ECON 434

MONEY AND BANKING

RESEARCH PAPER

Determinants of Exchange Rates Movement in Ghana

Group 13
GROUP MEMBERS
NAME
ARMAH MICHAEL ASANTE KWADWO OKRAH ASARE ASARE ASARE SUSANA ABENA KWABENA JNR SAMUEL

INDEX NUMBERS
10276000 10276313 10276383 10276403 10276437

3/28/2012

1.1

INTRODUCTION

Exchange rate between two currencies specifies how much one currency is worth in terms of the other. It is the value of a countrys currency in terms of a foreign nations currency. There are two methods of quotations of exchange rate between two different currencies; the direct or price quotation and the indirect or volume quotation. The price quotation method quotes exchange rate in terms of the number of units of domestic currency that can be exchanged for one unit of a foreign currency. For example, the annual average interbank exchange rate of Gh1.4284 to $1 means that one needs to pay an amount of Gh1.4284 for $1. The volume quotation is when one considers the units of foreign currency that can be exchanged for one unit of domestic currency. A typical example is the exchange between the cedi and the dollar in the year 2009 in Ghana quoted as $0.7 for Gh1. An effective exchange rate is determined by aggregating the various exchange rates between a domestic currencies relative to the countrys most important trading partners currency. If we adjust it with the inflation in that year, we arrive at the real effective exchange rate. A correct or appropriate exchange rate has been one of the most important factors for the economic growth in the economies of most developed countries whereas a high volatility or inappropriate exchange rate has been a major obstacle to economic growth of many African countries of which Ghana is inclusive (S.T Appiah and I.A Adetunde, 2011). The volatile nature of exchange rates has been the focus of many researchers. Although some previous studies suggest that variations in an exchange rate has the potential to affect a countrys economic performance, LDCs (Less Developed Countries) have received less attention compared to industrialized or developed economies (Osei-Assibey, 2010). Among the changes demanded by programs of comprehensive economic reform, perhaps none are more politically difficult than devaluation and altering the way the exchange rate is determined. Since the Ghanaian economy is open, exports plus imports routinely account for approximately 40 percent of
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gross national product and changes in the exchange rate will have a very broad effect. Control of the exchange rate also plays an important role in providing goods to political clients in many countries, making it extremely difficult for some Ghanaian leaders to enact reforms. Control of the exchange rate is seen by many in Ghana as a crucial aspect of economic sovereignty. Thus, demand for reform of the exchange from the International Monetary Fund, a common aspect of many conditionality programs, is always controversial. As a result, exchange rate reform often fails in Ghana. For instance, Ghana attempting to float its currencies in the 1980s, the reform was eventually abandoned, often with a real appreciation of the currency. Successful reform of the exchange rate in Ghana, therefore, is particularly interesting. Ghana has consistently chosen to control imports administratively. Unfortunately, reliance on an administrative system to control imports often leads, in practice, to an overvalued exchange rate. When leaders depend on administrative controls rather than the exchange rate to ration imports, they often do not feel compelled to adjust the value of the currency to reflect differences between domestic inflation and the inflation rates of their trading partners. Indeed, in a cantankerous manner, the use of administrative import regimes actually encourages ever-increasing overvaluation of exchange rates because the more the exchange rate becomes overvalued, the greater the benefit a government can bestow on those few who are granted access to foreign goods.

1.2

STATEMENT OF PROBLEM

The openness of a countrys economy is recognized as a cause of volatility of its exchange rate. Ghana presents a classic example of an open economy which engages in international trade transactions. Moreover, with the advent of globalisation, developing economies are becoming more integrated into developed economies with the results of increasing flow of imports and exports. Ghana is not an exception. Maintaining the value
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of the cedi relative to international currencies has posed challenges to policy makers in Ghana. The most important question that arises which is also the focus of this study is, What are the major determinants of the movement of the cedi on the foreign exchange market? A cursory examination of foreign exchange rate history in Ghana shows some considerable level of volatility. Therefore, it would be interesting to explore the determinants of movements in exchange rate and this is the objective of this research.

