i 

EMPIRICAL ANALYSIS OF MONEY DEMAND IN 

GHANA: IMPLICATIONS FOR INFLATION TARGETING 

 
       

BY 

 

 

REXFORD K. ASIAMA 

(10444061) 

 

THIS THESIS IS SUBMITTED TO THE UNIVERSITY OF GHANA, LEGON IN 

PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE AWARD OF 

THE MPhil ECONOMICS DEGREE 

 

 

 

 

 

 

JUNE, 2015 

 

 

 

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 ii 

 

 

 

DECLARATION 

I, REXFORD K. ASIAMA, hereby declare that, apart from the works of other people, 

which have been duly referenced; this research work is entirely mine and is not the work 

of any error of omission or commission. 

 

 

 

………………………………….. 

REXFORD K. ASIAMA 

(Student) 

 

 

…………………………………                          ………………………………… 

PROF. PETER QUARTEY                                        DR. ALFRED BARIMAH 

 

 

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ABSTRACT 

Getting monetary policy right is crucial to the health of any economy (Mishkin, 2004). 

While the current policy regime is expected to have better control at inflation, certain 

issues have cast doubt on the effectiveness of the policy regime.  As a result, monetary 

aggregate targeting has surfaced and a commitment has been made to incorporating this 

in the current policy framework. This has raised the importance of the demand for money 

function for Ghana again.  

The study estimates a long run demand for money function, determines the stability of 

the long run demand for money function and determines the causal links between demand 

for broad money and the inflation-targeting regime for Ghana.  The study uses time series 

data over the period 1979 to 2014.  

The cointegration approach by Pesaran et al. (2001) and the causality approach by Toda 

and Yamamoto (1995) were employed in estimating the models. The Bounds test to 

cointegration revealed that all the variables in the money demand function – inflation, 

dollar exchange rates, GDP growth, money supply growth and the inflation-targeting 

regime converged to long run equilibrium once there were deviations in the short run. 

Both CUSUM and CUSUMSQ tests showed that this long-run relationship was stable 

and converged to equilibrium.  

In the long run, while inflation and money supply were found to negatively impact 

demand for broad money, the dollar exchange rates and inflation were found to positively 

impact demand for broad money in the short run. These relationships were statistically 

significant at 5%.  

The study finds causality also for demand for broad money and inflation and suggests 

that the direction of policy to include monetary aggregate targeting is favorable.   

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DEDICATION 

This thesis is dedicated to Dennis, Derrick, Christina, Samuel and Samantha.  I would be 

nowhere if it had not been for your support.  

 

 

 

 

 

 

 

 

 

 

 

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ACKNOWLEDGEMENT 

I wish to thank God for strength and health during the period of this thesis.  

I sincerely acknowledge the support and help of Mr. Anthony Amoah, Mr. Edmund 

Kwablah, and Dr. Johnson Asiama for their time and effort in shaping this thesis into 

what it has become. To Dr. Asiama especially, I am grateful for the motivation. God 

bless you richly.   

To Dr. Edem E. Selormey, Dr. Franklin Oduro and Prof. E. Gyimah-Boadi, I am grateful 

for the opportunity they provided for me to learn. Their continuous advice and guidance 

has contributed to the success of this project. I am exceedingly grateful to them.  

Also, my sincere thanks go to my supervisors Prof. Peter Quartey and Dr. Alfred 

Barimah. I am grateful for their useful comments and supervision.  

Lastly, my heartfelt gratitude goes to my parents, Mr. and Mrs. Asiama, whose support 

kept me through the period of this work. They always see the best in me even when 

nobody does.  

God richly bless you.  

 

 

 

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 vi 

TABLE OF CONTENTS 

DECLARATION............................................................................................................... ii 

ABSTRACT ...................................................................................................................... iii 

DEDICATION.................................................................................................................. iv 

ACKNOWLEDGEMENT ................................................................................................ v 

TABLE OF CONTENTS ................................................................................................ vi 

LIST OF FIGURES ....................................................................................................... viii 

LIST OF TABLES ......................................................................................................... viii 

ABBREVIATIONS ........................................................................................................... x 

CHAPTER ONE ............................................................................................................... 1 

INTRODUCTION............................................................................................................. 1 

1.0 Background to the Study .............................................................................................................................. 1 
1.1 Statement of the Problem ............................................................................................................................. 5 
1.2 Objectives of the Study................................................................................................................................. 7 
1.2.1 General Objective ....................................................................................................................................... 7 
1.2.2 Specific Objectives ..................................................................................................................................... 7 
1.3 Research Hypotheses ..................................................................................................................................... 7 
1.4 Significance of the Study ............................................................................................................................. 8 
1.5 Chapter Disposition ....................................................................................................................................... 9 

CHAPTER TWO ............................................................................................................ 10 

LITERATURE REVIEW .............................................................................................. 10 

2.0 Introduction ................................................................................................................................................... 10 
2.1 Theoretical Review ..................................................................................................................................... 10 
2.1.1 Inflation Targeting ................................................................................................................................... 10 
2.1.2 Theories on Money Demand ................................................................................................................ 15 
2.1.2a Quantity Theory of Money ................................................................................................................. 15 
2.1.2b Liquidity Preference Theory .............................................................................................................. 16 
2.1.2c Modern Quantity Theory of Money ................................................................................................. 17 
2.1.2d Cambridge Approach to Money Demand ...................................................................................... 19 
2.2. Empirical Literature Review ................................................................................................................... 20 
2.2.1 Inflation Targeting and Monetary Policy ......................................................................................... 21 
2.2.2 Monetary Policy and Money Demand .............................................................................................. 25 
2.3 Conclusion ..................................................................................................................................................... 34 

 

 

 

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CHAPTER THREE ........................................................................................................ 36 

TRENDS ON ECONOMIC GROWTH, INFLATION, AND MONEY SUPPLY 

AND A BACKGROUND TO POLICY FRAMEWORKS IN GHANA .................... 36 

3.0 Introduction ................................................................................................................................................... 36 
3.1 Trends of GDP Growth, Inflation and the Growth of Money Supply in Ghana ...................... 36 
3.2 Background to Monetary Policy Frameworks in Ghana ................................................................. 46 
3.3 Conclusion ..................................................................................................................................................... 50 

CHAPTER FOUR ........................................................................................................... 51 

METHODOLOGY ......................................................................................................... 51 

4.0 Introduction ................................................................................................................................................... 51 
4.1 Theoretical Framework .............................................................................................................................. 51 
4.2 Empirical Models ........................................................................................................................................ 52 
4.3 Stationary Tests ............................................................................................................................................ 61 
4.4. Lag Length Determination Tests ........................................................................................................... 62 
4.5 Estimation Methods .................................................................................................................................... 63 
4.6 Data .................................................................................................................................................................. 63 
4.7 Conclusion ..................................................................................................................................................... 65 

CHAPTER FIVE ............................................................................................................ 66 

RESULTS AND DISCUSSION ..................................................................................... 67 

5.0 Introduction ................................................................................................................................................... 67 
5.1 Descriptive Statistics .................................................................................................................................. 68 
5.2 Unit Root Tests ............................................................................................................................................ 70 
5.3 Tests for Cointegration .............................................................................................................................. 72 
5.4 Tests for Causality....................................................................................................................................... 79 
5.5 Conclusion ..................................................................................................................................................... 83 

CHAPTER SIX ............................................................................................................... 84 

SUMMARY, CONCLUSIONS AND RECOMMENDATIONS ................................ 84 

6.0 Introduction ................................................................................................................................................... 84 
6.1 Summary of the Study ............................................................................................................................... 84 
6.2 Conclusions of the Study .......................................................................................................................... 86 
6.3 Recommendations ....................................................................................................................................... 88 

REFERENCES ................................................................................................................ 91 

APPENDICES ............................................................................................................... 106 

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LIST OF FIGURES 

Figure 3.0 Trends in Inflation, Money supply and Growth Under Monetary Targeting .................. 39 

Figure 3.1 Trends in Inflation, Money supply and Growth Under Inflation Targeting..................... 41 

Figure 3.2 Trends in Inflation, Money supply and Growth from 1979-2014 ....................................... 44 

Figure 5.0 Plot of Cumulative Sum of Recursive Residuals (CUSUM) ................................................ 77 

Figure 5.1 Plot of Cumulative Sum of Squares of Recursive Residuals (CUSUMSQ) .................... 78 

 

 

 

 

 

 

 

 

 

 

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 ix 

LIST OF TABLES 

Table 3.0 Decadal Mean and Median Inflation, GDP and Money Supply Rates ................................ 46 

Table 3.1 Inflation, GDP and Money Supply Growth Rates per Policy Regime ................................ 48 

Table 4.0 Summary of Description of Variables ........................................................................................... 65 

Table 5.1 Summary Statistics of the Variables, 1979-2014 ....................................................................... 68 

Table 5.2 Tests for Unit Root in the Variables at their Log Levels ......................................................... 70 

Table 5.3 Tests for Unit Root in the Variables at their Log Difference ................................................. 71 

Table 5.4: Bounds Test for Cointegration ....................................................................................................... 72 

Table 5.5 Estimated long-run coefficients ....................................................................................................... 74 

Table 5.5.1 Error Correction Model .................................................................................................................. 75 

Table 5.6 Lag Selection Procedure .................................................................................................................... 80 

Table 5.7 Results of the Toda and Yamamoto Causality Test .................................................................. 81 

 

 

 

 

 

 

 

 

 

 

 

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ABBREVIATIONS 

ADF          Augmented Dickey Fuller  

AIC            Akaike Information Criteria 

ARDL        Autoregressive Distributed Lag  

BOG          Bank of Ghana 

DISC          Discount Rate 

ERP            Economic Recovery Program 

FPE             Final Prediction Error 

GARCH      General Autoregressive Conditional Heteroskedasticity  

GDP            Gross Domestic Product 

GETS          General to Specific 

GSS             Ghana Statistical Service 

HIPC            Highly Indebted Poor Country  

HQ               Hannan-Quinn 

IMF              International Monetary Fund 

JML              Johansen Maximum Likelihood 

LPG              Liquefied Petroleum Gas  

LR                Likelihood Ratio 

MMINT        Money Market Rate 

MPC             Monetary Policy Committee  

OLS              Ordinary Least Squares 

PIC               Pacific Island Countries 

PNDC          Provisional National Defence Council 

PNG             Papua New Guinea 

PP                 Phillips Perron 

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RESBANK   Reserve Bank of South Africa  

SIC              Schwartz Information Criteria  

SUR            Seemingly Unrelated Regression  

SVAR          Structural Vector Auto-regression  

VAR            Vector Auto-regression  

 

 

 

 

 

 

 

 

 

 

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CHAPTER ONE 

INTRODUCTION 

1.0 Background to the Study  

Getting monetary policy right is crucial to the health of any economy (Mishkin, 2004). 

