Financial Deepening and Inflation in Nigeria: An Open Economy Model Approach*

Abstract

The purpose of this paper is to evaluate the short-run and long-run impact of financial deepening on inflation in Nigeria from 1980 to 2012 using open economy model. Data was collected from Central Bank of Nigeria Statistical Bulletin (2012) and United Nations Conference on Trade and Development (UNCTAD) Volume index. The study employed the use of Auto-regressive Distributed Lag Model (coefficient Diagnostic Wald test and Variance Decomposition Test), to enable us achieve our objectives. The result shows that import volume index (IMPV) and exchange rate (EXCR) in lags 1 & 2 respectively are significant to explain variations in the consumer price index (CPI) in the short-run while all other variable have no significant impact on CPI. Also the short –run result indicates that financial deepening variables; MS2/GDP ratio (Fd1) and PSC/GDP ratio (Fd2) have no significant impact on consumer price index. While in the long-run, import volume index (impv), prime lending rate (prim) and exchange rate (excr) are significant with P-values of 0.0002, 0.0017 and 0.0010 respectively.  The coefficients of FD1(-1)  and FD2(-1) designated with C(16) and C(17) was tested together using Wald Coefficient Diagnostic Test to see the impact of financial depth on the price level, and the result indicates a positive and significant impact of financial deepening on Consumer Price Index (CPI).  Meaning that, increase in money supply to GDP ratio (MS2/GDP) and private sector credit to GDP ratio (PSC/GDP) together generated consequent increases in price. The variance decomposition test indicates that shocks to FD1 can rarely cause variation in price level while shocks to PSC/GDP ratio (FD2) can cause variations in prices more than any other variable both in the short-run and long – run. Standing on our findings, appropriate monetary and exchange rate policies should be ensured as Nigeria move towards achieving her financial depth goals by the year 2020.

Keywords: financial deepening, Money supply, Private sector credit, Real Gross Domestic Product, Autoregressive model, inflation, Classical Economics, financial Development.