LITERATURE REVIEW

2.1 THEORETICAL REVIEW

In the past, approaches to exchange rate determination emphasized on the role of import and export demand in the short run. The more modern one uses the asset market approach since in the short run, decisions to hold domestic or foreign assets play a much greater role in exchange rate determination than the demand for import and export. (Frederic S. Mishkin) In a flexible exchange rate regime, just like the price of any other economic commodity, the price of foreign exchange which is the exchange rate is determined by the demand for and supply of foreign currency. This occurs in the foreign exchange market which is open to a wide range of different types of buyers and sellers where currency trading is continuous. The demand for foreign exchange is a derived demand from the aggregate demand for goods and services abroad (imports) and the aggregate supply of foreign exchange is also a derived supply of goods and services abroad (exports). The standard analysis of exchange rate changes and the trade balance uses the specification of the demand for imports and the foreign demand for exports derived from

a postulated 2 good -2 country utility maximization framework by Paul Samuelson in 1949.

2-Good-2 commodity exchange rate model

Assumptions Two countries (Ghana and US) Ghana currency is cedi and US currency is dollar Ghana produces only one commodity; cocoa, and US produces only one

commodity; computers. Diagram Exch. rate

S($)

Ex*

D($)

D*

Quantity of Dollars demanded per day

The equilibrium exchange rate Ex* is determined by the interaction of demand and supply of foreign currency derived from the demand and supply of cocoa and computers by both countries. At that exchange rate level, the amount of dollars demanded per day is denoted by D*. An equilibrium exchange rate of an economy refers to the exchange rate that will equilibrate the balance of payments over the long run when there is no distortion in that economy.
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Depreciation: A decrease in the value of domestic currency relative to foreign

currencies. In this case, the exchange rate is increasing above point Ex*. Appreciation: An increase in the value of domestic currency relative to foreign

currencies. That is when exchange rate is decreasing below Ex*. Two theories; the law of one price and the theory of purchasing power parity, have been developed to explain how the long run exchange rate is determined.

2.1.1

The law of one price

If two countries are producing a homogeneous commodity and the transportation costs and trade restrictions are low then the price of the commodity must be the same throughout the whole world. For instance suppose a car produced in Ghana by Apostle Kwadwo Sarfo Kantanka costs Gh20,000 and an identical American car costs $10,000, then for the law of one price to hold, the exchange rate between cedi and dollar must be Gh2 per dollar or $0.5 per cedi.

2.1.2

The theory of Purchasing Power Parity

The theory states that the exchange rate between two currencies will adjust itself to reflect changes in the price levels of the two countries. Suppose the price of the car increases in Ghana by twenty percent relative to the dollar price, then for the law of one price to hold, the exchange rate must rise by Gh0.20, a twenty percent increase depicting an appreciation of the dollar relative to the cedi. Maintaining the law of one price in the two countries brings about the theory of purchasing power parity which says that if the Ghanaian price increases by twenty percent relative to the American price, the dollar must appreciate by twenty percent. However, the theories have limitations since the assumptions are not realistic in the real world. For instance the assumption that identical goods are produced in both countries is not
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achievable since even furnishing may differ in the two countries. Similarly, the theories do not take into account goods and services that are not traded across borders such as haircut, houses, land and many more. Also trade barriers and transportation costs are assumed to be minimized which are usually not the cases. Due to infant industries protection, many countries tighten trade restrictions to prevent import. In general, factors that cause movement in exchange rate are inflation, interest rates, money supply, and a change in preference for either domestic or foreign goods, trade barriers, balance of payments and productivity.

2.2

EMPIRICAL REVIEW

Empirical research has shown that Ghanas currency has on the average depreciated against major foreign currencies such as the dollar, euro, pound, etc. over the years. The table below shows the year-average interbank exchange rates of the cedi from 2002 to 2011. Exchange Rate Movement in Ghana
US Dollar 0.8439 0.8852 0.9051 0.9131 0.9236 0.9704 0.2214 1.4738 1.4738 1.5224 GB Pound 1.3305 1.5296 1.7412 1.5673 1.8103 1.9511 1.8049 2.2991 2.2709 2.4308

Year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Euro 0.8512 1.0986 1.2309 1.0815 1.2145 1.4398 1.7211 2.0484 1.9407 2.1266

Source: The state of the Ghanaian economy, 2010.

