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

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. This research comprehensively analyzes the complex dynamics between exchange rate fluctuations and consumer prices in Somalia, revealing a pronounced asymmetry. Through sophisticated modeling, the study demonstrates that exchange rate depreciations significantly impact inflation more than appreciations, a finding critical for effective monetary policy in dollarized economies like Somalia. The findings indicate the need for robust regulatory frameworks to mitigate the adverse effects of exchange rate fluctuations on the economy. This work is instrumental for policymakers, providing evidence-based recommendations to enhance regulatory measures aimed at stabilizing prices and managing inflationary pressures. Additionally, it contributes to the broader economic literature by detailing the unique challenges and strategies relevant to managing economies with significant dollarization.