Exchange Rate Volatility and Inflation: The Nigerian Experience

Abstract

This paper investigates the impact of inflation on real exchange rate volatility in Nigeria, using a quarterly data of 181 series from the first quarter of 1970 all through to the last quarter of 2014. The models used in this work are GARCH (1, 1) model and granger causality in Vector Auto-Regressive environment. The conditional variance of the volatility in the real exchange rate at time t was found with the use of GARCH (1, 1) model to be susceptible to its conditional variance in the previous time period, the squared error term in the previous time period, the inflation rate, imported inflation, broad money supply and the lagged nominal exchange rate. The granger causality test shows that there is a un-directional causality running from inflation to real exchange rate volatility and there is a causality running from the whole sample variable to imported inflation which is proxied with import; an indication that there is a relationship between imported inflation, real exchange rate volatility and other sample variables. This study therefore recommends that the monetary authority should institute an inflation targeting policy to control the fluctuation in the price level as well as other macroeconomic variable that have a direct effect on the exchange rate. Government should also implement other macroeconomic policies that will help reduce the degree of volatility in the exchange rate.

Keywords: Exchange Rate, Volatility, Inflation Rate