Small Country Experiences with Exchange Rates and Inflation: The Case of Botswana

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