Determinants of Real Exchange Rate in Nigeria (1975-2009)

ABSTRACT Real exchange rate affects production, employment and trade as a result it is important to understand the factors responsible for its variation. This study analyses the determinants of the real exchange rate and the dynamic adjustment of the real exchange rate following shocks to those determinants, using annual Nigerian data covering the period 1975 to 2010. It begins with a review of literature on the determinants of the real exchange rate. Contrast to previous analyses, this study augments the co integration and vector auto regression with impulse response and variance decomposition analyses to provide the long run and short run effects on the real exchange rate. The variables that have been found to have a long run relationship with the real exchange rate are real interest differential and the degree of openness. The latter is also found to have a short run relationship with the real exchange rate. For the most part the impulse response and variance decomposition corroborate results from previous studies. However, only shocks to the real interest differential has a significant effect on real exchange rate while results from the variance decompositions show that real interest differential explain the largest variation in the real exchange rate.

TABLE OF CONTENTS

Title page .......................................................................................................................... i

Certification ...................................................................................................................... ii

Dedication ......................................................................................................................... iii

Acknowledgement ............................................................................................................ iv

Abstract ............................................................................................................................ v

CHAPTER ONE

INTRODUCTION

1.1 Background to the study .............................................................................................. 1

1.2 Problem statement ....................................................................................................... 6

1.3 Objectives of the study ................................................................................................ 7

1.4 Hypothesis .................................................................................................................. 7

1.5 Scope of the study ....................................................................................................... 7

1.6 Policy Preference of the study ..................................................................................... 7

CHAPTER TWO

LITERATURE REVIEW

2.1 Conceptual issues on real exchange rate ...................................................................... 9

2.2 Theoretical Literature ................................................................................................. 12

2.3 Empirical Literature .................................................................................................... 16

2.4 Justification of the Study ............................................................................................. 23

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CHAPTER THREE

METHODOLOGY

3.1 Review of Some of the Methods Used in Previous Studies .......................................... 25

3.2 Model Specification .................................................................................................... 26

3.3 Variables, Effects on Real Exchange Rate and Their Proxies ....................................... 27

3.4 Unit Root/Stationary Test ............................................................................................ 28

3.5 Cointegration............................................................................................................... 30

3.5.1 Impulse Response ..................................................................................................... 32

3.5.2 Variance Decomposition Analysis ............................................................................ 32

CHAPTER FOUR

DISCUSSION OF RESULTS

4.1 Empirical Results ........................................................................................................ 34

4.1.1 Stationary/Unit Root Test Results ............................................................................. 34

4.2 Cointegration............................................................................................................... 43

4.2.1 The long run relationship .......................................................................................... 45

4.2.2 The short run relationship ......................................................................................... 47

4.2.3 Impulse response analysis ......................................................................................... 48

4.2.4 Variance Decomposition analysis .............................................................................

CHAPTER FIVE

CONCLUSION AND POLICY RECOMMENDATION

5.1 Summary of the study and Conclusion ......................................................................... 51

5.2 Policy Implications and Recommendations .................................................................. 52

5.3 Limitations of the study ............................................................................................... 52

References........................................................................................................................ 54