Monetary policies, over the years, have developed to better achieve economic targets 

such as increasing the growth of real output, the reduction in unemployment, stability in 

exchange rate markets and the attainment of low and stable price levels. The different 

kinds of monetary policies that economies have used over time had been designed to 

solve economic challenges at the time and had been reviewed based on the results of 

some key indicators such as the rate of inflation.   

 

Over time, monetary policies of countries showed that countries have moved from 

periods of targeting precious items such as gold
1
 to targeting variables such as the 

exchange rates, money and inflation. The implementers of policies such as the gold 

standard realized the shortcoming of this policy and additional ones such as targeting 

monetary variables and exchange rates and developed improved frameworks in order to 

enhance the ability of monetary policy institutions to control target variables of policy 

(price levels, exchange rates and the growth of real output).  

 

                                                             
1
 The gold standard existed as monetary policy regime where the value of a currency of a country was 

directly linked to a fixed amount of gold. See Schwartz (1987) and Bordo (2003).  

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Currently, the policy of targeting inflation is practiced among central banks in emerging 

market or low-income economies across the globe (Roger, 2010). This policy is 

theoretically viewed as an improvement, compared to other policies such as monetary 

aggregate and exchange rate targeting. This is because regimes that targeted inflation 

basically provided the opportunity for central banks to improve transparency with the 

public as it worked solely to achieve low and stable price levels. Yet limiting monetary 

policy solely to price stabilization cannot guarantee economic growth will improve since 

low inflation does not essentially lead to high economic growth (Epstein, 2007).   

For policy makers however, this policy does not entirely sound new ringing tones. 

Countries such as New Zealand, Canada and the United Kingdom were notably the first 

set of countries to have practiced inflation targeting as a monetary policy framework in 

the late 19
th

 century (Mishkin, 2004). Other countries that followed shortly after included 

Sweden, Finland, Australia, Spain, Israel, Chile and Brazil (Mishkin, 2001). The United 

States however, seems to have similar structure to inflation targeting and is believed to be 

practicing implicit inflation targeting (Thornton, 2011).  

On the African continent, most countries have not fully embraced inflation targeting as a 

policy. Some countries still suffer from high inflation, unemployment and low economic 

growth. For various number of reasons, countries such as Liberia
2
, Rwanda

3
, Burundi

4
, 

The Democratic Republic of Congo
5
, and Central African Republic

6
 have experienced 

                                                             
2
 See IMF (2013). Letter of Intent, Memorandum of Economic and Financial Policies and Technical 

Memorandum of Understanding.  
3 See Rwangombwa (2015).  Monetary Policy and Financial Stability Statement.  
4
 See Ciza (2014). Monetary Policy Formulation Process: Experience of Burundi.  

5
 See Fischer et al. (2013). Making Monetary Policy More Effective: The Case of the Democratic Republic 

of Congo.  
6
 See IMF (2013).  Central African Economic and Monetary Community. Staff Report on Common Policies 

for Member Countries.  

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years of civil conflict and hence are not explicit inflation targeters. This, in addition to 

other factors such as corruption and politics, have not helped in embracing policies such 

as inflation targeting which require a more open, transparent and accountable central 

bank; one that is independent of governments and their pervasive influence. Other 

countries such as Togo, Zimbabwe, Libya have suffered political autocracies that have 

not allowed for flexible monetary policies because of the stringent rules of government 

leaders in these countries, over the times in which they have spent as presidents (Bijl, 

2013; Makochekanwa, 2008; Brett, 2006).  

Leading the way in the adoption of inflation targeting in Africa was South Africa and 

Ghana. These were the first two countries to have adopted inflation targeting fully 

(Heintz and Ndikumana, 2010). In South Africa, the full adoption of inflation targeting 

was in February 2000, after implicit practice began in August 1999. The Reserve Bank of 

South Africa (RESBANK) is the main institution that conducts inflation targeting and 

uses the cash reserve system as a framework for implementing their policy framework. 

Their cash reserve system was designed to manage liquidity needs of the economy by 

levying a cap on the amount that banks could borrow from the central bank of South 

Africa (RESBANK, 2015)  

For Ghana on the other hand, inflation targeting was practiced implicitly as a policy 

framework in the year 2002 (Burke, 2008). After five years of implicit practice of this 

framework (2007), the central bank announced full adoption of the inflation-targeting 

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regime for Ghana using the policy rate as its main operating instrument to control 

inflation
7
  

Under this framework, the Bank of Ghana (BOG) is mandated to ensure that there is low 

inflation that supports government’s prime economic objectives of growth and 

employment. A desired inflation target of 10%
8
 and below is optimal. However, the 

position of the Bank is that it is not bound to explain to the Finance Ministry in Ghana or 

to parliament whether the target was achieved or not. According to the BOG (2015), 

“when inflation stays above target for some obvious reasons, the Monetary Policy 

Committee (MPC) has the mandate to steer interest rates so that inflation can be brought 

back to target within a reasonable period of time without creating undue instability in the 

economy”  

The experience of Ghana in the period of inflation targeting could not be the same as that 

of South Africa. Compared to Ghana, average inflation rates in South Africa have been 

low since 2006, with the highest of 10% being recorded in 2008 (Triami Media, 2015). In 

the most part, the Ghanaian economy has not performed well in line with controlling 

inflation over the past couple of years, although some political points had been scored on 

the basis of the attainment of single-digit inflation.  

For monetary policy, recent developments have suggested a shift back to monetary 

aggregate targeting, although the inflation targeting framework is not being abandoned. 

This has raised the subject of the money demand function for Ghana again. By analyzing 

the money demand function for Ghana, inferences can be drawn in order to comment on 

                                                             
7
 See Ghana Web (2007).  Bank of Ghana adopt Inflation Targeting.  

8
 See Bank of Ghana (BOG) Official Website. Monetary Policy; Our Monetary Policy Framework.  

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the success of monetary aggregate targeting as a recent policy development for the policy 

framework that Ghana is currently pursing.   

1.1 Statement of the Problem 

The incorporation of monetary aggregate targeting in the inflation-targeting regime in 

Ghana has not been worked on in recent literature. For Ghana, this has become a new 

area of concentration for monetary policy. Over the last couple of years, the Ghanaian 

economy has suffered major shocks such as foreign exchange pressures, huge import 

bills, large wage bills and domestic oil shortages, that place extra pressure on prices to 

rise. Inflation rates in Ghana, for example, reduced from a year-end value of 16% in 2004 

to 13% in 2007, when the central bank formally adopted the framework. In the year 2008, 

inflation stood at 18% and reduced to 8.58% in 2010. This rate stayed at 8.58% in 2011 

and shot up to high of 17% at the end of 2014 (GSS, 2015). For the year 2015, the US 

dollar exchange rate hit over GHC 4 
9

, despite earlier interventions like Cocoa 

syndication loans and Euro Bonds that came in the course of the year 2014.  

As a result, some of these shocks suffered by the economy have contributed to the 

stability of prices being out of targeted range. As one of the recommendations to improve 

monetary policy performance for Ghana, the central bank was recently required by the 

IMF to reduce support in paying government deficits and expenses of state owned 

agencies in its policy framework. 

The current IMF program also incorporated limits on monetary aggregates as quantitative 

benchmarks. That is, the central bank, in a memorandum of understanding with the 

                                                             
9
 See Triami Media (2015). Daily exchange rates between the Ghana cedi and the US dollar between 

19/12/2015 and 16/5/2015.  

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Finance Ministry, was asked to reduce to its support to government to 5% of revenues of 

the previous year; a reduction from the existing 10% (IMF, 2015).  

Enforcing such new recommendations suggests a shift back to controlling money supply 

especially to the central government and state-owned agencies and raises the question of 

the role that the money demand function plays in targeting monetary aggregates in the 

current monetary policy framework. This is where the gap for Ghana exists. 

With such an understanding, theory posits that controlling money supply is most often 

anchored in the face of a stable money demand function. Indeed, the argument for 

controlling inflation through monetary aggregate targeting assumes the presence of a 

stable money demand relation (Hussein et al., 2012). This is because a stable money 

demand function means that the velocity of money is constant, and for that reason, the 

central bank can use money supply as an operating instrument to achieve low and stable 

price levels.  

