Exchange Rates and Monetary Dynamics in Sierra Leone: Evidence from a Modified Money Demand Function

The study has examined the impact of foreign monetary developments on the demand for real broad money (M2) balances in Sierra Leone. The Autoregressive Distributed Lag (ARDL) modelling technique is employed to estimate the long run relationship and short run dynamics using quarterly data for the period 1983Q1 to 2008Q4. The results suggest that there exists a cointegrating relationship between real M2 and its determinants. In the long run, the coefficient of the exchange rate exerts a negative and statistically significant effect on the demand for real M2, providing evidence of the currency substitution phenomenon. The short run dynamics also indicate the presence of currency substitution but the coefficient of the exchange rate is not significant, which is attributed to the mix of both currency substitution and wealth effects. The results also find statistically significant negative coefficient of the foreign interest rate, being consistent with the argument of the capital mobility effect. The CUSUM and CUSUMSQ stability tests indicate that the model is relatively stable over the study period. Based on the stability results, we conclude that M2 is an appropriate intermediate target in the conduct of the monetary targeting policy framework in Sierra Leone. JEL Classification Codes: E41, E52, F31