Trade Openness and Inflation in Nigerian Economy: A Vector Error Correction Model (VECM) Approach

Abstract

Trade between countries of the world is a vital economic index to be considered. Opening up the economy of a country will not only improve the trade of such a country, but will also affect its inflation rate, which is an important factor for policy decision makers. This study therefore used the VECM approach to investigate the effect of trade openness on the inflation of the Nigerian economy using annual data from 1970 to 2010. A multivariate cointegration test developed by Johansen was used to determine the existence of a long-run relationship among the variables. The results indicate two cointegrating equations at 5% level of significance and one cointegrating equation at 1% level. With the existence of at least one cointegrating vector, the VEC model was applied, which indicates a negative relationship between inflation and trade openness (-1.58) for the Nigerian economy, while the coefficient of the Error Correction Term (-0.91) of the model was significant and negative, which imply that the system corrects its previous period disequilibrium at a speed of approximately 91 percent annually. The results of the Impulse-Response Function (IRF) indicate that the response of inflation to openness shock was significant and positive for only two periods, but negative after the second period and all through the rest of the periods, thereby validating the negative relationship between inflation and trade openness in Nigerian economy.

Keywords: Trade openness, inflation, VECM, Error Correction Term, Impulse-response function, Nigerian.