Exchange Rate Movements in Ghana (2002 2011)

3 2.5 2 Dollar 1.5 1 0.5 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Pound Euro

Source: The state of the Ghanaian economy, 2010

From the time series data and graph above, it is clear that the exchange rate is not constant over the years 2002 through 2011. There has been a tremendous increase in the exchange rate between the cedi and euro, pound, and the dollar. According to the bank of Ghana working paper by Zakari Mumuni and Emmanuel Owusu Afriyie (May 2004), such movements in the exchange rates are mainly caused by money supply in Ghana, money supply in foreign countries, productivity in Ghana and foreign countries, inflation rate and interest rate differentials. Moreover, a research paper by Harry A Sackey, (University of Manitoba, Canada) reveals that the exchange rate of Ghana is also influenced by the level of external aid inflows into the country. According to him, the inflow of external aid into a country has a great impact on the countrys exchange rate. However, unlike many other countries, an
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increase in the foreign aid inflows into Ghana leads to decrease in the exchange rate, which actually leads to an improvement in the economy.

2.3 OVERVIEW OF THE EXCHANGE RATE SYSTEM IN GHANA

Ghana adopted a fixed exchange rate regime with occasional devaluation and exchange rationing immediately after independence. The history of exchange rate problems began with economic crises in the early 1970s. In response to a declining economic position, the government of Prime Minister Busia announced in December 1971 a surprise devaluation of 78 percent, thereby reducing the value of the cedi from 1.02 to the dollar to 1.82 to the dollar. In the ensuing years, the exchange rate was largely held steady while Ghana experienced considerable inflation, resulting in a rapid over-valuation of the cedi. In 1972, a black-market rate for the cedi was 28 percent greater than the nominal rate. By 1976, when the cedi was nominally valued at 1.15 to the dollar, the black-market rate was at 2.9 cedis to the dollar (60 percent over the official rate). By 1982, the cedi had only fallen to 2.75 to the dollar, but the black market was at an incredible 61.6 cedis to the dollar (an overvaluation of 2,242 percent). The great overvaluation of the cedi spawned a huge and thriving black market as goods became unavailable at the quoted price. The government implicitly admitted that it had lost control of the situation by creating, in 1980, a system of special unnumbered licenses that allowed Ghanaians to import goods but did not allocate any foreign exchange for this purpose. Potential importers therefore were encouraged to bid for funds on the black market and the overvalued exchange rate also had an important effect on exporters. Prices for the country's major export, cocoa, were artificially low, and Ghana's export farmers either stopped producing or smuggled their produce across the border to Cte d'Ivoire, which was

offering much higher prices, due in good part to a more realistic exchange rate. The overvaluation of the currency was central to Ghana's loss of market share in the 1970s. Other exporters were also hurt, with the result that the value of total exports in constant cedis in 1980 was only 52 percent of the 1970 level, while exports in 1981 were only 32 percent of what they had been eleven years before. In late 1982 the government took the first step to break the mass psychology by raising the price of imported fooduntil then artificially cheap because of the exchange rateso that it was equal to the price of locally produced goods. Government officials explained that it was done to break at least some of the psychological dependence on imported goods and to try to demonstrate to the population how the overvalued exchange rate was hurting peasant growers. The new government then moved dramatically to address the overvalued exchange rate and a host of other problems in the 1983 budget announced in April. It imposed a system of bonuses for exporters and surcharges for importers that lowered the effective value of the cedi from 2.75 to the dollar to 25 to the dollar. The policy improved the competitiveness of Ghanaian products on the world market, which subsequently improved Ghanas balance of payments position and creditworthiness. Government budgetary discipline also resulted in surplus during that period; except for a short period in the early 1990s where the real exchange rate began to appreciate again as the government relaxed its monetary and fiscal policies.

