the price level each month. This suggests that monetary, exchange rate and fiscal policy can be used to temper inflation in the short run. Changes in the exchange rate and prices will only have short-term price competitiveness effects, however. Over time adjustment back to the equilibrium real exchange rate occurs."