ABSTRACT

The study examines the determinants of real exchange rate in the recent years in Nigeria over the period of 1970 to 2006 using the Nigerian time series data. Following literature, we identified the potential determinants of real exchange rate as lag of real exchange rate, real interest rate, inflation rate, trade openness and real gross domestic product. After examined the time series characteristics of the data with Augmented Dickey-Fuller (ADF) unit roots test of stationarity and Engle-Granger procedure for co-integration test, we applied Auto-regressive Distributed Lag Model (ARDL-ECM). The result suggests that one year past value of real exchange rate and immediate past value of trade openness are the major determinants of real exchange rate in Nigeria. The result further indicates that there is evidence of long run relationship between real exchange rate and two explanatory variables (gross domestic product growth rate and trade openness).

TABLE OF CONTENT

TITLE PAGE                                                                                    ii

APPROVAL PAGE                                                                          iii

DEDICATION                                                                                  iv

ACKNOWLEDGEMENT                                                                 v

ABSTRACT                                                                                     vi

TABLE OF CONTENT                                                                    vii

LIST OF TABLES                                                                            ix

CHAPTER ONE:           INTRODUCTION                                      1

• BACKGROUND INFORMATION 1
• STATEMENT OF THE PROBLEM 3
• OBJECTIVES OF THE STUDY 5
• STATEMENT OF HYPHOTHESIS 5
• JUSTIFICATION OF THE STUDY 6
• SCOPE AND LIMITATION OF THE STUDY 6

CHAPTER TWO:          LITERATURE REVIEW                            7

• THEORETICAL BACKGROUND 7
• MODELS OF EXCHANGE RATE DETERMINATION 7
  • TRADITIONAL FLOW MODEL 7
  • THE PORTFOLIO BALANCE MODEL 8
  • THE MONETARY APPROACH 8
  • PURCHASING POWER PARITY (PPP) 9
  • BALANCE OF PAYMENTS APPROACH 9
  • EXCHANGE RATE REGIMES 10
  • CRAWLING PEG 10
  • ADJUSTABLE PEG EXCHANGE RATE 11
  • TARGET ZONE 12
  • CURRENCY PEG 12
• BRIEF THEORETICAL REVIEW 13
• AN OVERVIEW OF NAIRA EXCHANGE RATE MANAGEMENT 16
• EMPIRICAL REVIEW 21
• LIMITATION OF PREVIOUS STUDIES 28
• EXCHANGE RATE MOVEMENTS IN NIGERIA 1975-2006 29

CHAPTER THREE:      METHODOLOGY                                     31

• THE MODEL 31
• MODEL SPECIFICATION 31
• ESTIMATION PROCEDURE 32
• UNIT ROOT TEST 33
• CO-INTEGRATION TEST 34
• TECHNIQUES OF RESULTS EVALUATION 35
• MODEL JUSTIFICATION 35
• DATA SOURCES 36
• ECONOMETRIC SOFTWARE 36

CHAPTER FOUR: PRESENTATION AND INTERPRETATION OF RESULT                                                             37

• OVERVIEW 37
• CO-INTEGRATION TEST 38
• PRESENTATION OF DYNAMIC ECM MODELING OF

REXCH RESULT                                                                      38

• INTERPRETATION OF RESULT 39
• COEFFICIENT OF DETERINATION R² 41
• TEST OF AUTOCORRELATION 41
• F-TEST 41
• TESTOF MULTICOLLINEARITY 42

