Testing the non-linearities of exchange rate pass-through in Somalia: does dollarization affect consumer prices?

Abstract

Over the past three decades, Somalia’s economic landscape has witnessed a noticeable dependence on imported goods. The exchange rate was unregulated owing to the collapse of the country’s central bank. This unregulated environment has introduced significant volatility in exchange rates, profoundly impacting consumer prices and fostering a prevalent shift towards the utilization of the US dollar in economic transactions. Hence, this undertaking delves into the asymmetric effects of exchange rates on consumer prices in the presence of dollarization in Somalia from 1995 to 2019. Employing both linear and nonlinear autoregressive distributed lag (NARDL) cointegration methodologies, we explore the short-run and long-run dynamics between exchange rates and consumer price levels. The long-run empirical results from the NARDL demonstrate asymmetrical cointegration between the unregulated exchange rate and inflation in Somalia. Both appreciation and depreciation of exchange rates exert differing impacts on consumer prices, with depreciation exhibiting a more pronounced effect. In addition, the evidence suggests that the exchange rate pass-through is incomplete in Somalia regarding its inelastic coefficient. Oil prices exhibit a substantial and statistically significant association with inflation, both in the long-run and short-run, while GDP remains inconsequential. In the short-run, the most remarkable outcome indicates that dollarization significantly contributes to mitigating inflationary pressures. Based on our empirical insights, the central bank should enhance regulatory oversight of the foreign exchange market by strictly controlling and prohibiting the issuance of counterfeit banknotes to achieve price stability.