ABSTRACT
This paper examines the dynamic relationship between inflation and exchange rate volatility in Nigeria for the period 1970 to 2010 using Johansen Cointegration Technique. GARCH and ARCH (1,1) technique was employed to analyse the Volatility in Exchange Rate, and it was observed that the Exchange Rate was volatile over the study period. Augmented Dickey-Fuller was employed to determine the order of integration, and it was observed that the variables exhibited stochastic trend. Johansen Cointegration further confirms the presence of long run relationship among the variables, while the Error Correction Mechanism showed a 45.32% adjustment time for the variables in the long run. The result found that in the short run, Inflation and Trade Openness affect economic growth significantly, while inflation affects it positively, reverse was the case with Trade Openness. However, in the long run, Money Supply and Exchange Rate Volatility has significant positive effect on economic growth whereas, inflation has a positive but insignificant effect on economic growth. In the case of Trade Openness, significant negative relationship was observed between itself and economic growth. Since Trade Openness affect economic growth negatively both in the short and long run, we can conclude that Trade Openness is not a factor of growth over the study period.
INTRODUCTION
There has been an ongoing debate on the appropriate exchange rate policy in developing countries. The debate focuses on the degree of fluctuations in the exchange rate in the face of internal and external shocks. Exchange rate fluctuations are likely in turn to determine economic performance. In judging the desirability of exchange rate fluctuations, it becomes necessary to evaluate its effects on output growth and inflation. Demand and supply channels determine these effects.
On the demand side, devaluation or depreciation of the domestic currency may stimulate economic activity through the initial increase in the price of foreign goods relative to home goods. By increasing the international competitiveness of domestic industries, exchange rate devaluation diverts spending from foreign goods to domestic goods. In the words of Hirschman (1949), currency depreciation from an initial trade deficit reduces real national income and may lead to a fall in aggregate demand. Currency depreciation gives with one hand “by lowering export prices while taking away with the other hand by raising import prices”. If trade is in balance and terms of trade are not changed, these price changes offset each other. But if imports exceed exports, the net result is a reduction in real income within the country.
On the supply side, exchange rate devaluation leads to income transfer from importing countries to exporting countries through a shift in the terms of trade which therefore affect the economic performance of both importing and exporting nations.
Bruno (1979) and Van Wijnbergen (1989) postulate that in a typical semi-industrialized country where inputs for manufacturing are largely imported and cannot be easily produced domestically, firms’ input cost will increase following a devaluation. As a result, the negative impact from the higher cost of imported inputs may dominate the production stimulus from lower relative prices for domestically traded goods. However, Gylfason and Schmid (1983) provide evidence that the final effect depends on the magnitude by which demand and supply curves shift because of devaluation.
Soludo (1993) emphasize that devaluation of exchange rate on the supply side tends to lead to increased inflationary pressure, which deter economic growth. However, some economists seem to disagree with this notion, as several investigations have shown unidirectional relationship between inflation and growth. For instance, Bruno and Easterly (1996) and Mishkin and Posen (1997) observed that there is no long-run trade-off between inflation and economic growth. Put differently, increases in economic activities can occur without a spell of inflationary pressure as envisaged by the Phillips curve hypothesis.
The problem therefore lies in determining the inflation and exchange rate consistent with development of a nation. Thus, the aim of this article is to empirically examine the combine effect of inflation and exchange rate variability on the economic performance of Nigeria.