Hence, this study sets out to address this problem by estimating a long-run money 

demand function for Ghana and discussing the implications of the findings for inflation 

targeting for Ghana. Furthermore, not much exists in the literature about the stability of 

money demand and how it serves as an indicator of successful monetary aggregate 

targeting for inflation targeting countries such as Ghana. In that light, the empirical 

investigation of the demand for money function becomes imperative.  

 

 

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1.2 Objectives of the Study 

The following subsections present the general and specific objectives of the study. 

1.2.1 General Objective 

The broad objective of the study was to empirically analyze the money demand function 

in Ghana over the time period 1979-2014.  

1.2.2 Specific Objectives 

The following are the specific objectives of the study: 

1. To estimate a long run money demand function for Ghana 

2. To determine the stability of the long-run money demand function for Ghana.    

3. To determine the causality between demand for money and the inflation-targeting 

regime in Ghana.  

4. To offer policy recommendations on a suitable framework for monetary policy 

going forward.    

 

1.3 Research Hypotheses  

The findings from the study will be used to confirm or reject the following alternative 

hypothesis  

 The long-run money demand function in Ghana is not stable. 

  There is no causality between demand for money and inflation targeting in 

Ghana.  

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1.4  Significance of the Study 

The study contributes to the growing debate on the effectiveness of inflation targeting as 

a workhorse of monetary policy in typical developing countries such as Ghana. Given the 

trends in macroeconomic performance since its formal adoption of inflation targeting in 

2007, there has been sharp criticisms of the framework (Puni et al., 2014; Quartey and 

Afful-Mensah, 2014). Moreover, the current International Monetary Fund (IMF) program 

has incorporated monetary aggregates as part of the quantitative benchmarks, while still 

preserving inflation targeting as the workhorse of monetary policy. The evidence from 

this study should therefore help the debate on the effectiveness of the framework and the 

future of monetary policy in Ghana.  

Furthermore, the study makes its contribution to the literature by including a policy 

regime variable that captures both inflation targeting and non-targeting regimes. The 

results will show the estimated long-run effect of the current policy regime on demand 

for money in Ghana, following earlier evidence that suggested that the demand for money 

in Ghana was unstable and that inflation targeting was a suitable regime to adopt.  

The study will also close the research gap that already exists in the literature on Ghana by 

determining the causality between money demand and the existing monetary policy 

framework. This will serve as a point of departure for further research in addition to 

providing future information to researchers interested in studying the relations between 

demand for money and policy regimes such as inflation targeting in Ghana. More so, the 

direction of causality will be important in the formulation of policies that could help 

control inflation efficiently 

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1.5  Organization of the Study  

The study will be structured into six distinct chapters. Chapter one provides the 

background to the study, the statement of the problem, the objectives of the study, and 

outlines the significance of the study. Chapter two will feature a review of the theoretical 

and empirical literature on money demand and the inflation-targeting framework as a 

monetary policy. Chapter three presents trends in the growth of money supply growth, 

inflation and output growth in Ghana over the time period of the study and gives some 

background to monetary policy frameworks that have existed in Ghana. The fourth 

chapter explains the data and research methodology used in the study. The fifth chapter 

also presents the empirical analysis whiles the last chapter presents concluding remarks 

and implications, for policy.  

 

 

 

 

 

 

 

 

 

 

 

 

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CHAPTER TWO 

LITERATURE REVIEW 

2.0 Introduction  

This chapter is organized into a review of existing theories and also presents related 

literature on money demand functions and their implications for the conduction of 

monetary policy. 

2.1 Theoretical Review  

In this section, theories on inflation targeting and money demand are captured and 

reviewed. The theories discussed serve as the basis for examining the relationships 

between inflation targeting and money demand in the literature. 

2.1.1 Inflation Targeting  

There exists enough material on the theory, design, implementation and performance of 

inflation targeting in countries that have fully adopted it. These include Haldane (1995), 

Leiderman and Svensson (1995), Lowe (1997), Bernanke et al. (1999), Bank of Thailand 

(2000), Carson, Enoch and Dziobek (2002), Loayza and Soto (2002), Truman (2003), 

Reserve Bank of Australia (2004) and Bernanke and Woodford (2005). According to 

Mishkin and Schmidt-Hebbel (2006), most of these works combined theoretical questions 

on monetary theory and policy design under inflation targeting.   

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The theory of inflation targeting as a monetary policy is traced back to New Zealand. 

According to Svensson (2010), The Reserve Bank Act of 1989 of New Zealand 

established the policy, which has come to be known as inflation targeting. Key pillars in 

this policy framework were an inflation target that was agreed as a target for monetary 

policy, asserted independence of the monetary authority and accountability of the central 

bank, which was demonstrated, by open target publications and the opportunity to hold 

the Governor of the Reserve Bank responsible for achieving the set targets. Goodhart 

(2010) mentioned that the Reserve Bank Act of 1989 was not directly a result of 

monetary analysis but rather a result of intense dissatisfaction with the interference of the 

national government in entire aspects of the economy. The Act served as a means to 

cushion the New Zealand monetary authority from the influences of governments in that 

day.  

Mishkin (2004) highlighted some more elements in an inflation targeting framework. 

According to him, inflation targeting frameworks also included public announcements of 

medium-term inflation targets, a commitment of the monetary authority to price stability 

and a commitment to achieving price stability in  both the short and long terms, a strategy 

which includes many variables aside monetary aggregates which will help inform 

decisions about monetary policy, increased transparency of the central bank with the 

public and the markets about the plans and objectives of policy and increased 

accountability of the central bank on how it achieves its inflation objectives.  

Mishkin and Posen (2003) highlighted that the target of inflation in an inflation targeting 

framework provided an anchor for the paths of price levels and could be easily 

understood by the public as one of the advantages of the framework. This according to 

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them resulted in increasing transparency and raising the potential for promoting low 

inflation expectations. Once this was achieved, a desirable inflation outcome could be 

achieved. More so, inflation targeting decelerated the pressure on the central bank to go 

after short-run output gains that would make the policies of the central bank seem time-

inconsistent. In that light, an inflation targeting policy avoided several problems 

associated with monetary targeting or regimes that targeted fixed exchange rates. As an 

example, inflation targeting could preserve the independent monetary policy of a country 

so that the monetary authority could better deal with domestic shocks and help protect the 

domestic economy from foreign shocks (Mishkin and Posen, 2003). Hence in their view, 

a good inflation-targeting regime would eliminate the need to focus on the link between a 

monetary aggregate and income because of velocity shocks but rather focus on the using 

all relevant information in forecasting inflation and selecting a response to achieving a 

desirable inflation outcome.  

With regards to disadvantages of inflation targeting as a framework, Mishkin (2001) 

mentioned that there were seven major demerits of this policy framework. The first four 

demerits include the rigidity of the framework, the opportunity for central banks to 

exercise too much discretion, the potential for the framework to increase output 

instability and the potential of the framework to slow economic growth. These according 

to Mishkin (1999) and Bernanke et al. (1999) are not serious and will not occur in any 

framework designed to target inflation if the design of such a policy is best characterized 

by constrained discretion. The fifth disadvantage was that inflation targeting resulted in 

weak central bank accountability because of the difficulty in controlling inflation, noting 

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that the lags between monetary policy instruments and inflation outcomes are long and 

serious in markets of developing countries.  

Mishkin (2001) placed enough emphasis on the sixth and seventh disadvantages, which 

were that inflation targeting could not prevent fiscal dominance and that the flexible 

nature of the exchange rate required by the framework could result in financial instability 

especially in markets of developing countries. According to him, the inflation targeting 

framework could not ensure fiscal discipline and hence, could not prevent indiscipline. 

With governments pursuing irresponsible fiscal policy, in the face of an inflation 

targeting regime, deficits incurred would cause the framework to breakdown in the long-

run leading to a monetization of these deficits or a large devaluation of the local currency. 

Either of these would lead directly to high inflation.  

The absence of outright fiscal dominance therefore was a key pre-requisite for inflation 

targeting and the setting up of key institutions to help check fiscal policy was crucial to 

the success of the strategy (Masson et al., 1997 and Mishkin and Savastano, 2001).  

More so, a financial system that operates soundly was another criteria for a successful 

targeting regime. This was because in the event where financial systems blew up, 

inflation surges resulted especially in markets of developing countries. Hence as 

indicated by Mishkin and Savastano (2001), a financial system that is sound and a 

framework that was devoid of fiscal dominance were crucial to the successive 

implementation of any monetary policy including inflation targeting.  

Beyond these, Calvo (1999) indicated that a high degree of dollarization, be it partial or 

not, served as a disadvantage for inflation targeting as a framework. This was so because 

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for many firms, households and even banks, their balance sheets had figures quoted in 

dollars, with significant debt they owed being denominated in dollars. According to 

Mishkin (2001), although exchange rate fluctuations were expected as part of the 

inflation targeting framework, huge depreciations of local currency against the dollar 

were burdensome to dollar-denominated debt owed by households, firms and even 

governments and thus would lead to increases in debt servicing costs, debt structures, 

costs of borrowing from capital markets and eventually inflation.  

Despite all these demerits, the theory of inflation targeting is thought to be a success in 

the countries that have adopted it explicitly. Bernanke et al. (1999) and Corbo et al. 

