Econometric Analysis Of The Relationship Between Exchange Rate Depreciation And Inflation In Nigeria

Introduction

1.1 Background to the Study

The problem of how to reduce inflation has been a central issue among policy makers since the 1970s. Although available data show that the Nigerian economy has on the average experienced moderate inflation in the pre-SAP period, the unfavourable consequences of inflation have since assumed an intolerable dimension(Abramovitz, 1986). Several authorities have attributed it to the expansion of public expenditure arising from the increase in oil revenue, which culminated into a vast expansion of aggregate demand and the inelastic supply of domestic output.
The rapid growth in money supply arising from the monetization of oil earnings also exerted an upward pressure in general price level. When the price of crude oil slumped during the 1st half of 1980’s, Nigeria’s crude oil, which sold at slightly above US$41 per barrel in early 1981, fell to less than US$9 by August, 1986. This triggered off a series of developments in the economy. One example of such developments is the state of fiscal crisis as reflected in the persistent budget deficit, which culminated to approximately N17.4 billion in the five years between 1980 and 1984. Monetary policy became highly expansionary as a large part of the deficit incurred during this period were financed through the creation of credit thus the local domestic credit to the economy recorded an average annual growth rate of 29.9% in 1980–84 and most of the increase was attributable to net claim by government. However, the inflation in 1984, which stood at almost 40%, is often explained in terms of acute shortage of imported goods and services imposed by inadequate foreign exchange earnings, a derivation of the steep fall in crude oil prices (Abramovitz, 1986).

SAP was adopted in July 1986 to among other things get the price right using the foreign exchange rate reform as its central tool(Acar, 2000). In pursuit of this, the second tier foreign exchange market was introduced in late September 1986 and since that time, the naira has depreciated sharply against the US dollar and the other major currencies. This development shows that a depreciation of the naira has a role to play in Nigeria’s recent inflationary trends. In addition to the above, the frequent fiscal deficit operation in the last two decades in which budget deficit is financed through banks has further exerted upward pressure on the general price level. This suggests that the current inflation may have been caused by these factors. While the channels through which exchange rate depreciation affect prices are well known, the extent to which this phenomenon engenders price inflation in Nigeria is one of the reasons for the study.

1.2 Statement of the Research Problem

Statement of Problem The macroeconomic performance of a nation is determined by a number of factors categorised into two; exogenous and endogenous. The exogenous factors include changes in terms of trade, economic activities in industrialized countries and international interest rates and prices. The endogenous factors include fiscal stance and exchange rate policy (Adewuyi, 2005). The exchange rate has been singled out as one of the most important factors influencing economic performance. According to Agenor (1991), the dismal economic performance in Latin America, Asia and Africa can be linked to real exchange rate behaviour. Moreover, it is widely acknowledged that the real exchange rate is one of the most important relative prices in an economy; therefore, it can be argued that a sound exchange rate policy and an appropriate exchange rate are crucial conditions for improving the economic performance of a nation.

1.3 Research Objective

The main objective of this study is an econometric analysis of the relationship between exchange rate depreciation and inflation in Nigeria.

Specific objectives include to:

Ascertain whether exchange rate depreciation is a significant determinant of inflation in Nigeria.

Ascertain the stability of the inflation function in Nigeria over the sampled period.

Make recommendations based on findings.

1.4 Research Questions

Does exchange rate depreciation is a significant determinant of inflation in Nigeria.

Is there stability of the inflation function in Nigeria over the sampled period?

1.5 Research Hypotheses

There is no significant relationship between exchange rate depreciation and inflation in Nigeria.

Exchange rate depreciation does not significantly impact inflation in Nigeria.

1.6 Significance of the Study

This study is important to students and scholars in the department of economics and the Nigerian economy. The empirical reviews of this study will add significantly to the previous knowledge of readers and scholars. On the part of the government, the findings and recommendations that will be made in this study will add to the economic policy formation of Nigeria. This study will provide directions for Nigeria’s economic policy.

1.7 Scope of the Study

The study focuses on analysis of the relationship between exchange rate depreciation and inflation in Nigeria.The change in real effective exchange rate is decomposed into anticipated and unanticipated components and the effect of each component on total and sectoral outputs as well as inflation is investigated.

1.8 Limitations of the Study

This study is limited to the relationship between exchange rate depreciation and inflation in Nigeria. Also, lack of availability of previous research materials constituted a setback that ultimately determined the extent I could evaluate this study. The limited time allocated for the completion of this study also serve as a constraint in this study.

1.9 Definition of Terms

Exchange Rate:

The rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of the euro.

Inflation:

An increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money.

Economic Growth:

The increase or improvement in the inflation-adjusted market value of the goods and services produced by an economy in a financial year. Statisticians conventionally measure such growth as the percent rate of increase in the real gross domestic product, or real GDP.

Macroeconomics:

A branch of economics dealing with performance, structure, behaviour, and decision-making of an economy as a whole.

Interest Rate:

The amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, the compounding frequency, and the length of time over which it is lent, deposited, or borrowed.

1.10 Organization of the Study

There are five chapters in this study, the first of which discusses the background, statement of the research problem, aims, research question, and research hypotheses as well as the study’s significance, scope, and limitations. Chapter 2 contains conceptual, theoretical, and empirical reviews. The study methodology is covered in Chapter 3. This chapter covers the research design, the study’s population, the sample size and methodology, the data collection source and method, the study’s instruments, the data analysis method, and the validity and reliability of the study.