THE IMPACT OF INFLATION TREND ON EXCHANGE RATE (A CASE STUDY OF NIGERIA)

CHAPTER ONE

INTRODUCTION

1.O  BACKGROUND OF STUDY                                   

The tradition definition of money as anything that is generally accepted as a medium of exchange, which can also serve as a store of value has stressed money as an assets held in interim between receiving payment and making payment. Comprehensively, money is the set of liquid financial assets which has a close correlation with the development of the economy and is potentially subjected to the control of monetary authorities. From this definition above one can conclude that money is a central to the efficient working of any modern economy that relies on specialization and exchange.

Furthermore there is a general saying that no man is an Island, so I believe no country is also an Island, that there is scarcely any country that lives in absolute autarky in this globalised world. The economies of all the countries of the world are linked directly or indirectly through asset or/and goods markets. This linkage is made possible through trade and foreign exchange. The price of foreign currencies in terms of a local currency (i.e. foreign exchange) is therefore important to the understanding of the growth trajectory of all countries of the world.

The consequences of substantial misalignments of exchange rates can lead to output contraction and extensive economic hardship. Moreover, there is reasonably strong evidence that the alignment of exchange rates has a critical influence on the rate of growth of per capita output in low income countries (Isard, 2007).

Nigeria, like many other low income open economies of the world, has adopted the two main exchange rate regimes for the purpose of gaining internal and external balance. The augments and conditions for and against each of the regime is clear given that they are all aimed at maintaining stability in exchange rates. Direct administrative control exchange rate policy was used to manage Nigeria’s foreign exchange from independence in 1960. The country changed to a market regulated regime in 1986 for obvious reasons.

What is however yet to be clear is the relative advantage of the various organized market arrangement for selling and buying the foreign exchange under the dirty float regime that the country now operates. The country has and is still experimenting with various market arrangements. First in 1986, it chose to operate the Second Tier Foreign Exchange Market (SFEM) on an auction basis. More than two decades now after the introduction of the flexible exchange regime, Nigeria has operated several variants of the auction system (Auction System, Dutch Auction System, Wholesale Dutch Auction System, and Retail Dutch Auction System) towards determining the exchange rate of the naira to US dollar.

Trade as well know is widely accepted as a major engine of economic growth. This has been the experience of Nigeria since the 1960s even though the composition of trade has changed over the years. For instance, in the 1960s, agricultural exports (including cocoa, cotton, palm kernel and oil, groundnuts and rubber) were the country’s main sources of foreign exchange and revenue to the government. But with the discovery and export of crude oil in the late 1960s and early 1970s, the important role of agricultural exports began to wane, replaced by crude oil exports.

Therefore exchange rate is a relative price that measure s the worth of domestic currency in terms of another currency. It relates the purchasing power of a domestic currency, in terms of the goods and services it can purchase vis-à-vis a foreign or trading partner’s currency, over a given period of time. Since the exchange rate expressed the value of one currency in terms of another, when one currency appreciates, the other will depreciate.

However, when exchange of goods are made in the international market in a higher proportion of currency, example dollars to naira, that is, the value of dollars appreciate while naira depreciates, the effect of this on nation is that importation price becomes high reflecting on final price level of such goods at the local market.

Subsequently, due to the risk in importation cost, few goods are imported which reduces the supply of such goods.  The net effect of this is that, if effective demand for such goods rises, much more money will be chasing few available goods in local market, better still we say inflation arises. Therefore inflation as defined the neo-classicalist is always and everywhere a monetary phenomenon and can be produce only by a more rapid increase in the quality of money than output. The most important features of the definition of inflation are; there must be a persistent increase in the general price level, it must be noticeable in the whole economy, and it must persist over a period of time.

Conclusively, the study of exchange rate is useful for macro economic management since it reflects the performance of both the domestic and external sectors of the economy.

