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Exchange
Rate Variations And Inflation In The Nigerian Economy
ABSTRACT
This study
examines the impact of exchange rate variations on inflation in Nigerian
economy between 1979 and 2008. This study made use of Ordinary Least Square
(OLS) regression in analyzing the impact of exchange rate variations on
inflation in Nigeria. There are also other variables that determine the impact
of exchange rate on inflation in Nigeria in the last 30 years by evaluating the
relationship between government expenditure, money supply, exchange rate and
inflation as the dependent variables. This revealed a strong relationship
between inflation rate and government expenditure and a negative relationship
between exchange rate and inflation.
CHAPTER ONE
1.1
BACKGROUND OF THE STUDY
Exchange
rate is the price of one currency in terms of another. Given two currencies,
the Naira and the US Dollar, for example, the exchange rate between naira and
the dollar is equal to the units of naira needed to purchase one unit of the
unit of the US dollar. The value of naira in terms of dollars, in this case, is
a reciprocal of the N/$ exchange rate.
The exchange
rate is one of the intermediate policy variables through which monetary policy
is transmitted to the larger economy through its impact on the value of
domestic currency, domestic inflation (the pass through effect), the external
sector, macroeconomic credibility, capital flows, and monetary and financial
stability. Thus, exchange rate might induce changes in relative prices of goods
and services, and the level of spending by individuals and firms, especially if
significant levels of their wealth are held in foreign currencies. An
appreciation in the value of an exchange rate rise makes imported goods and
services relatively cheap, while depreciation makes export become cheaper to
foreign buyers, thereby inducing higher competition in export markets at
home.
The
evolution of the foreign exchange market in Nigeria up to its present state was
influence by a number of factors such as the changing pattern of the
international trade, institutional changes in the economy and structural shifts
in production. Before the establishment of the Central Bank of Nigeria (CBN) in
1958 and the enactment of the Exchange Control Act 1962, foreign exchange was
earned by private sectors and held in the balances aboard (outside Nigeria) by
commercial banks which acted as agent for local exporters. During this period,
agriculture export contributed the bulk of foreign exchange receipts. Then the
currency was Nigerian pound which was tied to the British pound sterling her
colonial master at par, with easy convertibility, delayed the development of
active foreign exchange market in Nigeria.
The foreign
exchange market experienced a boom during this period and the management of
foreign exchange became necessary to ensure that shortage s did not arise.
However it was not until 1982 that comprehensive exchange controls were applied
as a result of the foreign exchange variations that set in that year. The increasing
demand for foreign exchange at the time when the supply was shrinking
encourages the development of a flourishing parallel market of foreign
exchange.
The exchange
controls was unable to evolve an appropriate mechanism for foreign exchange
allocation in consonance with the goal of internal balance. This led to
introduction of second tier Foreign Exchange Market (SFEM) in
September1986.Under SFEM, the determination of the Naira exchange rate and
allocation of foreign exchange were based on market forces.
To enlarge
the scope of Foreign Exchange Market, Bureaux de Change was introduced in 1989
for dealing in privately sourced foreign exchange. As result of volatility in
rates, further reforms were introduced in the Foreign Exchange Market in 1994.
These included the formal pegging of the Naira exchange rate, the restriction
of Bureaux de Change to buy foreign exchange as agents of the CBN, the
reaffirmation of the illegality of the parallel market and the discontinuation
of open account and bills for collection as means of payments sectors.
The Foreign
Exchange Market was liberalized in 1995 with the introduction of an Autonomous
Foreign Exchange Market (AFEM) for the sale of foreign exchange to end-users by
the CBN through authorized dealers at the market determined exchange rate. In
addition, Bureaux de Change again accorded the status of authorized buyers and
sellers of foreign exchange. The Foreign Exchange was further liberalized in
October, 1999 with the introduction of the Inter-bank Foreign Exchange (IFEM).
The Nigerian
foreign exchange market has witnessed tremendous changes. The Second- Tier
Foreign Exchange Market (SFEM) was introduced in September, 1986, the unified
official market in 1987.
