# Exchange Rate Variation and Inflation in Nigeria

Pages: 7 (2193 words) Published: September 12, 2010
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Max

School of Technology and Society

MASTER DEGREE PROJECT

EXCHANGE RATE VARIATION AND INFLATION IN NIGERIA (1970- 2007)

Master Degree Project in Economics and Finance D-Leval 15 ECTS Spring term Year 2008 Onosewalu Okhiria 761130-P319 Taofeek Sesan Saliu 761130-P719 Supervisor: Bernd-Joachim Schuller(PhD) Examiner: Max Zamanian (PhD)

ABSTRACT

This study examines the impact of exchange rate on inflation in Nigeria economy between 1970 and 2007. We analysed the trend of inflation and exchange rate in the last 38 years by evaluating the relationship between government expenditure, money supply, Oil revenue, exchange rate and inflation as the dependent variables. We adopted the Augmented Dickey- Fuller to carry out the unit root test and cointegration with Johansen test. Our result shows that the individual variables are integrated order one, that is a unit root exist. This means that each variable tends to follow a random walk. On the other hand, inflation rate, exchange rate, oil revenue, government spending and money supply are cointegrated. This revealed a strong relationship among the variables though inflation rate and exchange rate show no long term relationship, but short term relationship seems to exist between them.

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Acknowledgements We would like to express our gratitude to all those who gave us the possibility to complete this thesis. We want to thank the Department of Financial Economics for giving our opportunity to commence this program and the thesis in the first instance, to do the necessary research work. We are deeply indebted to my supervisor Bernd-Joachim Schuller (PhD) whose advice, stimulating suggestions and encouragement helped ours in all the time of research for and writing of this thesis. We thank almighty God, for sustaining us during the program, furthermore thanks to and all our lecturers, especially Hans Mörner and Max Zamanian (PhD) whose role as lecturers gave us enduring foundation. Finally thanks to our family members.

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1.1 Introduction-------------------------------------------------------5 1.2 Statement Problem-----------------------------------------------7 1.3 Objective of Study-----------------------------------------------8 1.4 Justification of Study--------------------------------------------8 1.5 Study Methodology----------------------------------------------9 1.6 Scope of the study------------------------------------------------9 1.7 Plan of Study------------------------------------------------------9 1.8 Type and Sources of Data---------------------------------------9 CHAPTER TWO: The Foreign Exchange Market in Nigeria 2.1 Foreign Exchange Market Evolution--------------------------10 2.2 The Exchange rate Channel of Monetary Policy-------------11 2.3 Exchange Policy in Nigeria-------------------------------------13

CHAPTER THREE: Literature Review 3.1 Exchange Rate-----------------------------------------------------17 3.2 Money Supply Mechanism--------------------------------------24 3.3 Government Expenditure----------------------------------------26 3.4 Theories of Inflation----------------------------------------------28 3

3.5 Review of Empirical Studies------------------------------------33 3.6 Phenomenon of the Dutch Disease Model---------------------38 CHAPTER FOUR: 4.1 Model and Empirical Estimation--------------------------------40 4.2 Presentation of the Model----------------------------------------40 4.3 Interpretation of Result-------------------------------------------42 CHAPTER FIVE: Conclusion--------------------------------------------------------------47 Bibliography------------------------------------------------------------48 TABLE: 2.1 Annual...