Importantly, if exchange rate is managed, it will sprout the attainment of a stable and realistic exchange rate that will lead to a locative efficiency in the foreign exchange market, increase domestic productivity, guarantee the attainment of internal balance, encouragement of export activities leading to improve foreign exchange earnings, attraction of foreign direct investment and reduce the inflationary spiral.

1.1   PROBLEM ANALYSIS

In an economy that is dependent on international trade, exchange rate will be the important price, in that it will determine virtually all other prices. The problem of exchange rate in Nigeria includes; relative shifts in money supply, real output and inflation rates between trade partners.

This research work is aim at identifying the reforms that need to be considered in unifying and improving the efficiency of the foreign exchange market and allowing for more flexible determination of the exchange rate and also policy measure should be directed at moving these aggregates towards the desired levels.

A realistic exchange rate should be stable, prevent short term volatility in capital flows and overtime, more towards its equilibrium level and stabilize the balance of payments.

1.2   OBJECTIVES OF THE STUDY

1. The specific objective of this study is to examine the effect of changes in exchange rate on inflation in Nigeria.

2. To determine the relationship between exchange rate policy and their effect on the Nigeria economy.

3. To proffer possible policies to exchange rate policy on how effective exchange rates could help achieve the major macro economic objectives.

1.3   RESEARCH QUESTIONS

The research study makes an attempt to answer the following questions;

1.  What are the roles of Central Bank of Nigeria (CBN) in Nigeria foreign exchange market?

2.  What is the relationship between exchange rate and inflation in Nigeria?

3.  What are the effects of exchange rate policy on Nigerian economy?

4.  Is there any relationship between exchange rate and money supply in Nigeria?

5.  What are the effects of inflation rate on Nigerian economy?

6.  What are the effects of inflation on exchange rate?

1.4   STATEMENT OF HYPOTHESIS

The hypotheses that will be formulated and tested for this study includes;

 H_o: There is no positive relationship between inflation rate and exchange rate in Nigeria.

H₁: There is a positive relationship between inflation rate and exchange rate in Nigeria.

 H_o: There is no positive relationship between gross domestic product, inflation rate and exchange rate in Nigeria.

H₁: There is a positive relationship between gross domestic product, inflation rate and exchange rate in Nigeria.

 H_o: There is no positive relationship between gross domestic product, inflation rate, exchange rate and money supply in Nigeria.

H₁: There is a positive relationship between gross domestic product, inflation rate, exchange rate and money supply in Nigeria.

1.5   SIGNIFICANCE OF STUDY

The exchange rate serves as the fundamental channel to the economy. The study is important because it is directed towards ascertaining whether exchange rate have lived up to expectation, as a medium of improving the country economy by implementing a number of sensitive exchange rate policy which will affect the economy positively. Those that will benefit from this study are the monetary authority and the Nigerian economy as a whole.

1.6   SCOPE OF THE STUDY

For this research work, the researcher implores the use of data on exchange rate, inflation and gross domestic product and money supply within the year 1990 to 2008. This is aimed at enabling the researcher to be able to critically analyze the relationship between the variables in question (exchange rate, inflation, gross domestic product and money supply).

1.7   DEFINITION OF TERMS / CONCEPTS

C.B.N – Central Bank of Nigeria is the country leading bank, generally responsible for overseeing the banking system, acting as clearing banker for commercial Banks and for implementing Monetary policy, also responsible for handing the government budgetary account’s and for managing the country’s external monetary affairs, in particular the exchange rate.

DAS- Dutch Auction System is a means of selling goods and services to the highest bidder among the member of potential customers.

EXCH- Exchange Rate is the price of one currency expressed in term of some other currency.

FEM- Foreign Exchange Market is a market engage in the buying and selling of foreign currencies, such a market is required because each currency involved in the international trade and foreign exchange.

GDP- Gross Domestic Product is the total monetary value of all final goods and services produced in an economy over a one year period.

IFN- Inflation rate is an increase in general level of prices in an economy that is sustained over a period of time.

MS- Money Supply is the amount of money in circulation any economy.