EXCHANGE RATE VARIATIONS AND INFLATION IN THE NIGERIAN ECONOMY

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.