Bibliography: -----------------------------------------------------------48 TABLE: 2.1 Annual Data--------------------------------------------------------12 4.1 ADF Test-----------------------------------------------------------41 4.2 Co-integration on the Five Variables---------------------------43 4.3 Co-integration, Inflation and Exchange Rate------------------44 4.4 Co-integration, Inflation and Money Supply------------------44 4.5 Co-integration, Inflation and Government Expenditure-----44 4.6 Co-integration, Inflation and Oil Revenue--------------------45 DIAGRAM: Demand Shift----------------------------------------------------------18 Supply Shift------------------------------------------------------------18
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CHAPTER ONE
1.1 INTRODUCTION WHAT IS INFLATION? Inflation is one of the most frequently used terms in economic discussions, yet the concept is variously misconstrued. There are various schools of thought on inflation, but there is a consensus among economists that inflation is a continuous rise in the prices. Simply put, inflation depicts an economist situation where there is a general rise in prices of goods and services, continuously. It could be defined as ‘a continue rise in prices as measured by an index such as the consumer price index (CPI) or by the implicit price deflator for Gross National Product (GNP). Inflation is frequently described as a state where “too much money is chasing too few goods”. When there is inflation, the currency losses purchasing power. The purchasing power of a given amount of naira (currency) will be smaller over time when there is inflation in the economy. For instance, assuming N10.00 (Nigeria unit currency) can purchase 10 shirts in the current period, if the price of shirts double in the next period, the same N10.00 can only afford 5 shirts. In the definition of inflation, two key words must be borne in mind. First, is aggregate or general, which implies the rise in prices that constitutes inflation must cover the entire basket of goods in the economy as distinct from an isolated rise in the prices of a single commodity or group of commodities? The implication here is that changes in the individual prices or any combination of the prices cannot be considered as the occurrence of inflation. However, a situation may arise such that a change in an individual price could cause the other prices to rise. An example is petroleum product prices in Nigeria. This again does not signal inflation unless the price adjustment in the basket is such that the aggregate price level is induced to rise. Second, the rise in the aggregate level of price must be continuous for inflation to be said to have occurred. Broadly, inflation can be grouped into four types, according to its magnitude: 1. Creeping inflation: This occurs when the rise in price is very slow, a sustained annual rise in price of less than 3% per annum falls under this category. Such an increase in prices is regarded safe and essential for economic growth. 2. Walking Inflation: Occurs when prices rise moderately and annual rate is a single digit. It has a range of between 3% and less than 10%. Inflation of this kind is a warning signal for government or policy 5
makers to control it before it turns into running inflation. 3. Running Inflation: When prices rise rapidly at the rate of between 10 percent and 20 percent per annum, it is called running inflation. The middle class and the poor feel the bite. Only strong monetary and fiscal measures can control such inflation. This is where the Nigeria economy finds her self in the last two and half decades which to this moment is still an issue in the economy. 4. Hyper Inflation: When prices double or triple in digit rates, that could result in a situation where inflation rate can no longer be measured or controlled. Prices could rise many times everyday. For instance, the current Zimbabwe inflation rate is at 37131.9%. Basically, two identified causes are Demand pull and Cost push inflation. This would be discussed in later chapters. Inflation generally is a worldwide phenomenon; it is not peculiar to Nigeria only. The major four factor that have been identified as the causes of inflation in Nigeria are the money supply, nature of government spending, exchange rate, price of energy product and the oil revenue hence the wealth of the country depend largely on the oil price. Why is inflation a must fight issue with central bank? Central banks world over are obsessed about inflation and therefore, devote a significant amount of resources at their disposal. Hence, the primary objective of monetary policy is to ensure price stability. The focus by central bank of Nigeria (CBN) on price stability derived from the overwhelming empirical evidence that it is only in the midst of price stability that sustainable growth can be achieved. Price stability does not connote constant price level, but it simply means that the rate of change of the general price level is such that economic agents do not worry about it. Inflationary conditions imply that general price level keeps increasing over time. To appreciate the need for policy makers (CBN) to fight inflation, it’s imperative to understand the implications of frequent price increase in the system. Such implications are: 1. Discouragement of long term planning 2. Reduction of savings and capital accumulation 3. Reduction of investment 4. Shift in the distribution of real income and consequent misallocation of resources and