(2000) mentioned that the evidence on countries that are inflation targeting showed that 

they had been able to reduce their long-run inflation to levels lower than that which they 

would have been experiencing in the absence of the inflation targeting framework. The 

independence of most central banks had also been mutually reinforced under inflation 

targeting while the focus of monetary policy has been revised clearly (Bernanke et al., 

1999, Cecchetti and Ehrmann, 2000 and Corbo et al., 2000).  

However, the inflation targeting regime remains a viable solution to the problems faced 

by monetary policy, especially in Ghana. Since inflation targeting uses all available tools 

to target inflation, in the midst of improved openness and accountability, money supply 

has become relevant again, especially for Ghana. One of the pre-requisites to ensuring 

that money supply works successfully is a stable money demand function. A stable 

money demand function means that the velocity of money is constant and for that reason, 

money supply can be used to target inflation successfully. The next section explores the 

role of money demand in monetary policies reviewed in the literature.  

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2.1.2 Theories on Money Demand 

Theories of money demand are essentially from three independent schools of thought 

(Schmitt, 2003). These three schools of thought are the Classical, Keynesians and the 

Monetarist schools of thought. These and other schools and their theories are considered 

under the following subsections: 

2.1.2a Quantity Theory of Money 

This theory of money is traced to classical economist Irving Fisher and is based on the 

equation of exchange that relates money supply to nominal income (Schmitt, 2003). His 

objective was to examine the link between total Money Supply (MS) and the total amount 

of spending on final goods and services produced in a given period (PY). His equation 

was sufficient to provide a relation for explaining the velocity of money as the average 

number of times per year that a unit currency was spent on purchasing goods and services 

(Mishkin, 2004). The equation is represented as follows: 

-------------------- (1) 

Equation (1) is known as the equation of exchange and the velocity of money (V) is 

shown by making V the subject in the equation. 

--------------------- (2) 

Where V is the velocity of money, MS is the money supply, Y represents nominal 

income and P is the price level. 

A major assumption in the equation of exchange is that V is constant and hence nominal 

income (PY) is determined only by movements in money supply, through changes in 

PYVM S 

SM

PY
V 

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price (Mishkin, 2004). Fisher (1911) stated that the quantity of money supply in the 

economy was sufficient to cause a change in the price level, noting the constancy of the 

velocity of money and that of output because of the assumption of full employment. By 

the assumption of constancy of money velocity and output at full employment, the 

equation of exchange became the quantity theory of money as shown in equation (3) 

below.  

----------------------------- (3) 

 Where M and P are the money supply and the price level respectively and V and Y are 

the money velocity and output that are constant because of full employment.  

Once the money market is in equilibrium, Money demand (MD) = Money supply (MS) 

and hence the money demand became a function of price and income by making M the 

subject and replacing  with some constant k. The assumption of constancy of the 

velocity of money suggests that stability of money demand and implies that money 

supply will be effective for controlling the price level.  

2.1.2b Liquidity Preference Theory 

John Maynard Keynes (1936) developed his money demand theory in his book, The 

General theory of Employment, Interest Rates and Money. The theory specified three 

motives for holding money. Keynes (1936) described these motives as the transactionary 

motive; which arose from the use of money as a medium of exchange, the precautionary 

motive; which arose from the need for money to meet unplanned expenditure and the 

speculative motive, which arose from the need to keep money as a store of wealth. 



 YPVM

V
1

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Schmitt (2003) outlines the function Keynes used to represent money demand for real 

money balances. This is shown in equation (4) below 

------------------------------- (4) 

 Where represented the real money supply and i and Y represent interest rate and 

income respectively. Hence in equilibrium, the demand for money would be dependent 

on interest rate and income. The liquidity preference theory rejects the constancy of the 

velocity of money proposed by the Quantity Theory of Money. The liquidity preference 

theory suggested that the velocity of money was not constant but related positively with 

the movement in interest rates. With this fluctuation, price levels could not be controlled 

with the use of money supply because the velocity of money was bound to change with 

the movement in the interest rate. For that matter, the liquidity preference theory casted 

doubts on the classical quantity theory and suggested interest rate as a viable option for 

monetary policy to use in controlling prices.  

2.1.2c Modern Quantity Theory of Money 

Schmitt (2003) retraced this theory back to the monetarist Milton Friedman, a Nobel 

Prize winner. According to her, Friedman believed that money demand should be a 

function of wealth and the returns of other assets relative to money. This was shown in 

equation (5) below:  

-------------------------- (5) 

),( Yif
P

M 

P
M

),,,( memembp

d

rrrrrYf
P

M


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 18 

Where is permanent income (the expected long-run average of current and future 

income), is the expected return on bonds,  is the expected return on money,  is 

the expected return on stocks and is the expected inflation. Friedman’s distinction in 

his money demand function was the introduction of other assets for which money 

demand would be reliant on. This meant that the demand for money was not only a 

function of income or the interest rates on bonds that Keynes used in his theory but also 

based on the returns on other assets that the consumer might hold. This was based on the 

assumption that a consumer held more assets than just money and/or bonds. Compared to 

the liquidity preference theory by Keynes, the modern quantity theory suggested that 

changes in interest rates on only bonds had little effect on the demand for money because 

any individual was assumed to hold more than one asset. In addition, Friedman stressed 

on the stability of the demand for money compared to the preference theory by Keynes. 

Friedman suggested that because random fluctuations in the demand for money were 

small, the demand for money could be predicted accurately by the money demand 

function. Based on the small fluctuations in the demand for money, the velocity of money 

was assumed to highly predictable. This would then mean that a change in the quantity of 

money would be sufficient to cause a predictable change in aggregate spending and 

eventually affect prices. For that matter, the modern quantity theory also suggested that 

money supply would be the primary tool to use in controlling income and prices, thus 

affirming the postulations of the quantity theory.  

pY

br mr er

e

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2.1.2d Cambridge Approach to Money Demand 

Xueping (n.d) explains this theory of money demand as one developed by other classical 

economists such as A.C Pigou and Alfred Marshall. In this model, the individual was 

allowed some flexibility in their decisions to hold money unlike in the quantity theory of 

money where the decisions to hold money are influenced by institutional constraints and 

the level of transactions in the economy. Although the model did not rule out the effects 

of interest rates on the demand for money, it did however present two properties that 

made people want to hold money;  

 The utility of money as a medium of exchange, 

 The utility of money as a store of wealth. 

Xueping (n.d) explained that Cambridge economists understood the transactions 

component of money demand and also suggested that the level of people’s wealth also 

affected the demand for money. They believed that wealth in nominal terms was 

proportional to nominal income and also mentioned that the wealth component of money 

demand was proportional to nominal income. This is expressed as: 

----------------------- (6) 

where k is the constant of proportionality. Cambridge economists often treated k as a 

constant and their theory allowed that individuals could choose how much money they 

wished to hold. This would imply that k could fluctuate in the short run ultimately 

because decisions concerning money as a store of a wealth are resident on other forms of 

wealth and their yields. Compared to the Quantity Theory of Money, the Cambridge 

model takes away the element of velocity of money being determined by institutional 

PYkM d 

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factors and leaves this determination to individuals in the short run. However, the 

Cambridge school of thought agreed with the classical school that nominal income is 

determined by the quantity of money, because the velocity of money was predictable. In 

the long run, the velocity of money could be determined, thus suggesting that income and 

prices could be controlled using money supply, just as the classical school postulated.   

For countries such as Ghana, the theory of money demand that works best for Ghana 

remains an empirical one. While the current policy has focused less attention on the 

money demand function and its stability, the policy rate has received immense attention 

as the main operating instrument for inflation targeting. With recent recommendations for 

monetary policy in Ghana, the money demand function has become relevant again for 

successful conduction of monetary aggregate targeting. The literature in the next section 

points to evidence of inflation targeting and the role of the money demand function and 

its stability for monetary policies of different countries.  

2.2. Empirical Literature Review 

A number of researchers have examined monetary policy and the demand for money 

across developed and developing economies using a number of approaches (Dagher and 

Kovanen; 2011; Gathoni, 2011; Lungu et al., 2012; Combes et al., 2012; Nduka and 

Chukwu, 2013; Okonkwo, Ajudua and Alozie, 2014; Kumo, 2015). However, variation 

in results present different views on the role that successive monetary policies play in the 

economy and how the demand for money shows its importance in the process. In this 

section, a selected number of the empirical studies are reviewed. The empirical studies 

reviewed are grouped in two: (i) Inflation Targeting and Monetary Policy and (ii) 

Monetary policy and Money Demand.  

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2.2.1 Inflation Targeting and Monetary Policy  

Chinaemerem and Akujobi (2012) worked on inflation targeting and monetary policy 

instruments in Nigeria and Ghana. The objective of the paper was to examine if the pre-

conditions for a successful inflation-targeting framework was present in Nigeria and 

Ghana. In other words, the paper examined if there was a stable and predictable 

relationship between inflation and monetary policy instruments in the two countries. The 

study used vector regressive models built by Goltschalk and Moore (2002) and Tutar 

(2002). The study found that inflation was an inertial concept for the countries considered 

and that money innovations were not significant in determining prices, compared to price 

changes themselves. After adding financial variables like exchange rates and interest 

rates, the paper still did not observe any significant improvement in the model. 

Accordingly, the study found that their own shocks and instruments such as interest rates 

mostly explained long run innovations in prices and that exchange rates had little or no 

effect on prices. The study concluded that Nigeria and Ghana did not have strong policy 

linkages between inflation and monetary policy instruments and therefore were not yet 

candidates for inflation targeting.  

