Understanding inflation dynamics in The Gambia : the roles of unemployment, monetary policy and output gap

Abstract

Maintaining Price stability while fostering for economic growth remains a central challenge for monetary policy, especially in small open economies vulnerable to external shocks. Equally critical is the management of the output gap as it directly affects the inflationary pressure and employment outcomes. Coupled with, these twin monetary policy and output gap dynamics continue to attract considerably attention from researchers and policymakers due to their impact on economic performance and societal well-being. Despite all of the policy interventions, the simultaneous presence of high inflation, high unemployment and weak macroeconomic stability. remains baffling to policy makers. Against this backdrop, this study re-examines the inflation dynamics by integrating unemployment, monetary policy variables (money supply and interest rate) and output gap in The Gambia for the period 1991 to 2024, employing the Autoregressive Distributed Lag (ARDL) bounds testing approach to cointegration. Findings from the bound test confirms the presence of long-run cointegration relationships and the error correction mechanism suggests a quick reversion to equilibrium, suggesting the strength of the long-run relationships in all three models. The results of long run and the short-run indicate that unemployment exert a significant negative effect on inflation, validating the Phillips curve hypothesis in The Gambia though moderated by structural rigidities in the labour market. Money supply expansion significantly fuels inflation whiles a rise in interest rate consistently reduce inflation, validating the monetarist view that inflation is a monetary phenomenon. However, output gap exerts no significant effect on inflation in both the short-run and long-run underscoring that inflation in The Gambia is not demand driven. This finding is particularly relevant for policy makers, as it highlighting that unemployment does exert a significant influence on inflation but its effect is moderated by structural rigidities in the labour market rather than cyclical demand dynamics. Consequently, price stability measures alone maybe insufficient to reduce unemployment, suggesting the need for labour market and institutional reforms to that operate alongside inflation-targeting policies, ensuring that monetary discipline is matched with structural interventions to address joblessness in order achieve sustainable unemployment growth. Therefore, our recommendations for policy are three-fold. Strengthen the monetary discipline by efficient management of interest rates as they emerge as strong instrument against inflation. Second, maintain an appropriate pace of money supply growth as growth in money supply is directly linked to price instability. Third, address the issue of unemployment through structural labour market and institutional reforms. These measures combined stabilize prices and help to solve the long-term employment problems. Finally, our study was limited by employing only the linear ARDL model and does not extend to nonlinear ARDL (NARDL) model, also incomplete data which resulted in the exclusion of some important monetary policy instrument such as exchange rate policy, reserve requirements and open market operations. Thus, future research is recommended to integrate these limitations to capture full monetary policy transmission mechanism and the potential asymmetric effects of positive and negative shocks.