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5. Creating uncertainty and distortions in the economy. These are what the Central bank of Nigeria must guard against to achieved a stable economy and devour of inflation and exchange rate fluctuations. HOW DOES INFLATION AFFECT THE ORDINARY MAN IN NIGERIA? Inflation affects different people or economic agents differently. Broadly, there are two economic groups in every society, the fixed income and the flexible income group. During inflation, those in the first group lose while those in the second gain. This is because the price movement of different goods and services are not uniform. During inflation, most prices rise, but the rates of increase of individual prices differ. Prices of some goods and services rise faster than others while some may remain unchanged. As mentioned before the poor and the middle class suffer because their wages and salaries are more or less fixed but the prices of commodities continue to rise. On the other hand, businessmen, Industrialist, traders, real estate holder’s speculators and others with variable incomes gain during rising. This will be discussed in detail in the literature review. The major objective of macro economic policy is to create a stable economy that would maintain and achieve an acceptable level of employment, good utilization of available resources, a good balance of payment, sustainable growth in economic and relatively price stability. The price stability level has a greater impact on average individual standard of living. Nigeria has experience severe inflationary economy since 1970 till date. Several measures have been taken to against the worst form of inflation and exchange rate fluctuations that had characterized the Nigeria economy for more the three decades. 1.2 STATEMENT OF PROBLEM Nigeria has experienced continuous rise in the prices of goods and services in the mid 1970s due to fixed exchange rate policy introduced. It was worst during the period surrounding exchange rate deregulation policy in the mid 1980s. Inflation in the 1970s was due to civil war, salary awards (Ndogwi award) and excess government spending. Although, Nigerian’s economy generated a lot of revenue from oil boom it goes along way to cater for its increased expenditure. Inflation in the mid 1990s became terrible due to sanction on Nigeria by international community. Inflation rate has been reduced due to policy maker adoption of deregulation and privatization policy in mid 2000s while Exchange rate as well reduced from double digit to a single digit due to adoption of Dutch Auction system (DAS) introduced 7
in 2002. There are various studies on the subject matter. Elbadawi (1990) concludes that devaluation of the official exchange rate is not inflationary; he further stated that prices have adjusted to the parallel exchange rate. Greene and Canetti (1991) in their study on ten Africa countries arrived at the conclusion that exchange rate movement explains the inflationary change. Moser (1994) found that monetary expansion driven mainly by expansionary fiscal policies, and devaluation of the naira as well as agro-climatic conditions, explains the inflationary process in Nigeria. The different views held by these schools of thought mentioned above as to what obtainable in the Nigeria economy brought some certain questions: . What is the completely accurate impact of the exchange rate on inflation in Nigeria? . What is the relationship between government expenditure, money supply, exchange rate and inflation in Nigeria? This study will attempt to answer these questions and find out empirically through economic modelling, the relationship between exchange rate management and inflation in Nigeria. 1.3 OBJECTIVE OF STUDY This study will be guided by the following objectives: (a) To find out the impact of exchange rate on the current rate of inflation in the economy. (b) To show the relationship among money supply, revenue from oil, inflation, government expenditure and exchange rate in Nigeria. (c) To come up with suitable suggestions that can assist future policy making in Nigeria. 1.4 JUSTIFICATION OF STUDY Central banks the worlds over are obsessed about inflation and, therefore, devote a significant amount of resources at their disposal to fight inflation. Hence, the primary reasons are because of its adverse consequences on individuals and the economy as a whole. The effects of inflation include continuous erosion of the purchasing power of money, inequitable distribution of income among earners, loss of social welfare due to price increases and reduction in savings and investments. The justification of the study is that it intends to answer certain questions such as, what are the causes of inflation in Nigeria, and how can it be related to exchange rate, money supply and government expenditure. This answer will form the basis upon which suggestions will be made as to how inflation can be reduced or eliminated totally or to the 8
minimum level. 1.5 STUDY METHODOLOGY This study will adopt the unit root test (Augmented Dickey Fuller) as well as Johansen co-integration test. The null hypothesis is accepted if unit root exists (H0 = â = 0) otherwise the alternative hypothesis is accepted (HA =â < 0). While the null hypothesis for co integration is accepted if (HA= ∏ = 0) otherwise rejected if (H0= ∏