Also, Heintz and Ndikumana (2010) examined the question of whether inflation targeting 

monetary policy was suitable as a framework for Sub-Saharan African countries. The 

paper used dynamic panel data to investigate the determinants of inflation in some 

selected African countries and discussed the implications for inflation targeting. The 

panel dataset of 29 countries covered the period 1975-2007 and captured the annual 

inflation rate (based on the consumer price index), the growth rate of money supply (M2), 

the percent change in the food production index, the percentage change in the nominal 

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exchange rate, the percentage change in the terms of trade index, the percentage change 

in the nominal lending rate and the change in government consumption expenditure as a 

percentage of Gross Domestic Product (GDP) in a fixed effects model that was used in all 

estimations.  

The paper concluded that a strict rules-based option to monetary policy, including 

inflation targeting, was not desirable for the countries of Sub-Saharan Africa, because of 

inflation dynamics and structural realities. In addition, the paper suggested that inflation-

targeting would be suitable in Sub-Saharan Africa if compared to alternative regimes that 

lacked the elements of transparency and accountability even though their objectives may 

be to keep inflation at a low level. On the other hand, if compared to an alternative 

monetary policy that placed greater emphasis on real economic outcomes, then inflation 

targeting may not necessarily be suitable as a policy option for Sub-Saharan Africa.  

Similarly, Combes et al. (2012) analyzed the effects of inflation targeting but added the 

element of fiscal rules on fiscal behaviors and inflation dynamics. The paper presented its 

novelty in that it had the objectives of accounting for the role of interactions between 

inflation targeting and fiscal rules regarding the fiscal and inflationary repercussions and 

then also answering questions regarding the existence of an optimal sequence of adoption 

of inflation targeting. The authors used a wider panel dataset of 152 developed and 

developing countries, compared to the work by Heintz and Ndikumana (2010), and the 

data used covered the period 1990-2009. The System-Generalized Method of Moments 

(GMM) estimations was used in order to address the likely endogeneity in the adoption of 

both inflation targeting and fiscal rules.  

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The results showed that adopting both inflation targeting and fiscal rules led to better 

fiscal and monetary outcomes by improving the primary and overall fiscal balances and 

also bringing down the average inflation rate, compared to cases where only fiscal rules 

or inflation targeting was adopted. The paper suggested that, for policy implications, 

considerations were not only to be made for the interactions between inflation targeting 

and fiscal rules but also for the timing of the adoption of the two frameworks. In addition 

the paper suggested that in the event of considering the adoption of both inflation 

targeting and fiscal rules, it was suitable for countries to first introduce fiscal rules before 

adopting inflation targeting instead of adopting inflation targeting before enacting fiscal 

rules.  

Gathoni (2011) also worked over the period 1990-2009 on providing a theoretical and 

empirical framework that analyzed the pre-requisites relating to the adoption of inflation 

targeting in low-income countries and emerging markets. The study used panel data 

comprising of macro-economic variables and institutional arrangements that could make 

it possible for the adoption of the inflation-targeting framework in the sampled countries. 

Data analysis was done using a logit model comprising of both macro variables (money 

and quasi money growth, liquid liabilities to GDP, central bank assets to GDP ratio and 

the ratio of private credit to deposit money banks to GDP) and institutional variables like 

the Central Bank Independence Index. The dataset covered a sample of low-income and 

upper-income level countries who were either inflation targeting or non-targeting. The 

inflation targeting countries included Brazil, Chile, Colombia, Czech Republic, Ghana, 

Hungary, Indonesia, Israel, South Korea, Peru, Philippines, Poland, Romania, Thailand, 

Turkey and South Africa. The findings suggested that countries with low inflation rates 

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stood a better chance of adopting inflation targeting as a framework and that institutional 

development was not an important pre-requisite to the initial adoption periods of inflation 

targeting as a framework.  

Considering some inflation targeting countries particularly, Kamal (2010) conducted an 

empirical investigation of the policy frameworks of Brazil, Chile and South Africa. This 

paper presents a different approach and only focused on inflation targeting countries in its 

sample.  The paper used the unrestricted Vector Auto-regression (VAR) and Structural 

Vector Auto-regression (SVAR) approaches based on the data that covered the period 

from 1970(q1) to 2007(q4). In addition, the paper used the Likelihood Ratio (LR) 

Statistic to test for possible structural changes due to the adoption of inflation targeting in 

the countries sampled. The main findings of the study were that inflation targeting did not 

a make a difference in the performance of monetary policy in the sampled countries, as 

these countries had been adept in keeping inflation on a low and stable trajectory in the 

early years of adoption. More so, the paper suggested the experience of Brazil, Chile and 

South Africa as important lessons that other emerging economies could learn from if they 

wished to adopt a framework such as inflation targeting.  

For South Africa as an inflation targeting country, Kumo (2015) investigated the impact 

of inflation targeting monetary policy and inflation volatility on economic growth in 

South Africa. The paper used a Generalized Autoregressive Conditional 

Heteroskedasticity (GARCH) model for seasonally adjusted annualized quarterly 

consumer price inflation for the period 1960Q1-2013Q3. The measure of volatility used, 

together with macroeconomic control variables, were used to estimate economic growth 

models for periods that corresponded to two monetary policy regimes and a third model 

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that covered the full sample period. The study found that inflation volatility had a 

significantly negative impact on economic growth during the pre-inflation targeting 

period covering 1960Q1-1998Q4. For the post-inflation targeting period, the study found 

that inflation volatility did not have significant impact on economic growth. The 

implication from these findings was that for South Africa, the adoption of the inflation-

targeting framework had succeeded in achieving low and stable general price levels 

hence creating the right environment for economic growth. Accordingly, higher growth 

periods in the mid 2000s followed after inflation targeting had been adopted as a 

monetary policy.  

2.2.2 Monetary Policy and Money Demand  

There exists large and growing literature on money demand and monetary policy. Most of 

these studies aimed to test stability of the money demand function in the face of structural 

changes, financial innovations and even shocks such as food shortages in order to inform 

monetary policy action. Nigeria comes up more often in the list of countries in Africa 

however, whose money demand function has been tested (see Kumar et al., 2010; Omotor 

and Omotor, 2010; Bitrus, 2011; Bassey et al., 2012; Nduka and Chukwu, 2013).  

Other countries in which studies on money demand have been carried out include 

Ethiopia (Sterken, 1999), Zambia (Mutoti, 2006), Pakistan (Sarwar et al., 2013), Kenya 

(Nyamongo and Ndirangu, 2013; Kiptui, 2014), Rwanda (Rutayisire, 2010), Sierra Leone 

(Mansaray and Swaray, 2013), South Africa (Wesso, 2002; Niyimbanura, 2013) and 

Ghana (Kovanen, 2011). Many of these studies discussed the implications for monetary 

policy in their countries in the face of different shocks or economic activities and mostly 

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estimated long-run and short run functions but failed to add causality tests in their 

analysis.   

However, tracing back from years after the Great Depression, Tobin (1947) studied the 

relationship between money demand and interest rates in the United States (U.S). His 

methodology separated transactions balances from idle balances based on the assumption 

that transactions balances were solely dependent on income. He investigated the 

relationship between idle balances and interest rates by plotting the average level of idle 

balances from 1922-1941 against the interest rates on commercial papers and discovered 

an inverse relationship between idle balances and interest rates. He concluded that money 

demand was sensitive to interest rates and this was backed up in the 1950s and 1960s 

(Schmitt, 2003). In the view of Schmitt (2003), although the money demand function of 

Tobin was found remarkably stable until the mid-1970s, the problem with it was the 

difficulty in separating idle balances and transactions balances since both transactions 

and idle balances depended on income and interest rates.  

Following this, Schmitt (2003) extended the study by Tobin (1947) by studying the 

breakdown in the stability of the money demand (M1) function in the United States (US) 

starting in 1974. Because policy makers relied on the demand for M1 function for 

effective monetary policy, the breakdown created a problem where actual money demand 

was lower than what the old demand functions predicted. His results revealed that this 

was due to financial innovations in the 1970s that changed working definitions of money. 

Even though the problem grew worse in the 1980s, policy makers turned to alternative 

money demand functions (M2), which also broke down in the 1990s thus causing the 

Federal Reserve to stop targeting M2 in 1992. Comparatively, while Tobin’s study 

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proved the theory of money demand by Keynes (1936), the study by Schmitt went further 

to add evidence to the causes of the break in the demand for money.  

Also, Kumar (2000) used a panel cointegration approach to estimate the demand for 

narrow money for a panel of five Pacific Island Countries (PIC) - Fiji, Vanuatu, Samoa, 

Solomons, and Papa New Guinea, over the period 1975-2007. The study found that there 

was a unique long-run association between real narrow money, real income and the 

nominal interest rate. In addition, the study suggested that aside stable money demand 

function, financial reforms were yet to have any significant effects in the countries 

considered. 

Similarly, Kumar and Singh (2009) worked on the demand for money for the same set of 

five PICs. For this study, the exchange rate was not captured because of the under-

developed nature of the financial markets. The study used the time series approaches of 

LSE- Hendry General to Specific (GETS) and the Johansen Maximum Likelihood (JML) 

and agreed with Kumar (2000) that real income, nominal interest rate and real narrow 

money moved together in the long run. In addition, the study found the money demand 

function to be stable implying that money supply could be targeted for policy. The study 

differs in that it suggested the need for the countries to focus on targeting money supply 

instead of targeting bank rates since there was no evidence of instability in their money 

demand functions.  

