MONETARY POLICY AND EXCHANGE RATE IN NIGERIA.
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MONETARY POLICY AND EXCHANGE RATE IN NIGERIA.
Chapter one
1.1 Introduction
Monetary policy and exchange rates are critical tools in economic management, as well as macroeconomic stabilisation and adjustment in developing nations such as Nigeria, where non-inflationary growth and international competitiveness have emerged as fundamental policy objectives.
The real exchange rate is a broad measure of international competitiveness, whereas inflation is primarily caused by monetary growth, currency devaluation, and other economic structural rigidities.
The question of which exchange rate regime a small open economy should adopt has no definitive solution because it is dependent on monetary authorities’ objectives and focus, as well as assumptions about the economy’s structural characteristics.
In this context, a structural characteristic of the economy refers to the degree of openness, capital mobility, wage indexation, and the level of economic growth.
Monetary policy development and implementation have an impact on macroeconomic variables (and consequently macroeconomic stability) in any economy, developed or underdeveloped.
The crucial distinction is how exchange rate swings affect domestic macroeconomic variables, particularly consumer prices, output (as measured by GDP), and private consumption.
The choice of an exchange rate regime is, to some extent, tied to the achievement of specific monetary authorities’ aims. Most of the time, these aims are linked to internal and external imbalances.
As a result, there is likely to be a link between the exchange rate regime chosen and actual output, prices, balance of payments stabilisation, and the sources of economic shocks.
When the goal is balance of payments stability, it is preferable to have a flexible exchange rate mechanism to correct any current or capital account imbalances.
The Marshall-Lerner conditions, the degree of capital mobility, and foreign reserve limits all need to be considered here. When the goal is to stabilise domestic pricing, the financial discipline issue becomes important.
Many economists feel that because the exchange rate is one of the economy’s prices, it can serve as an anchor for financial stability. In this sense, a fixed exchange rate promotes financial discipline by discouraging the use of inflationary finance.
In contrast, proponents of exchange rate flexibility claim that announcing a fixed exchange rate will result in financial crises followed by constant depreciation.
Finally, when the goal is to stabilise real production, the exchange rate regime primarily serves as a shock absorber. That is, the exchange rate regime is chosen to disperse the consequences. As a result, this choice will be determined by the nature of the shocks and the economy’s structural characteristics.
Thus, it appears that there is a clear trade-off between output/consumption volatility and inflation volatility. With such a large exchange rate pass-through, all monetary laws confront major trade-offs.
The nature of the trade-off is clearly evident between “fixed and flexible” exchange rates. The primary point is that mature industrial economies will face a very different trade-off than emerging market or transition economies.
Monetary policy, which attempts to stabilise output, necessitates considerable exchange rate volatility. This suggests substantial inflation volatility; but, with restricted or delayed pass-through, the trade-off is much less obvious. A flexible exchange rate strategy helps stabilise output while minimising inflation volatility.
Devereux (2001) contends that the ideal monetary policy rule in an open economy is one that stabilises non-traded goods price inflation, and that rigorous inflation targeting is far more desirable in an economy with minimal pass-through.
If the monetary authorities are concerned with consumer price inflation {over and above non-traded goods inflation}, the flexible exchange rate regime has both costs and benefits.
Furthermore, the same logic suggests that a stringent inflation targeting policy is highly undesirable in an open economy because it basically requires the exchange rate to be fixed. It stabilises inflation while causing significant output instability.
The primary goal of this study is to investigate the consequences of the exchange rate regime on the ability of monetary policy to stabilise the economy and the impact of exchange rate volatility on economic growth in Nigeria.
1.2 Statement of Problem
Nigeria’s prices for products and services have been steadily rising since the mid-1970s, when a fixed exchange rate policy was implemented. It was at its worst in the mid-1980s, at the time of exchange rate deregulation.
Inflation in the 1970s was caused by civil conflict, wage increases (Ndogwi award), and excessive government spending. Although the oil boom created a lot of revenue for Nigeria’s economy, it went a long way towards covering its increasing spending.
Inflation rose dramatically in the mid-1990s as a result of the international community’s sanctions against Nigeria. The inflation rate has been reduced as a result of policymakers’ embrace of deregulation and privatisation policies in the mid-2000s, and the exchange rate has been dropped from a double digit to a single digit as a result of the introduction of the Dutch auction system (DAS) in 2002. There are several studies on the subject.
Elbadawi (1990) concludes that devaluation of the official exchange rate does not cause inflation; he also states that prices have adjusted to the parallel exchange rate. In their analysis of eleven African nations, Greene and Canetti (1991) concluded that exchange rate movements explain inflationary changes.
Moser (1994) discovered that monetary expansion, driven primarily by expansionary fiscal policies, naira devaluation, and agro-climatic conditions, explains Nigeria’s inflationary process.
The various points of view held by the aforementioned schools of thought regarding what is available in the Nigerian economy prompted the researcher to conduct this study on exchange rate volatility and monetary policy in the country.
1.3 Objectives of the Study
The overall goal of this research is to establish the impact of exchange rates and monetary policy on Nigeria’s GDP. The specific aims are:
1. Determine the exchange rate condition in Nigeria.
ii. To investigate the impact of exchange rates, money supply, and inflation on Nigeria’s GDP.
iii. To investigate the effects of exchange rate volatility on the Nigerian economy.
1.4 RESEARCH QUESTIONS.
What are the variables that generate exchange rate volatility in Nigeria?
i. Does exchange rate policy have any impact on the Nigerian economy?
ii. Does monetary policy have an impact on exchange rate volatility in Nigeria?
iii. What is the relationship between the exchange rate, money supply, inflation, and Nigeria’s GDP?
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