Testing for Fisher’s Hypothesis in Nigeria (1970-2012)

Abstract

This paper has examined the causal link between interest rates and inflation in Nigeria using quarterly data on Nigeria for the periods of 1970 – 2012. Maximum likelihood method of co-integration, suggested by Johansen (1988, 1991) and Granger causality in ADL models with p and q lags suggested by Koop (2005) are implemented to determine the number of co-integrating vectors and verify the nature and direction of causality between interest rates and inflation in Nigeria respectively. The co-integration results show that the null hypothesis of no significant long-run stable relationship between interest and inflation rates cannot be rejected for Nigeria and that Fisher hypothesis which supports the view that nominal interest rates consist of two components of the “real” rate of interest (to which investments respond) plus a premium based on expected change in the price level, is violated for Nigeria in the long-run. The ADL models were used to investigate the causal link between interest rates and inflation in the short-run. The results indicate non existence of a significant causal link from interest rates to inflation in the short run, suggesting that interest rates may be considered exogenous in inflation modeling in Nigeria. Furthermore, the results identified existence of a significant causal link from inflation to interest rates in the short-run. In effect, Fisher’s hypothesis that nominal interest rates consist of two components of the “real” rate of interest plus a premium based on expected change in the price level is verified for Nigeria in the short-run. This finding supports that, in the short-run, market participants incorporate a predictable portion of the inflation rate into the nominal interest rate in Nigeria.

Keywords: co-integration, Causality, Inflation, Nominal Interest Rate.