For Kumar and Rao (2011), their work focused on the demand for money in the United 

States. The study used annual data from 1960-2008 and used the Gregory and Hansen 

(1996) test. Their method varies in that they used alternative specifications including 

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trend and additional variables to proxy the interest rate. The results showed a structural 

change in 1998 with income elasticity being unity even with smaller sample regressions. 

The study suggested that real income, nominal interest rate and real narrow money 

moved together in the long run.  

Also from Fiji, one of the PICs, Katafono (2001) employed data covering the years 1975-

1990 to estimate the demand for narrow money (M1) using the Johansen Maximum 

Likelihood (JML) technique. Her study revealed a low-income elasticity thus asserting 

that the demand for M1 in Fiji was unstable in the short run. Even though Katafono was 

probably in support of the central bank of Fiji’s monetary policy of targeting interest rate, 

Rao and Singh (2005) used alternative time series approaches of General to Specific 

(GETS) and JML and disagreed on the use of the interest rate for policy. Their study 

concluded that the demand for M1 in Fiji was stable and well determined with data 

covering the period 1971-2002. 

For the PIC of Papua New Guinea (PNG), Kannapiran (2001) also used the Engel- 

Granger method of cointegration to estimate the demand for M2 in PNG and obtained a 

very low-income elasticity of 0.20 using data covering the period 1979-1995. The 

findings support that of Rao and Singh (2005) and implied that the probability of using 

money supply as a monetary policy was high just like the case of Fiji. 

In Africa, Treichel (1997) examined broad money demand and monetary policy in 

Tunisia. This work found lower income elasticity as compared to the one applied by the 

Central Bank and ultimately proposed a different methodology for achieving monetary 

targets. The study used co-integration and error correction techniques and included the 

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monthly rate of return on treasury bills being and other interest rates like the discount rate 

(DISC) and the money market rate (MMINT). The paper found demand for money to be 

stable and suggested a base or price regime that would help the Central Bank to achieve 

its monetary objectives.   

In addition, Nigeria’s demand for money was examined in the study done by Teriba 

(1974). With a double log specification and static Ordinary Least Squares (OLS) 

technique, the study revealed high significant income-elasticity of demand deposits in 

Nigeria while interest rates were not statistically significant using annual data over the 

period 1958-1972 (Teriba, 1974). Studies of Nwaobi (2002) and Nwafor et al. (2007) also 

used the vector auto regression approach to test the stability of broad money demand in 

Nigeria and their results confirmed a stable money demand function for Nigeria whiles 

Omotor (2009) also used the Bounds Testing Autoregressive Distributed Lag (ARDL) 

technique and equally found Nigeria’s money demand as stable. Nduka and Chukwu 

(2013) also used the Engle-Granger approach to cointegration and CUSUM charts to test 

the stability of long-run demand for real broad money over the period 1986-2011. The 

results of the study showed positive income elasticity of income and foreign interest rates 

while domestic interest rates, inflation and the exchange rate had negative coefficients.  

Also Okonkwo, Ajudua and Alozie (2014) used the Johansen Cointegration approach to 

test the stability of the demand for broad money in Nigeria over the period 1981 to 2012 

and found demand for broad money to be stable. The paper recommended the monetary 

authority to be structured in the growing challenges posed by financial innovations. 

Comparatively, Aiyedogbon et al. (2013) used data over the period 1986-2010 and 

introduced new variables such as gross capital formation, government expenditure and 

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economic openness and found cointegration with broad money supply. The study 

employed vector error correction modeling in its analysis and also found interest rates, 

inflation and economic openness to have negative coefficients. 

Also for Nigeria, Bitrus (2011) examined demand for money. The study used time series 

data covering both narrow and broad money, interest rates, exchange rates and the stock 

market. The methods employed were multiple regression analysis, unit root testing and 

CUSSUM tests using data from 1985 to 2009. This study added dividend yield in its 

specification and found that this had significant influence on demand for broad money in 

Nigeria. Also, the study found income as the most important determinant of the demand 

for money while mentioning that stock market variables could improve the performance 

of money demand. The study recommended that stock market activities and monetary 

targeting could help improve inflation control.   

 Galen and Oskooee (2007) also investigated the stability of money demand in 21 African 

countries. The methodology included the design of a standard money demand function 

following the works of Domowitz and Elbadawi (1987) and Bahman Oskooee (1996), 

and estimated using a bounds testing approach for co-integration and error correction. 

Some of the countries studied included Ivory Coast, Burkina Faso, Egypt, Ghana, 

Ethiopia, Gabon, Burundi and Cameroon. Data used for the study was quarterly data over 

the period 1971-2004. The study found that the demand for money (M2) was stable in 

almost all the 21 countries. For this study, a notable difference was that inflation was 

suitable as a measure of opportunity cost because of the lack of well-developed financial 

markets,  

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For Gambia, Sriram (2009) investigated demand for money and discussed the 

implications for monetary policy conduct in that country. The study employed the 

cointegration methods of Johansen (1991) and Johansen and Juselius (1990). The study 

was conducted using data for the period beginning from January 1988 to June 2007. The 

results showed a long run relationship for real broad money, which was not stable, 

contrary to the case of Nigeria. Reasons for such instability included output shocks, 

financial innovation, changes in income velocity and inadequate data quality. The study 

recommended the authority to apply a flexible monetary targeting regime with the overall 

objective of preserving price stability; with a possible option being inflation targeting lite.  

Similarly, Lungu et al. (2012) worked on the demand for money in Malawi and discussed 

implications for monetary policy conduct in that country. The study also used the 

Johansen-Juselius approach to cointegration, just like Sriram (2009). The data used was 

over the years 1985-2010. For this study, financial depth was included as an additional 

variable to income, inflation and exchange rates. Results from the study showed the 

stability of the demand for money function as co-integration results indicated a long-run 

relationship between real money balances, prices, income, exchange rate, Treasury bill 

rates and financial innovation.  The study recommended a direction of policy in the short-

run, to increasing financial innovation, open market activities and increased productivity 

in order provide higher returns on alternative investments.  

Sarwar et al. (2013) tested the stability of the money demand function in Pakistan. The 

study also used the Johansen and Juselius approach to cointegration although it tested 

three official monetary aggregates and settled on the broader aggregate (M2), which 

provided a stable money demand function for Pakistan. The data used was from the year 

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1972 to 2007. The findings showed that real GDP and interest rates were positively and 

negatively related to money demand respectively. However, as a recommendation, the 

study mentioned that the role of financial innovation would best help monetary policy if 

it had more attention given to it.  

For South Africa, Husein et al. (2012) worked on estimating long run demand for real 

money. They used a cointegrated VAR approach with data from 1985 to 2008. The VAR 

model had short-term interest rates, long-term interest rates, inflation, the exchange rate, 

real money and real income as arguments. The study found three cointegration relations 

between long run constant money velocity and inflation, exchange rate and the short-term 

interest rate and the bond rate, inflation and real income. However, the study found the 

long run money demand relation to be unstable with deviations from equilibrium not 

converging in the short term.  

However, Niyimbanira (2013) on the other hand, worked on the stability of money 

demand also for South Africa. The paper worked with quarterly data using cointegration 

and error correction methods over a shorter time period (1990-2007). In contrast to the 

findings of Husein et al. (2012), the results confirmed the stable relationship and proved 

the effectiveness of monetary policy. In addition, the study found a lag in the time to 

which any disequilibrium would be restored to be approximately four quarters (a year), 

thus making monetary policy slow in dealing with emerging situations.  

For Ghana and its inflation-targeting regime, not much literature exists investigation the 

role of the demand for money in monetary policy. The study by Dagher and Kovanen 

(2011) is the last recent empirical evidence of demand for money specifically for Ghana. 

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Prior to this, studies by Ghartey (1998) and Bawumia and Abradu-Otoo (2003) present 

mixed evidence on the stability of money demand for Ghana. Ghartey (1998) used 

quarterly data covering the period from 1970-1992 and found evidence of a stable 

demand function while Bawumia and Abradu-Otoo (2003) used vector error correction 

modeling and the Johansen cointegration approach with monthly data from 1983-1999 

and found a stable relationship between inflation and broad money in Ghana. Following 

this, Amoah and Mumuni (2008) also estimated a long run demand for money function 

and used quarterly data from 1980 to 2007. Also using cointegration and error correction 

models, they found an unstable money demand function, which they attributed to 

structural reforms and the deregulation of the financial sector. The study concluded that 

money was no longer relevant in predicting future inflation and output.  

However, Dagher and Kovanen (2011) investigated the long-run demand for money 

using the Bounds Testing approach to cointegration. The study used quarterly data from 

the year 1990 to 2009 and found strong evidence for the presence of a stable and well-

identified money demand function, despite substantial changes in the financial markets. 

The evidence suggests that there are complex dynamics between money demand and its 

determinants and those deviations from equilibrium were short-lived.  

 

 

  

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2.3 Conclusion  

From the works mentioned above, lessons could be drawn. Firstly, inflation proved to be 

a significant measure of opportunity costs in countries where financial markets were not 

completely developed. Following the work of Galen and Oskooee (2007), the study used 

inflation equally as a measure of opportunity cost since the interest rate was used 

comparatively as a dependent variable in a separate estimation.  

Secondly, the work of Galen and Oskooee (2007) identify a role for exchange rates in 

their model. The study employed the use of exchange rates in its model estimation 

because of the role that the exchange rates played in the demand for money in countries 

like Ghana as observed in their work.  

