The Role of Energy Price Shocks in the Transmission of Monetary Policy in an Inflation Targeting Country: The Case of Ghana

Energy inflation has become more volatile and has evolved independently of other components of headline inflation over the years. Therefore, the use of one Phillips curve to capture short-run inflation dynamics may be inadequate in terms of helping the monetary policy authorities to determine the appropriate path of the monetary policy rate. Such an approach may introduce noise into the model system, making it difficult to get reliable forecasts for inflation. We extend the existing New-Keynesian model to include separate Phillips curves for energy inflation and non-energy inflation. This approach would help the monetary policy authority in Ghana to gain a deeper understanding of how shocks to energy prices affect inflation, thereby leading to informed decisions about the appropriate path of the monetary policy rate in Ghana. We also incorporate a fiscal block to capture the effects of fiscal deficits on inflation in Ghana. We use the extended model to study the transmission mechanisms of the real economy, and of the exchange rate. This analysis allows us to understand the importance of these shocks in explaining inflation developments in Ghana and their implications for monetary policy. The results are mixed, indicating that isolating energy price from the rest of prices in the CPI basket does not necessarily improve the forecasts of the key macroeconomic variables, and will therefore not necessarily lead to better policy outcomes.