CHAPTER FIVE: SUMMARY, CONCLUSION AND POLICY

RECOMMENDATION                              43

• SUMMARY AND CONCLUSION 43
• POLICY RECOMMENDATION 44
• CONCLUSION 46

REFERENCES                                                                           48

APPENDIX

LIST OF TABLES

• UNIT ROOT TEST 37
• CO-INTEGRATION RESULT 38
• RESULT SUMMARY 38
• CORRELATION MATRIX 42

CHAPTER ONE INTRODUCTION

1.1 Background Information

The exchange rate is the rate at which one currency is exchanged for another. It is the price of one currency in terms of another currency ( Jhingan, 2005). Exchange rate is the price of one unit of the foreign currency in terms of the domestic currency. The debate over what determines the choice of exchange rate regimes has continued unabated over some decades now. Friedman (1953) argued that in the presence of sticky prices, floating rates would provide better insulation from foreign shocks by allowing relative prices to adjust faster. His popular support for floating exchange rate stipulates that in the long run the exchange rate system does not have significant real consequences. His reasoning is that the exchange rate system is ultimately a choice of monetary regimes. In the end, monetary policy does not matter for real quantities, but in the short run it does. While Mundell’s (1963) posits that in a world of capital mobility, optimal choice of exchange rate regime should depend on the type of shocks hitting an economy: real shocks would call for a floating exchange rate, whereas monetary shocks would call for a fixed exchange rate. Traditionally, it has been argued that a country’s optimal real exchange rate is determined by some key macroeconomic variables and that the long-run value of the optimal real exchange rate is determined by suitable (permanent) values of these macroeconomic variables (Williamson, 1994). Incidentally, since the fall of Bretton-Woods system in 1970s and the subsequent introduction of floating exchange rates, the exchange rates have in some cases become extremely volatile without any corresponding link to changes in the macroeconomic fundamentals. This however has led to higher interest in exchange rate modeling as the question of exchange rate determination reveals to be one of the most important problems on theoretical field of monetary macroeconomics. There are different types of exchange rate regimes practiced all over the world; from the extreme case of fixed exchange rate system to a freely floating regime. Practically, countries tend to adopt a combination of different regimes such as adjustable peg, crawling peg, target zone/crawling bands, and managed float, whichever that suits their peculiar economic conditions. For instance, exchange rate managements in Nigeria has witness different significant changes over the past four decades. Nigeria maintained fixed exchange rates from 1960 till the breakdown of the Bretton Woods Monetary System in the early 1970s. Between 1970 and mid 1980 Nigeria exchange rate policy shifted from fixed exchange rate to a pegged arrangement and finally, to the various types of the floating regime since 1986 following the adoption of the Structural Adjustment Programme (SAP) (see Sanusi, 2004). A regime of managed float, without any strong commitment to defend any particular parity, has been the predominant characteristic of the floating regime in Nigeria since 1986. The changes from the different regimes are not peculiar to the Naira as the US dollar was fixed in gold terms until 1971 when it was de-linked and has since been floated. The fixed exchange rate regime induced an overvaluation of the naira and was supported by exchange control regulations that engendered significant distortions in the economy. That gave vent to massive importation of finished goods with the adverse consequences for domestic production, balance of payments position and the nation’s external reserves level. Moreover, the period was bedeviled by sharp practices perpetrated by dealers and end-users of foreign exchange. These and many other problems informed the adoption of a more flexible exchange rate regime in the context of the SAP, adopted in 1986 (Sanusi, 1988).