Also structural changes, output shocks and financial innovation could contribute to the 

stability or instability of money demand functions, which would affect the plans of policy 

makers to control price. Where such influences were managed well, the effect on price 

would be minimal in the face of a stable demand for money; noting that countries and 

their economies differed in their structures.   

Lastly, the methods employed in the literature reviewed failed to account for causality 

analysis and focused mainly on cointegration approaches and how long deviations from 

equilibrium took to restore. This is the case specifically for studies on Ghana. This is a 

gap that this study fills. With Ghana being one of the first emerging market economies to 

have formally adopted inflation-targeting
10

, studies such as this add value to the debate 

                                                             
10

 See Alichi et al. (2010). A Model for Full-fledged Inflation Targeting and Application to Ghana. IMF 

Working Paper. 

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on the whether monetary aggregate targeting is still relevant for Ghana, despite the 

transition into an inflation targeting regime.  

 

 

 

 

 

 

  

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CHAPTER THREE 

TRENDS ON ECONOMIC GROWTH, INFLATION, AND MONEY 

SUPPLY AND A BACKGROUND TO POLICY FRAMEWORKS IN 

GHANA 

3.0 Introduction 

This chapter discusses trends and statistics on inflation, economic growth and money 

supply growth in Ghana over the time period of the study. The chapter then concludes 

with some fundamental facts about monetary policy frameworks that Ghana experienced.  

3.1 Trends of GDP Growth, Inflation and the Growth of Money Supply in Ghana 

There exists literature on inflation and economic growth in the case of Ghana
11

 as well as 

literature on inflation and money supply in Ghana. Most of these papers considered 

methods that tested causal relationships, the presence of structural breaks and the optimal 

threshold level that guaranteed maximum growth.  

Major structural transformations such as changes in government, political unrests, or 

even changes in policy regimes affected Ghana largely between the end of the 1970s and 

the early 1980s. Coupled with severe drought, bush fires, the arrival of Ghanaians from 

Nigeria and policies that completely ignored external obligations, inflation was recorded 

at its highest in the early 1980s. Particularly in 1983, exchange rate overvaluation as well 

as the development of a buoyant parallel market contributed to the hike in prices 

                                                             
11 See Marbuah (2012), Quartey (2010), Ahortor et al. (2012) and Frimpong and Oteng-Abayie 

(2010).  

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(Aryeetey et al., 2007, Fosu, 2003 and Akoena et al., 2007). Inflation was recorded at its 

highest in the history of the country at 123% in 1983. Prior to this, double-digit inflation 

of between 50-54% had been recorded from 1979 to 1980. Afterwards, triple digit 

inflation crept in at 117% in 1981. However, inflation was very low the year after (1982) 

and raised many hopes with regards to the economic fortunes of the country with a record 

of about 23%. Clearly, pre-1983 inflation reflected excessive demand pressure sustained 

by fiscal expansion and consequent monetary growth. The problem was made worse by 

inadequate growth of output and supplies due to particular structural constraints faced by 

the economy (Sowa and Kwakye, 1993). 

With the highest record of inflation in 1983, the Economic Recovery Programme (ERP) 

was the best shot for Ghana. The government of the Provisional National Defence 

Council (PNDC) launched the ERP in mid-1983 with the support of the World Bank and 

the International Monetary Fund (IMF). The main purpose of the program was to stem 

the slide in the economy, minimize imbalances and establish a path of sustainable growth 

(Sowa and Kwakye, 1993). The program was to help refocus and restore debt levels, an 

overly devalued currency and negative growth rates that had been seen from 1979. 

Specifically, between 1979 and 1983, the economy contracted at an average rate of 3.4% 

and observed the largest contraction of 6.92% in 1982.  However, the economy appeared 

to have responded positively to the ERP. According to Fosu (2000), the economy 

recovered from a negative growth rate of about 5% in 1983 to a significantly positive 

growth rate of 8% in 1984. The favorable growth appeared to have continued since that 

the time despite little slowdown in the growth rate of the economy from 1990.  

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A year after the ERP was introduced, inflation dropped from its highest to 40% in 1984. 

While this change was mostly attributed to the program, the implementation of the 

program only began in 1984 and for that matter the reduction in inflation could have 

come from increased external inflows and liberalization that allowed the agricultural 

production to recover quickly (Sowa and Kwakye, 1993).  

Enhancing the benefits of improved external inflows and the improvement in the 

productivity of the agricultural sector was the drop in inflation to about 10% in 1985. 

This was associated with an especially good harvest where food prices actually fell. After 

the take off of the recovery programme, inflation between 1983 and 1986 was about 25% 

on average with the economy recovering by 6.3% on average over the same time period.  

Money supply had grown by 47% averagely from 1983 to 1986, compared to 33% from 

1979 to 1983. The success of the ERP seemed short-lived as inflation rose again to about 

40% in the year 1987, the highest since 1979. In that same year, money supply growth 

had increased to 53% from 48% in 1986 and the growth of the economy retarded to 4.8% 

in 1987. The next couple of years saw the introduction of a program of structural 

adjustment that was meant to reshape the economy as an export oriented one after 

clearing debts and balance of payment pressures. In between 1987 and 1992, the highest 

growth rate of 5.3% was recorded in 1991 with inflation hovering around 18% and 

money supply remaining at 39%.   

As a result of tight fiscal and monetary controls, inflation dropped to 10% in 1992, which 

happened to be the year Ghana witnessed the commencement of democratic rule.  At this 

point, monetary policy regimes had shifted from the direct credit controls to monetary 

aggregate targeting, which began in 1983. After three years of implementing the money-

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targeting regime, inflation had reached its lowest of 10%, which happened to have been 

recorded in 1985, after the ERP was introduced.  

Figure 3.0 Trends in Inflation, Money supply and Growth under Monetary 

Targeting  

 

Source: Author’s computation from WDI, 2014  

Notably, the influence of politics in trends of inflation, growth and money supply is 

shown in the comparison between election periods from 1992 to 2012. Before the 

election year 1992, inflation was recorded at 23% between 1989 and 1992, while the 

economy had recovered by about 4.4% over this time period compared to decadal 

average of 1.6% between the years 1979 to 1989.  Money growth in between 1989 and 

1992 was recorded at about 40% compared to the decadal average of 42.4% in between 

1979 and 1989.  

-20 

0 

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1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 

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%

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Money and quasi money growth (annual %) 

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Inflation, consumer prices (annual %) 

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Interestingly, the first four years after democratic elections in 1992 saw average inflation 

rise by 10% from 1992 to 1996, to settle at 33%, while the economy contracted by 2% to 

settle at about 4.2% over the period 1992 to 1996. Over the same period money supply 

had grown to about 44% compared to the average of 40% over the period of 1989 to 

1992. Substantial government expenditure increases in 1992 contributed immensely to 

inflation rates rising from 10% in 1992 to about 60% in 1995. In 1996, inflation stood at 

46.6% while the average inflation between 1996 and 1999 was 25.4% (Marbuah, 2012). 

Average economic growth over the years 1996 to 1999 was 4.5% whiles money supply 

growth was 31.5% on average.  The four years after the 1996 elections (1996 to 2000) 

saw inflation at a lower rate. Average inflation over this period was about 25% and the 

economy had recovered by about 4.3% over this same period, while average money 

supply growth was at 36% over this period. With a much better performance of the 

economy over this period, the next four years after the change of hands in government 

saw massive expenditures because of the elections in 2000. The evidence from national 

statistics showed that the end of period inflation as at December 2000 had almost tripled 

from 13.8% in 1999 to 40.5% in 2000 due to expansionary monetary policies, 

depreciation of the domestic currency which was as high as 49.5%, the terms of trade 

shocks, the general loss of confidence in the domestic economy and deficit financing 

practiced by the central bank in respect of the elections in 2000 (Marbuah, 2012). 

However, over the period 2000 to 2004, average inflation had reduced to 22.4%, average 

money supply growth was about 40% and the economy had grown at an average of 5%.  

 

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There was a notable change in the monetary policy regime in the early years of 2002 

where the central bank had decided to implicitly practice targeting inflation (See Figure 

3.1 below). This was well received as inflation more than halved from 33% in 2001 to 

15% in 2002 allowing the economy to expand to 4% in 2002 from 3.7% in 2001. Also, 

money supply growth reduced significantly from 56.5% in 2001 to 39.2% in 2002.  For 

the last quarter of 2002, the inflationary trend was as a result of the payment of cocoa 

purchases. In 2003, inflation was 23.6% and was mainly caused by the increase in prices 

of petroleum products given that Ghana remained susceptible to supply shocks from 

commodity prices. 

Figure 3.1 Trends in Inflation, Money supply and Growth Under Inflation 

Targeting  

 

Source: Author’s computation from WDI, 2014  

 

0 

10 

20 

30 

40 

50 

60 

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 

A
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Money and quasi money growth (annual %) 

Inflation, consumer prices (annual %) 

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The government did not change hands after the 2004 elections, and some stabilization 

measures had been put in place to ensure Ghana grew and attained macroeconomic 

stability with growth, especially after securing the mandate of the people. There was a 

trend of disinflation, which began in 2004. Inflation reduced from 27% in 2003 to 12.6% 

in 2004 and ended up at 11% in 2007. Over this time, the economy had grown from 5.2% 

in 2003 to 6.5% in 2007. Major determinants of this trend included the use of resources 

from debt relief and debt cancellation from the HIPC and Multilateral Debt Relief 

Initiative (MDRI), new aid flows and external loans and inward private transfers 

(including remittances) by the central bank to avert accelerated inflation in the economy 

(CEPA, 2009).  Even so, the trend could also have been because of the inflation targeting 

framework that the central monetary authority adopted. The framework, until the second 

quarter of 2008, had well anchored expectations surrounding inflation and had clearly 

redefined the goal of the central bank to be price level stability (Marbuah, 2012).  

