An Empirical Assessment of Exchange Rate Depreciation and Currency Substitution in Sierra Leone

Abstract

This paper investigates the dynamics of exchange rate depreciation and currency substitution in Sierra Leone, focusing on the period between 2020M1 to 2023M5, which is marked by the COVID-19 pandemic, global supply chain disruptions, elevated inflation, the Russia-Ukraine war and interest rate hikes. Currency substitution, defined as the substitution of a domestic currency with a foreign one due to the inefficacy of the former, has been associated with economic instability, adversely impacting living conditions, financial system de velopment, and monetary policy autonomy. The paper employs the ARDL modeling and bounds testing, to analyze variables such as Broad Currency Subs titution (BCS), Narrow Currency Substitution (NCS), Nominal Exchang e Rate Depreciation (NERD), Gross International Reserves (GIRs), and Consumer Price Index (CPI). The ARDL estimates, which capture both short-run and long-run relationships, highlighted the importance of exchange rate depreciation, gross international reserves, and the consumer price index in influen cing currency substitution. The results revealed valuable insights for policy makers in understanding the dynamics of currency substitution in the context of exchange rate depreciation. The study’s policy implications emphasize the im portance of exchange rate stability, as depreciation emerged as a significant driver of currency substitution. Policymakers are also encouraged to implement measures to build a strong international reserves buffer, control inflation and combat the practice of currency substitution.