Estimating Bilateral Exchange Rate and Inflation Interdependencies: A Case Study of Guinea and Sierra Leone

This study investigates the relationship between bilateral exchange rate fluctuations between the Leone and Guinean Franc and inflation dynamics in Sierra Leone, emphasizing the vulnerability of the latter's economy to external shocks from its larger neighbor. Utilizing a Seemingly Unrelated Regression (SUR) approach, the study examines monthly data from January 2014 to December 2023 to reveal insights into the Bilateral Exchange Rate Depreciation on inflation in Sierra Leone. Specifically, the study concludes that for every 1% depreciation of the Leones against the Guinean Franc, there is a corresponding 0.62 percentage point increase in inflation within Sierra Leone. Furthermore, the analysis indicates a negative correlation between inflation in Sierra Leone and Guinea, indicating counter-movements between the two variables. The Breusch-Pagan test of independence validates the use of a SUR model to account for systematic interdependency or correlation in the residuals. The testing of cross-equation constraints demonstrates a distinct and statistically significant impact of the depreciation of the bilateral exchange rate on inflation in Sierra Leone and Guinea. Overall, this research contributes to our understanding of the complex relationship between exchange rates and inflation within the West African context, informing evidence-based policy decisions. The study accentuates the critical importance of exchange rate stability, effective monetary policy tools, and cross-border economic surveillance to mitigate inflationary pressures and ensure economic stability in Sierra Leone, with a specific focus on interventions by the Bank of Sierra Leone, controlling of currency in circulation and better management of the frequent price shocks from global energy markets.