However, over the period 2004 to 2008, average money growth was recorded at 32% 

whiles average inflation had been observed to be the lowest ever since 1979. The 

economy had expanded averagely by about 7% over this period and this record was 

enough political capital for the government of the day at the time. Perhaps the beginning 

of what was popularly known as ‘single digit’ inflation, average inflation over the years 

2008 to 2012 was about 13% while average growth in the economy had increase to about 

9% over this time. Average money supply growth over this period was about 31% and 

this showed good evidence of the monetary policy stance, after the formal declaration of 

a new policy stance in 2007.  

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More so, there were setbacks to the disinflationary process that occurred between 2001 

and 2007 (Andinuur, 2013). These setbacks were as a result of external shocks from the 

global financial crisis, high food prices, excessive government spending, fiscal deficits 

beyond 10% of GDP and a depreciating currency. At the end of 2009, the depreciation of 

the local currency had reached about 19.3% of GDP. However, the central bank was able 

to halt the depreciation of the currency and contributed to inflation reducing from 20.7% 

in June 2009 to a single digit of 8% at the end of 2010. At that time, the successes of the 

inflation targeting regime were hailed and the government used the achievement of single 

digit inflation as a means to earn itself some political capital. Along with the talk about 

single digit came the news about exchange rate stabilization.  

The trends changed in the early months of 2013, as inflation began rising again, going 

past the 10% ideal target and ending at 13.5% in December 2013. More pressure came 

the way of the central bank as inflation spiked through the months of 2014 with some 

allegations of incompetence on the part of the governor of the monetary institution. 

Inflation spiked largely because of pressures from world markets for crude, wider fiscal 

deficits, largely caused by a huge public wage bill and large amounts of debt owed to by 

the government that contributed to high lending rates. In addition the policy rate was 

increased as a form of contractionary monetary policy but the central bank was found to 

be financing deficits of the government and state owned enterprises by the IMF team that 

reviewed the performance of the economy as a result of the request by Ghana for an 

extended credit facility.   

 

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Considering trends over the period (1979-2014), inflation, money supply and output 

growth have shown differences. In earlier monetary policy regimes such as direct 

controls and sole monetary targeting, money supply growth was comparatively higher 

and inflation was not well controlled and thus eventually resulted in negative trends in the 

growth rates of real output. Even though programs were instituted to ensure economic 

restructuring, pressures from politics, fiscal dominance and shocks from external markets 

resulted in inflation that caused the slower growth of output and a higher growth in 

money supply, compared to the period between 2002 and 2014 where inflation targeting 

was the policy regime. The trends in inflation and money supply go downward especially 

from the year 2003 with the successful practice of inflation targeting for the Ghanaian 

economy as this anchored expectations surrounding inflation. Growth of real output took 

an upward trend especially in between 2005 and 2009.  

Figure 3.2 Trends in Inflation, Money supply and Growth from 1979-2014 

Source: Author’s computation from WDI, 2014  

-20 

0 

20 

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140 

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GDP growth (annual %) 

Inflation, consumer prices (annual %) 

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The figure above shows that the period between 2005 and 2014 exhibited a downward 

trend in inflation while GDP growth on the other hand showed an upward trend but only 

goes close to 20% over this period, especially in the year 2011. The data showed that the 

highest recorded growth in GDP of 15% occurred in 2011 with the most contraction of 

6.92% in 1982. This record high growth could not be sustained in subsequent years even 

though the growth of the country had exceeded that for Sub-Sahara Africa. Growth of 

real output in 2013 was 5.4%, much lower than the growth rate of 7.9% in 2012. The 

double-digit growth of 15% recorded in 2011 was partly due to the revenue from the 

exploration of oil resources that had come to add to the size of the economy. Despite this, 

growth rates in 2013 and 2014 have been much lower than the 7.8% in 2012 and the 

9.4% in 2011, especially as a result of the increased susceptibility of the economy to 

shocks from foreign markets and the depreciating local currency (ISSER, 2014). 

Holistically, average inflation over the period 1979 to 2014 still remained in double-

digits at about 30%. The economy of Ghana had averagely grown by 4.4% over this 

thirty-two year period and average money supply growth from 1979 to 2014 still 

remained at 37%, which followed average trends over this period.  

Analysis by decade in between 1979 and 2009 showed that average money supply growth 

remained above 30%, average inflation rates had all been above the optimal inflation rate 

of 10% and the growth rates of national output for Ghana had all been below 10% 

indicating that trends in inflation, growth and money supply had not been appreciably 

controlled by monetary policy for the economy to fully experience improvement.  

Table 3.0 summarizes the average inflation, GDP growth and money growth figures for 

Ghana, along with their medians.  

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Table 3.0 Decadal Mean and Median Inflation, GDP and Money Supply Rates  

Year  

Inflation   

(CPI, Annual%) 

GDP growth  

(Annual %) 

Money Supply (M2) 

Growth Rates  

(Annual %) 

  Mean  Median  Mean  Median Mean Median 

1979-1989 48.89 39.7 1.6 4.79 42.4 46.3 

1989-1999 27.41 25 4.34 25 37.72 39.2 

1999-2009 17.92 15.1 5.33 15.1 35.03 36.8 

1979-2014 29.7 24.6 4.38 4.79 37.05 39.2 

Source: Author’s computation from WDI, 2014  

 

3.2 Background to Monetary Policy Frameworks in Ghana 

The time period considered for the study covered all three policy frameworks for Ghana. 

Ghana has had three monetary policy regimes since its independence. The first was direct 

monetary controls, which lasted for twenty-six years (1957-1983) until the economic and 

fiscal challenges hit the Ghanaian economy in 1983. Monetary aggregate targeting was 

the next policy regime for Ghana and this lasted for 18 years (1983-2001) until Ghana 

opted for the Highly Indebted Poor Country (HIPC) programme to retrace its steps back 

to economic growth and poverty reduction. 
12

  

                                                             
12

 The HIPC Initiative was a World Bank programme that was meant to help poor countries that 

were highly indebted re-focus their strengths on debt reduction, economic growth and poverty 

alleviation. Ghana accepted to join this program in March 2001.  

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In that time (2001), money supply growth had risen from 25.6% in 2000 to 56.5%, the 

economy had grown from 3.6% in the year 2000 to about 4%, and inflation had surged up 

from about 25% in the year 2000 to almost 36%.  

The third policy framework for Ghana was inflation targeting which took over from 

monetary aggregate targeting in 2001. This is the framework that Ghana is using 

currently although the years from 2001 to 2007 had been periods of implicit inflation 

targeting. This meant that the central bank had been taking steps in line with the targeting 

framework whiles complimenting such steps with monetary aggregate targeting. The 

bank formally announced its decision to use the inflation targeting framework in May 

2007 and after, the use of the framework required setting an interest rate for which policy 

linkages could be triggered to ensure that monetary policy worked.  

In prior times, direct monetary controls and monetary aggregate targeting would not have 

directly considered the policy rate, although with other tools like open market operations 

and discount rates, the policy rate remained a tool that central banks could use to control 

the liquidity in the economy through their dealings with commercial banks.  

The table below shows the average growth rates of GDP, inflation and money supply 

growth of each of the regimes that Ghana has experienced.  

 

  

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Table 3.1 Inflation, GDP and Money Supply Growth Rates per Policy Regime  

Regime Period 

Inflation 

(average %) 

Money and 

Quasi Money 

Growth (%) 

GDP Growth 

(Average%) 

Direct Controls 1979-1983 73 33 -3.4 

Monetary Aggregate 

Targeting 1983-2001 33 43 4 

Inflation Targeting 2001-2014 16 32 7 

Source: Author’s computation from WDI, 2014  

The results in the table above showed that the inflation targeting regime produced the 

lowest average inflation and money supply growth rates compared to inflation and money 

supply growth rates for the other frameworks. Average GDP growth on the other hand 

was the highest in the inflation-targeting framework compared to the direct control and 

monetary aggregate targeting frameworks. This growth rate of 7% is higher than the 

period average of 4.38% in table 3.0 and speaks positively about the benefits of the 

inflation targeting framework for Ghana.  

According to Bawumia (2010), ‘of all the monetary policy regimes implemented since 

independence, the inflation targeting regime (and the accompanying fiscal framework) 

had yielded the best performance in terms of key macroeconomic indicators’. The 

Ghanaian economy also dealt better with external shocks under the inflation targeting 

regime (2001-2008) than under the monetary targeting regime (1983-2001) and the direct 

controls regimes (1957-1983).  

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Bawumia (2010) mentioned that the inflation targeting regime implemented had been 

very supportive of economic growth.  The data in table 3.1 proves the first part of the 

statement of this statement. Although the book by Bawumia discussed monetary policy 

performance from 1957 till 2008, it made no room for discussion on the resilience of the 

economy to shocks, especially after the 2012 elections. Notable among these shocks was 

the drop in foreign aid and donor support funds that occurred because of the Election 

Petition, in which the election results of 2012were challenged in the Supreme Court of 

Ghana .  

This was primarily a result of low investor confidence that the external development 

partners had