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AN ECONOMETRIC ANALYSIS OF THE RELATIONSHIP BETWEEN EXCHANGE RATE DEPRECIATION AND INFLATION IN NIGERIA

CHAPTER ONE

INTRODUCTION

1.1         Background of the Study

In Nigeria, like many other countries, the relationship between exchange rate depreciation and inflation has been a topic of significant interest and debate among economists and policymakers. Exchange rate depreciation refers to the decline in the value of a country's currency relative to other currencies, while inflation is the sustained increase in the general price level of goods and services in an economy over time.

Historically, Nigeria has experienced periods of exchange rate depreciation, often driven by factors such as changes in global oil prices, external imbalances, and domestic economic policies (Nnanna & Ajayi, 2017). Concurrently, the country has also grappled with high inflation rates, which have fluctuated due to various factors, including supply chain disruptions, fiscal deficits, and monetary policy actions (Adeniyi et al., 2017).

The relationship between exchange rate depreciation and inflation is complex and multifaceted. On one hand, exchange rate depreciation can lead to cost-push inflation by increasing the prices of imported goods and inputs, thus raising production costs for domestic producers (Obiora & Amassoma, 2019). On the other hand, exchange rate depreciation may also have demand-pull inflationary effects by boosting exports and reducing the purchasing power of consumers (Adeniyi et al., 2017).

Understanding the nature and magnitude of the relationship between exchange rate depreciation and inflation in Nigeria is crucial for policymakers in formulating effective monetary and exchange rate policies. A comprehensive econometric analysis can provide insights into the causal mechanisms and transmission channels linking exchange rate movements to inflation dynamics in the Nigerian context.

By investigating this relationship empirically, researchers can identify key determinants and drivers of inflation in Nigeria, assess the effectiveness of past policy responses, and inform future policy decisions aimed at achieving price stability and sustainable economic growth.

1.2         Problem Statement

The relationship between exchange rate depreciation and inflation in Nigeria is a topic of considerable interest and importance for policymakers and economists. However, the nature and magnitude of this relationship remain unclear, and existing studies offer conflicting findings. Therefore, the problem statement of this study seeks to address the following question: What is the empirical relationship between exchange rate depreciation and inflation in Nigeria, and how do fluctuations in exchange rates affect inflation dynamics in the country? By examining this relationship, the study aims to provide valuable insights into the underlying mechanisms driving inflation in Nigeria and inform policymakers' decisions regarding monetary and exchange rate policies.

1.3         Objectives of the Study

The aim of this study is to empirically analyze the relationship between exchange rate depreciation and inflation in Nigeria. The specific objectives are;

1.    To examine the short-term relationship between exchange rate depreciation and inflation in Nigeria.

2.    To investigate the long-term relationship between exchange rate depreciation and inflation in Nigeria.

3.    To identify transmission channels linking exchange rate depreciation to inflation in Nigeria.

4.    To assess the effectiveness of past policy responses to exchange rate depreciation and inflation in Nigeria.

1.4         Research Question

1.    What is the short-term impact of exchange rate depreciation on inflation in Nigeria, and how quickly do changes in exchange rates affect consumer prices?

2.     What is the long-term relationship between exchange rate depreciation and inflation in Nigeria, and how do structural factors and policy responses influence this relationship over time?

3.    What are the transmission channels through which exchange rate movements influence inflation in Nigeria, and which channels are most significant in driving inflationary pressures?

4.    How effective have past policy responses been in addressing inflationary pressures arising from exchange rate depreciation in Nigeria, and what lessons can be drawn for future policy formulation and implementation?

1.5         Research Hypotheses

1.    (H0): There is no significant short-term relationship between exchange rate depreciation and inflation in Nigeria.

(H1): Exchange rate depreciation has a significant short-term impact on inflation in Nigeria.

2.    (H0): There is no significant long-term relationship between exchange rate depreciation and inflation in Nigeria.

(H1): Exchange rate depreciation has a significant long-term effect on inflation in Nigeria.

3.    (H0): There are no significant transmission channels linking exchange rate depreciation to inflation in Nigeria.

(H1): Exchange rate depreciation affects inflation through various transmission channels in Nigeria.

4.    (H0): Past policy responses to exchange rate depreciation have not been effective in mitigating inflationary pressures in Nigeria.

(H1): Past policy responses to exchange rate depreciation have been effective in addressing inflationary pressures in Nigeria.

1.6         Significance of the Study

This econometric analysis of exchange rate depreciation and inflation in Nigeria holds immense significance. It equips policymakers with the knowledge to design effective measures that control inflation, manage trade imbalances, and improve economic forecasts. Additionally, the study fosters investor confidence and contributes to the academic understanding of inflation in developing economies. By illuminating this critical relationship, the analysis paves the way for a more stable and prosperous Nigerian economy.

1.7         Scope of the Study

This econometric analysis focuses on deciphering the cause-and-effect relationship between a weakening Naira (exchange rate depreciation) and inflationary pressures within the Nigerian economy. It aims to quantify the impact of a depreciating currency on inflation and shed light on the underlying mechanisms at play.

1.8         Operational Definition of Terms

The operational definitions of terms in this study are specified as follows:

Exchange Rate Depreciation: This term refers to a decrease in the value of the Nigerian Naira relative to a basket of foreign currencies. It is operationally defined as the percentage change in the nominal exchange rate, which is the rate at which the Naira is exchanged for other currencies. This data can be obtained from the Central Bank of Nigeria or other financial institutions, and it is typically expressed as a monthly or annual percentage change.

Inflation: In this study, inflation is defined as the rate at which the general level of prices for goods and services rises, leading to a decrease in the purchasing power of money. Operationally, inflation is measured by the Consumer Price Index (CPI), which is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically. The CPI data is sourced from the National Bureau of Statistics in Nigeria, and it is expressed as an annual percentage change.

Econometric Models: These refer to the statistical methods used to analyze economic data. In this study, econometric models include time-series analysis, regression models, and co-integration tests. These models help in understanding and quantifying the relationship between exchange rate depreciation and inflation by analyzing historical data and testing hypotheses.

Time-Series Analysis: This is a method used in econometrics to analyze a sequence of data points collected at successive, equally-spaced points in time. Time-series analysis is used to identify trends, cycles, and other patterns in the data, which are crucial for understanding the dynamics of exchange rate depreciation and inflation over time.

Regression Models: These are statistical methods used to estimate the relationships among variables. In this study, regression models will be used to quantify the impact of exchange rate depreciation on inflation. The primary model likely to be used is the Ordinary Least Squares (OLS) regression, which estimates the linear relationship between the dependent variable (inflation) and one or more independent variables (exchange rate depreciation and other control variables).

Co-integration Tests: These are used to determine whether a long-term equilibrium relationship exists between two or more time-series variables. In the context of this study, cointegration tests will help to identify if there is a stable, long-term relationship between exchange rate depreciation and inflation in Nigeria.

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