A study of the relation between inflation and exchange rates in the Fiji islands: a cointegration and vector error correction approach

The main purpose of this study is to examine the effects of the exchange rates, international prices, and the demand shocks on inflation in Fiji. How the domestic inflation in a pegged exchange rate system is aligned with international price shocks is an important monetarist idea, and this is tested in this study. This study employs annual data from 1975 to 2010. The multivariate cointegration tests are done after the unit root tests, and further, the Vector Error Correction (VEC) model shows that the changes in Fiji’s CPI are Granger caused by the long-term trends in all other variables, and the CPI in Australia, and devaluation-year dummies are used as exogenous variables in the VEC model, and the changes in exchange rate and changes in demand shocks are the independent variables but made endogenous in the VEC model. The impulse response function also shows that due to the exchange rate depreciation, inflation has increased for many years in Fiji. The policy implication of our study is that as a monetary policy instrument, the flexibility of the exchange rate policy is indispensable for Fiji to appropriately absorb the international supply and price shocks.