The foreign
exchange market, or forex, is one of the largest markets in the world, and is
in constant flux. When its night in one part of the world, its morning in
another and exchange rates fluctuates as currencies are bought and sold.
Changes in
the exchange rate therefore, have implications for individual spending and
investments behaviour of firms, all of which can affect aggregate demand. A
market based exchange rate will change whenever the values of either of the two
component currencies change. A currency will tend to become more valuable whenever
demand for it is greater than the available supply. It will become less
valuable whenever demand is less than available supply (this does not mean
people no longer want money, it just means they prefer holding their wealth in
some other form, possibly another currency).
Increased
demand for a currency is due to either an increased transaction demand for
money, or an increased speculative demand for money. The transaction demand for
money is highly correlated to the country’s level of business activity, gross
domestic product (GDP), and employment levels. The more people there are
unemployed, the less the public as a whole will spend on goods and services.
Central Banks typically have little difficulty adjusting the available money
supply to accommodate changes in the demand for money due to business
transactions.
The
speculative demand for money is much harder for a central bank to accommodate
but they try to do this by adjusting interest rate. An investor may choose to
buy a currency if the return (that is the interest rate) is high enough. The
higher country’s interest rates, the greater the demand for that currency. It
has been argued that currency speculation can undermine real economic growth,
in particular since large currency speculators may deliberately create downward
pressure on a currency in order to force that central bank to sell their
currency to keep it stable (once this happens, the speculator can buy the
currency back from the bank at a lower price, close out their position, and
thereby take a profit).
The
advocates of flexible exchange rates are of the view that a system of free rate
enables a country to pursue an independent economic policy. Its monetary policy
has to deflate its currency and hinge the country into depression and unemployment.
Internal stability is a better aim to pursue hence a country should look into
internal stability of prices, output and unemployment and allow the exchange
rate to vary as they would. Such a policy would eliminate external interference
with the economy.
Exchange
rate acts as shock absorber, if rigidly fixed, the shocks of inflation and
deflation from abroad are transmitted to internal economy systems. But
variations in the exchange can ward off the invasion of the inflationary and
deflationary forces. If demand and supply could work excellently in economic
sense, it would be better to allow exchange rate to be freely determined by
both demand and supply.
1.2
STATEMENT OF PROBLEM
Nigeria has experienced continuous
rise in prices of goods and services in the mid 1970s due to the introduction
of fixed exchange rate policy. It was worse during the period surrounding
exchange rate regulation policy of the mid 1980s. Inflation in the mid 1990s
became terrible due to sanction of Nigeria by international community.
Inflation in the 1970s was due to civil war, salary awards (Udoji awards) and
excess government spending. Although, Nigerian’s economy generated a lot of
revenue from oil boom it goes a long way to cater for its increased
expenditure. Inflation in the mid 1990s became terrible due to sanction on
Nigeria by international community.
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.
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 is
obtained in the Nigerian economy lead to some pertinent questions, and these
are;
· How does a change in the foreign
exchange rate led to inflation?
· What is the relationship between
exchange rate variations and inflation in Nigeria?
This study
will attempt to answer these questions and find out ways through which the
vagaries that occur as a result of these can be cushioned in the economy.
1.3
OBJECTIVE OF STUDY
This study
will be guided by the following objectives:
(a) To find
out the impact of exchange rate variations on the current rate of inflation in
the economy.
(b) To
examine the extent to which inflation affect economic activities in Nigeria.
1.4
STATEMENT OF HYPOTHESIS
To achieve
an effective research work, the following hypothesis can be adopted:
Ho: There is
no significant relationship between exchange rate variations and inflation in
Nigeria.
1.5
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 minimum level.
1.6 SCOPE OF
THE STUDY
This study
will cover a period of 30 years (1979 - 2008) for a detail analysis of the
work. In the cause of this study emphasis shall be on central government
spending, the narrower definition of money supply (M2) shall be adopted. For
example, Money supply could be defined as the total sum of money in any
currency of a country held by commercial banks and other financial
institutions. However, government spending, exchange rate, low productivity,
corruption, and money supply are some known factors of inflation in
Nigeria.
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