In February 1988, the government embarked on further liberalization of the exchange rate by allowing the establishment of foreign exchange bureaus. These bureaus, which were privately owned, were allowed to trade openly in foreign exchange with no questions asked of either Ghanaians or foreigners who wanted to buy or sell foreign exchange. The establishment of the bureaus led to a further real depreciation of the currency from the auction rate. This further decline occurred because the auction was partially managed and because some Ghanaians were reluctant to indicate to the government how many cedis they possessed. The
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establishment of the bureaus was an extraordinary step because it marked the abandonment of the old system, in which the government had allocated all foreign exchange, in favour of one in which the foreign exchange rate was either determined by auction, for a limited number of goods, or by a competitive free market. The bureaus also served as a lucrative new form of business for those who previously made their living exchanging money on the black market or through privileged access to government-allocated foreign exchange. Thence Ghana has used the flexible exchange rate regime in whose wake the national currency, has experienced volatility for the most part. Against this background, one of the most important issues in Ghanas policy arena over the past years has been that of exchange rate stabilization as demonstrated by successive budgets and policy statements (Politics of Exchange Rate Reform: Strategy and Tactics by Jeffrey Ira Herbst).

3. DATA ANALYSIS, METHODOLOGY

DEFINITION

OF

VARIABLES

AND

At this point of the study, one may ask the following questions: what factors affect exchange rate movements in Ghana? And how do they affect exchange rate? Relative interest rates on assets Potential investors are so conscious about interest rates differentials which determine how much to invest in a particular country. They usually invest by purchasing financial assets such as stocks, and bonds. Suppose the interest rate on assets in Ghana increases relative to those of the foreign countries. The rise in the interest rate will attract foreign investors and Ghanaians who have already invested outside to repatriate their foreign investment into the country to demand assets which requires the use of the cedi. Holding other things constant, the cedi will appreciate since there will be an excess demand for the cedi. In this case the exchange rate will fall drastically. The converse is the situation whereby the
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interest rate in the domestic country falls relative to those of the foreign countries. There will be an investment drain causing exchange rate to increase and depreciating the cedi. In the long run, high rate of interest in the domestic country causes its currency to appreciate and vice-versa, when all other determinants are held constant.

Differences in inflation If the price of the car increases in Ghana relative to that of America, the cedi tends to depreciate so that car can still sell well in Ghana and this is what the theory of purchasing power parity says. In contrast, if the price of car in America increases with all other factors held constant, the cedi will appreciate as a result of exchange rate decreasing. In general and in the long run, higher rates of inflation in a countrys price level (relative to the foreign price levels) cause the domestic currency to depreciate and vice versa, holding all other factors constant. Changes in money supply also affect exchange rate in Ghana but through either inflation or changes in productivity. Changes in productivity in both domestic and foreign countries Higher output in a country tends to lower prices of its domestically produced goods relative to those of the foreign countries when everything is held constant. In this case demand for locally produced goods increases causing the countrys currency to appreciate. On the other hand if there is a decline in the growth rate of output levels relative to that of the population, prices of goods and services in the domestic country will shoot up, ceteris paribus. People will then demand more of foreign goods which are relatively cheaper. This will cause the countrys currency to depreciate in the long run. Ghana also experiences the same problem as a country.

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Net export Net export is simply the export of a country minus its import. Ghana exported goods worth $135m to the United States and imported $715.9m worth of goods in the year 2009. The difference which is the net export or balance of payments of $-580.9m requires an additional demand for dollars of about $580.9m holding other things constant. This led the cedi to depreciate relative to the dollar from Gh1.21 to Gh1.42 per dollar. In general, an increase in the net export between two countries causes its exchange rate to decrease in favour of the domestic currency and hence an appreciation of that currency when all other factors are held constant. On contrary, if the net export decreases, the countrys currency will depreciate. An increase in trade barriers such as tariffs and quotas in a domestic country decreases import and its currency appreciates relative to foreign currencies in the long run. We then complement this research with data analysis through econometrics principles to estimate the coefficient of each of the determinants to see whether indeed they significantly affect the exchange rate in Ghana.

