Inflation and exchange rate dynamics pass-through effect: Policy implications

Abstract

Understanding the mediating role of inflation on macroeconomic variables is essential for elucidating the transmission mechanism of monetary policy. Understanding the channels through which monetary policy influences inflation, which in turn affects exchange rates, is important in understanding the indirect channels through which monetary policy impacts the economy (Nwoko et al., 2016; Arestis & Sawyer, 2002; Mann, 1969). The objective of the study is to investigate the mediation role of inflation in the relationship between exchange rates and the interactions of money supply, interest rates, and economic growth (MIG index). The study utilised the structural equation modelling (SEM) to investigate the relationships discussed above. The study is premised on balanced panel data for five Southern African Development Community (SADC) countries during the period 2010–2024. The results reveal that inflation partially mediates this relationship, suggesting that monetary policy and economic activity influence exchange rates through both direct and indirect channels. The findings imply that policymakers should consider both direct and indirect effects of monetary policy on exchange rates and inflation. This study highlights the complex dynamics between monetary policy, economic activity, inflation, and exchange rates, emphasizing the need for informed policymaking.