This study was motivated by the wide variations in the output of cotton between 1976 and 1995, given that estimated domestic resource cost ratio for cotton production was 0.6, indicating the country’s comparative advantage in the use of labour and capital in cotton production.

Building on earlier research findings that level of price incentives was one of the most important factors that influence cotton supply, the author justified studying the underlying factors that determine prices themselves. One such factor is the real exchange rate, which affects the transmission of changes in world price of lint to the domestic prices of lint and seed cotton. The real exchange rate is said to be misaligned if it is not equal to the equilibrium exchange rate. Such misalignment has its root in monetary, fiscal, trade and exchange rate policies.

The real exchange rate misalignment be an overvaluation of domestic currency which serves as a tax on prices of traded goods; in the case of overvaluation, it exchange rate misalignment serves as a subsidy. That economic policies influence price incentives through the RER and play a very important role in agricultural development is well documented (Bautista, 1987; Mundlak et al. 1990; Fosu, 1992 and Fosu, 1994). Kruega (1992) in a study of policies in selected African countries, including Ghana, found that macro policies, including those on the exchange rate, taxed agricultural producers in sub-Sahara Africa by 28.6 percent on average; the implicit tax through direct agricultural policies, was 23 percent.

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