IMPACT OF INFLATION TREND ON EXCHANGE RATE.
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IMPACT OF INFLATION TREND ON EXCHANGE RATE.
Chapter one
INTRODUCTION
1.O Background of Study
The traditional definition of money as anything that is widely accepted as a means of exchange and may also function as a store of value has emphasised money as assets retained in the interim between receiving and making payments.
\Money is broadly defined as a set of liquid financial assets that are closely related to economic development and may be subject to monetary authorities’ control.
According to the definition above, money is essential to the efficient operation of any contemporary economy based on specialisation and trade.
Furthermore, there is a popular adage that no man is an island, therefore I believe no country is an island, and that there is barely any country that lives in complete isolation in today’s globalised globe.
All of the world’s economies are linked, either directly or indirectly, by asset or products markets. This connection is made possible by trade and foreign exchange.
The pricing of foreign currencies in terms of a local currency (i.e. foreign exchange) is thus critical to understanding the growth trajectory of all countries around the world.
Significant mismatch of exchange rates can result in output decline and widespread economic distress. Furthermore, there is pretty solid evidence that exchange rate alignment has a significant impact on the pace of growth in per capita output in low-income countries (Isard, 2007).
Nigeria, like many other low-income open economies throughout the world, has used the two primary exchange rate regimes to achieve internal and external balance.
The advantages and disadvantages of each regime are obvious, given that they are all focused at maintaining exchange rate stability. Nigeria’s foreign exchange has been managed under a direct administrative control exchange rate regime since its independence in 1960. For obvious reasons, the country adopted a market-based regulatory structure in 1986.
What remains unclear is the relative advantage of the various organised market arrangements for selling and purchasing foreign currencies under the country’s current dirty float regime.
The country has and continues to experiment with various market arrangements. First, in 1986, it decided to run the Second Tier Foreign Exchange Market (SFEM) on an auction system.
More than two decades after the introduction of the flexible exchange regime, Nigeria has used several variations of the auction system (Auction System, Dutch Auction System, Wholesale Dutch Auction System, and Retail Dutch Auction System) to determine the naira’s exchange rate to the US dollar.
Trade is widely recognised as a primary driver of economic growth. This has been Nigeria’s experience since the 1960s, even though the content of trade has altered over time.
For example, in the 1960s, agricultural exports (such as cocoa, cotton, palm kernel and oil, groundnuts, and rubber) were the country’s primary source of foreign money and revenue for government.
However, with the discovery and export of crude oil in the late 1960s and early 1970s, agricultural exports became less important, being replaced by crude oil exports.
As a result, the exchange rate is a relative price that determines the value of one currency in relation to another. It expresses a local currency’s purchasing power in terms of the goods and services it can buy in comparison to a foreign or trading partner’s currency over time. The exchange rate expresses the worth of one currency in terms of another, thus when one currency appreciates, the other depreciates.
However, when goods are exchanged in the international market in a higher proportion of currency, for example, dollars to naira, the value of dollars increases while the naira depreciates, the effect on the nation is that importation prices rise, reflecting on the final price level of such goods in the local market.
As a result, due to the danger of high importation costs, few commodities are imported, reducing their availability. The net effect of this is that if effective demand for such things increases, much more money will be chasing a limited supply of goods in the local market, resulting in inflation.
As a result, inflation, as defined by neoclassicalists, is always and everywhere a monetary event that can only be caused by a faster increase in the quality of money than in output.
The most fundamental features of the definition of inflation are that there must be a steady increase in the general price level, it must be evident throughout the economy, and it must last for a period of time.
In conclusion, exchange rate analysis is useful for macroeconomic management since it represents the performance of both the internal and external sectors of the economy.
Importantly, managing the exchange rate will result in the achievement of a stable and realistic exchange rate, which will lead to locative efficiency in the foreign exchange market, increased domestic productivity, the maintenance of internal balance, encouragement of export activities, which will improve foreign exchange earnings, the attraction of foreign direct investment, and the reduction of the inflationary spiral.
1.1 Statement of the Problem
In an economy that is dependent on foreign trade, the exchange rate is the most essential price because it determines almost all other prices. The problem of exchange rates in Nigeria comprises relative fluctuations in money supply, real production, and inflation rates between trading partners.
This research aims to identify the reforms that need to be considered in unifying and improving the efficiency of the foreign exchange market, as well as allowing for more flexible determination of the exchange rate. Policy measures should also be directed at moving these aggregates towards the desired levels.
A realistic exchange rate should be steady, preventing short-term volatility in capital flows, gradually approaching its equilibrium level, and stabilising the balance of payments.
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