1.2   Statement of the Problem

Foreign exchange is said to be an important element in the economic growth and development of a developing nation. Foreign exchange policies influence the economic activities and to a large extent, dictate the direction of the macro- economic variables in the country. The mechanism of exchange rate determination are different systems of managing the exchange rate of a nation’s currency in  terms of other currencies and this should be properly done in a way that will bring about efficient allocation of scarce resources so as to achieve growth and development. Jhingan (2005) posited that to maintain both internal and external balance, a country must control its exchange rate. Optimal exchange rate policy is designed to obtain real exchange rate (RER) that maintains both internal and external balance (Agu, 2002). The concept of real exchange rate comes from a realization that the observable nominal exchange rate movements, result from both price changes and inflation rate changes in trading economies. When the real exchange rate is optimal, domestic producers of tradable goods can compete internationally; imports are not artificially cheaper than comparable domestic alternatives. Exporters also are not disadvantaged by the exchange rate, when the real exchange rate is right (Maciejewski, 1983). What determines the exchange rate regime for an open economy is one of the oldest issues in international economics. The single most influential idea in this context has been the Mundellian prescription that if shocks facing the country are mostly monetary then fixed exchange rates are optimal whereas flexible rates are optimal if the shocks are mostly real (Amartya et al.2004). The key friction underlying Mundell’s results was the assumption of sticky prices in the goods market. Since the fall of Bretton-Woods system in 1970s and the subsequent introduction of floating exchange rates, the exchange rates have in some cases become extremely volatile without any corresponding link to changes in other macroeconomic variables. Nigeria’s exchange rate changes have been a subject of debate among policy makers, concerned monetary authorities and academics because of the recognition of the vital role exchange rate regime plays in the achievement of sustainable growth. Government and monetary authorities in Nigeria, over the years have done a lot of work in the area of finding the appropriate exchange rate management, given the peculiarities of the economy. Since the adoption of the Structural Adjustment Programme in 1986, Nigeria has adopted different types of exchange rate regimes, ranging from floating exchange rate regimes to fixed/pegged regimes. However, maintaining a realistic exchange rate for the naira in Nigeria is very crucial, given the structure of the economy. Sanusi (2004) opined the importance of maintaining a realistic exchange rate for naira, and also the need to minimize distortions in production and consumption, increase the inflow of non-oil export receipts and attract foreign direct investment. This is expected to ensure that the naira is not overvalued in real terms, and that the external sector remains competitive. Nigeria in 1960 and in the early 1970s, maintained fixed exchange rates. Between 1970 and mid 1980 Nigeria exchange rate shifted from fixed exchange rate to a pegged arrangement and since the introduction of Structural Adjustment Programme in 1986 till date Nigeria has adopted various types of floating exchange regime (Sanusi 2004). The quest for a realistic naira exchange rate made the Central Bank of Nigeria (CBN) in the time past to employ the Purchasing Power Parity (PPP) model as a guide to gauge movements in the nominal exchange rate and to determine deviations from the equilibrium exchange rate. Although the PPP as a relative price does not provide clear criteria for choosing a base period, and is generally criticized for its insensitivity to short-term policy actions, it nonetheless, provides a reasonable framework for a comparative analysis of trading partners’ performances. Nigeria, having adopted various types of exchange rate mechanism over the years with Dutch Auction System (DAS) being the latest and still the exchange rate did not maintain both internal and external balance. Thus, the ultimate questions which this research seeks to answer are: what determines exchange rate in Nigeria? Again, is there any long run relationship between the exchange rate and its identified determinants in Nigeria?

1.3   Objectives of the Study

The general objective of this study is to investigate which of the macroeconomic variables best determine the real exchange rate in Nigeria. Specifically, the study will find out:

1. The determinants of exchange rate in
2. If there is any long run relationship between the exchange rate and its identified determinants in

1.4   Statement of Hypothesis

1. The determinants exchange rate in Nigeria is unknown?
2. There is no long run relationship between the exchange rate and its identified determinants in Nigeria?

1.5   Justification of the Study

The policy thrust of the NEED document is to use the retail Dutch Auction System to determine the nominal exchange rate regime, and adopt a wholesale Dutch auction in the medium to long term (NEED 2004). This is in view of the fact that the overall goal of monetary policy remains price and exchange rate stability.  Thus, economic relevance of studying the determinants of real exchange rate need not be overemphasized. This study is imperative given the recent efforts by monetary authorities in Nigeria to revive the economy through the financial sector reform which among other things sought to maintain stability in exchange rate. Consequently, this study will assist the nation’s economic planners in their economic development planning. Specifically, the outcome of this study would provide a basic understanding of the dynamics of exchange rate and the key macroeconomic variables in Nigeria and it also contribute to knowledge.

1.6   Scope and Limitation of Study

This study shall cover the period of 1970-2006; a sample size of 36 years is long enough for time series analysis. The choice of this period is largely informed by data availability, and also due to the fact that Nigerian economy has practiced different types of exchange rate regimes within the given period.

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