Monetary Policy, Exchange Rate and Inflation Rate in Nigeria A Co-integration and Multi-Variate Vector Error Correction Model Approach

Abstract

Evidences from empirical literature on the nexus among monetary policy, exchange rate and inflation rate have been mixed. Thus this paper attempts to re-examine this issue in Nigeria for the period spanning 1986 to 2010.In contrast to previous studies, this paper employed a Co-integration and Multi-Variate Vector Error Correction Model approach to examine both the long run and the short run nexus among monetary policy, exchange rate and inflation rate. Based on this approach, the paper found that there exist at least a co-integrating vector among the variables and the VECM estimate showed that a uni-directional causation exist from exchange rate and inflation rate to short term interest rate (measure of monetary policy) while a bi-directional causality exist form inflation rate to exchange rate. No evidence of causality was observed in the from short term interest to exchange rate and from interest rate to inflation rate. The theoretical transmission nexus deduced from the VECM estimate further revealed that changes in macroeconomic variables such as exchange rate and inflation rate granger caused a change in monetary policy stance and not otherwise. Based on these findings, this study recommends appropriate control and management of both the exchange rate and inflation rate.

Keywords: monetary policy, exchange rate, inflation rate and VECM.