Assumptions
1. Nominal exchange rate is used as the dependent variable in this analysis. 2. There is a linear relationship between exchange rate and the independent variables. 3. The Ordinary Least Square together with its assumptions is used to estimate the variances and the parameters of the independent variables. 4. The variables fit the additive model type of time series specification 5. Gross domestic product, inflation and interest rate on all assets of Ghanas trading partners are held constant. 6. All assets are held in the form of 91- days Treasury bills.
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We will first of all establish a relationship the exchange rate between the cedi and the US dollar and its determinants. The main type of data used is the time series data and limited between the period 1992 and 2010. Relevant statistics are collected from various sources. The following variables; balance of trade (net export between Ghana and US) was obtained from the World Economic Outlook of International Monetary Fund and the Ghana Statistical Service whereas the data on Treasury bill rates and foreign exchange rates were obtained from the Bank of Ghana. The following notations are used; Excht TBRDt INFDt NXt is the exchange rate is the Treasury bill rate differentials is the inflation differentials is the Net export or balance of payments

Where exchange rate is measured in cedis, Treasury bill rate and inflation are in percentages and Net export is measured in millions of dollars.

Model Specification
Based on the assumptions and variables defined, we specify an additive model as: .. (1) Where Bi s represent the coefficients of the independent variables and et represents all errors incurred in measuring the dependent variable, specifying the model and omitting any other determinants of exchange rate in Ghana. Now since GDP, interest on assets and inflation of all Ghanas trading partners are held constant, the specified model in equation (1) reduces to: .. (2)
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But we also know that net export depends on both price levels and the level of productivity. In other words, there is a relationship between balance of trade, price levels and output levels of an economy when analyzing international trade. Therefore we reduce equation (2) to: . (3)

4.1

REGRESSION RESULTS AND INTERPRETATION

Using data in appendix 2, we obtain the following results; Model Summary Mode Adjusted l R R Square R Square 1 Model Summary .796 .892 .771 Std. Error of the Estimate .22610

ANOVA Model 1 Sum of Squares 3.193 .818 4.011 Df 2 16 18 Mean Square 1.596 .051 F 31.225 Sig. .000

Regression Residual Total

Mode l 1 (Constant) 91 DAY TREASURY -.019 BILL RATE NET EXORT -.001

Coefficients Unstandardized Standardized Coefficients Coefficients Std. B Error Beta T .922 .165 5.583 .005 .000 -.471 -.573 -3.719 -4.525

Sig. .000 .002 .000

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... (4) (0.167) (0.007) (0.000)

Now considering equation (4), the coefficient of the Treasury bill rate is negative and statistically significant because we are 99.8% confident that interest on assets affect exchange rate. And the interpretation is that a 1% change in interest rate on assets in Ghana with that of US held constant, will cause about Gh0.019 change in exchange rate in the opposite direction, holding all other variables constant. Hence the model has established the negative relationship between the exchange rate and the interest rate on assets as required. This result indicates that in reality interest rate on assets is one of the determinants of exchange rate between the cedi and the dollar. Equation (4) also shows that the coefficient of net export between Ghana and US is negative and statistically significant at all levels. And so the interpretation is that when Ghanas balance of payments change by $1, the exchange rate between the cedi and the dollar will change by GH0.001 in the opposite direction holding all other variables constant. The model has a high coefficient of determination (R2) which indicates that the determinants jointly explain about 80% of the variations in the dependent variable (Exchange rate). The parameters in general are statistically significant since the P-value of F is significant at all levels (that is Prob > F = 0.000). This implies that, the independent variables are indeed the major determinants of exchange rate movements in Ghana. However, the fact that these variables affect the exchange rate between the cedi and dollar does not necessarily mean that they also affect the effective exchange rate. To address this problem, we will further establish a relationship between the dependent variable (effective exchange rate) and the independent variables (balance of payments and interest rate on assets) using the same model. . (5)
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Where EERt is the effective exchange rate at year t with base year 2005. The necessary data is taken from The state of the Ghanaian economy by ISSER, 2009 and 2010 editions. Making use of the data in appendix 1, we also obtain the following results;

Model Summary Model R 1 .934 Adjusted R -Square Square .872 .821 R- Std. Error of the Estimate 2.50092

ANOVA Model 1 Sum Squares Regression 213.766 Residual Total 31.273 245.039 of Df 2 5 7 Mean Square F 106.883 6.255 17.089 Sig. .006

Coefficients Unstandardized Coefficients Model 1 (Constant) B 110.654 Std. Error 3.447 .221 .000 -.947 -.469 Standardized Coefficients Beta T 32.099 -5.698 -2.823 Sig. .000 .002 .037

interest rate -1.261 net export -.001

.. (6) (3.447) (0.221) (0.000)

Equation (6) also establishes a negative relationship between the effective exchange rate and the independent variables which are the balance of payments and interest rate on assets. Since each of the parameters is statistically significant at levels less than 5% conventional and the
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overall significance of the parameters is also less than 5%, then we can conclude that indeed the effective exchange rate is also determined by both balance of payments and interest rates on assets.

5.

CONCLUSION AND RECOMMENDATION

The main aim of this study was to establish the determinants of exchange rates movement in Ghana and our objective has been achieved through the use of an econometric analysis. Based on the regression results, it is clear that interest rate and net exports are the main determinants of exchange rates movement in Ghana. Indeed the coefficient of each of the independent variables conforms to economic theory. There is the need to encourage export rather than import which will bring about a high trade balance (surplus) that will reduce the exchange rate and appreciate the cedi to an equilibrium level. Policy makers need to put in place measures that will ensure a stable macroeconomic environment with the aim of having a stable exchange rate system. This will attract both foreign and viable Ghanaian investors to engage in investment portfolios.

REFERENCES:
1. Albina, M. 2011. International Monetary Fund (IMF), World Economic Outlook 2. Appiah, S. T and I.A. Adetunde, 2011. Current Research Journal of Economic Theory 3 (2): 76-83. 3. Osei-Assibey, K.P., 2010. Exchange rate volatility in LDCs. 4. Zakari, M. and O. Afriyie, 2004.Bank of Ghana: Working paper.
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5. Herbst, J.I., 1993.Politics of Exchange Rate Reform in Ghana: Strategy and Tactics 7. ISSER., 2009 and 2010.The state of the Ghanaian economy. 8. Bank of Ghana., 2010. Treasury Bill Interest Equivalence Rates. 9. Sackey, S.H.,University of Manitoba, Canada. 10. Mihkin, F.,2004.The Economics of Money Banking and Financial System Appendix
Appendix 2

Year 2003 2004 2005 2006 2007 2008 2009 2010

EER 92.8 91.5 100 107.3 104.5 99.5 91.6 98.1

Rates on T-bills(91 days) 18.09 16.38 11.13 9.41 10.34 18.22 21.33 11.89
Appendix 1

Export(mUS$) 1990.4 2285.7 2370.7 2845 3403.7 4598.9 3425.4 7960.08

Import(mUS$) 3850 5192.7 5932.5 7043.2 9571.9 12205.5 10470.8 10922.1

NX(mUS$) -1859.6 -2907 -3561.8 -4198.2 -6168.2 -7606.6 -7045.4 -2962.02

Sources: The state of Ghanaian economy, 2009 and 2010 editions, World data bank official website.

Year 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Exch. rate GH 0.04 0.06 0.0956 0.12 0.164 0.12 0.23 0.35 0.7 0.704 0.73 0.84 0.89 0.91 0.92 0.97 1.21 1.42 1.47

T-bill rate(Gh) 20.85 34.6 30.72 38.37 42.01 45.82 38.41 26.46 36.91 41.65 25.96 29.95 18.29 16.35 11.11 10.32 18.86 24.48 13.57

NX($mm) -27.6 0.3 74.1 28.9 -124.4 -159.7 -81.9 -24.1 13.4 -12.5 -76.1 -127.3 -164.2 -179 -97.3 -217.6 -386.2 -580.9 -715.9

Sources: World economic outlook of International Monetary Fund, The Bank of Ghana and World data bank official website.

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