ABSTRACT
This
research work is an empirical attempt to examine determinants of exchange rate
in Nigeria with annual data from 1980 to 2016. The main type of data used in
this study is secondary sourced from central bank of Nigeria statistical
bulletin. For this purpose, annual figures of interest rate, inflation rate,
balance of payments and gross domestic product were regressed on exchange rate
in a framework of multiple regression models; ordinary least square technique
at estimation were employed. The evidence from the result revealed that
interest rate and real gross domestic product are positive and they have
significant impact on exchange rate whereas Inflation rate and balance of
payment and are negative and have no significant impact on exchange rate. The
work recommends that the government should encourage export promotion and
discourage import in order to increase the gross domestic product and also
effective fiscal and monetary policies should be adopted in order to reduce and
maintain a single digit interest rate figure.
CHAPTER
ONE
INTRODUCTION
1.1
Background of the study
One
of the features that distinguish international trade from domestic trade is
that each nation has its own currency and its own banking system. Prices in
each country rely on the country’s currency units be it dollars, naira, pounds,
euro, rupees, francs, ceddis and so on.
Exchange rate refers to the price of a domestic currency in terms of a
foreign currency. Exchange rate plays a key role in international economic
transactions because no nation is self sufficient due to varying factor
endowment as well as comparative advantages. According to Jhingan (2009), this
price is as a result of the interaction of the forces of demand and supply of foreign
currencies in any particular period of time. It determines the relative price
of domestic goods and services as well as the external sector participation in
the international trade. Dornbusch (2004), defined exchange rate as the rate at
which one currency is exchanged for the currency of another country. Whereas
Mankiw (1997), defined it as the price at which exchange between two countries
takes place. The exchange rate has two main components; the domestic currency
and foreign currency and it can be quoted directly or indirectly. In a direct
quotation, the price of a unit of a foreign currency is expressed in terms of
the domestic currency; the foreign currency is the base currency while the
domestic currency is the counter currency. In an indirect quotation, the price
of a unit of domestic currency is expressed in terms of foreign currency. In
this case, the domestic currency is the base currency while the foreign
currency is the counter currency. Most exchange rates use the American dollar
as the base currency and other currencies as the counter currency. (1: N) (Base: counter). In addition, there are
exceptional cases such as the Euro and commonwealth currencies like British
pound, Australian Dollar and New Zealand Dollar.
The
exchange rate between the Nigerian naira and the American dollar is the number
of naira required to purchase one dollar which is currently about N360 per dollar. The exchange rate of
naira per dollar will be maintained in the world exchange market by arbitrage.
Arbitrage refers to the purchase of foreign currency in a market where its
price is low and to sell it in some markets where its price is high. The
essence of arbitrage is to remove differences in the foreign exchange rate of
currencies so that there will be a single rate in the world exchange rate
market. Exchange rate has played an important role in the macroeconomic
performance of a nation. Many economists argue that exchange rate stability
facilitates production activities and economic growth and misalignment in real exchange
rate distorts production activities and hinders export growth, generates
capital flight and macroeconomic instability (Mamta Chowdhury 1999).
The exchange rate appreciated when less of
naira is needed to buy a dollar, it was caused by an increase in gross domestic
product, favourable balance of payment etc and it depreciates when high amount
of naira is needed to buy a single dollar and it was caused as a result of over
dependence on importation, heavy debt burden, weak balance of payments position
and capital flight.
Movement in exchange rates have ripple effect
on other economic variables such as Foreign Direct Investment (FDI), inflation
rate, interest rate, balance of trade etc. These facts emphasize the importance
of exchange rate to the economic well-being of every country that opens its
doors to international trade in goods, services and cross border investment.
Ellsworth (1964) defined exchange rate as the rate at which a country’s
currency exchanges for those of other countries measures its external values. An
exchange rate is simply the value or price of one currency in terms of another
and it makes no difference in which currency the price ratio is expressed
(Ellsworth, 1964). Exchange rate is of two types: real and nominal exchange
rate.
The
real exchange rate is defined as the ratio of the price level abroad and the
domestic price level where the price level is converted into domestic currency
units through the current nominal exchange rate. Montiel (2003), defined real
exchange rate as the relative price of foreign goods in terms of domestic
goods. The real exchange rate tells us how many times, more or less goods and
services can be purchased abroad. Real exchange rate determines the ratio of
price in the local market to the price in the foreign market. According to
purchasing power parity, real exchange rates do not change. The nominal
exchange rate is defined as the number of units of the domestic currency that
can purchase a unit of a given currency. A decrease in this variable is termed
nominal appreciation of the currency. An increase in this variable is termed
nominal depreciation of the currency. Nominal exchange rate tells how many
times an item of goods purchased locally can be purchased abroad. If the
nominal exchange rate is high, it will benefit an economy a lot in the trading
activities. If it is high, the goods and services get more foreign units. If
there is a change in the real exchange rate, the nominal exchange rate is less
affected as compared to the real exchange rate. There are factors that can
affect exchange rate and they are: inflation rate, interest rate, balance of
payments, political stability, internal harmony and these factors can lead
to either increase or decrease in
exchange rate.
There
are different types of exchange rate regimes practiced all over the world; from
the extreme case of fixed exchange rate system to a freely floating regime, and
managed floating, whichever that suits
their peculiar economic conditions. For instance, exchange rate managements in
Nigeria have witnessed different significant changes over the years. Nigeria
maintained fixed exchange rate from 1960 till the breakdown of the Bretton
Woods Monetary System in the early 1970s. Between 1970 and 1986, Nigeria
practiced a fixed exchange rate when the Naira was pegged against the British
Pounds and later on the American Dollar. Nigeria exchange rate policy shifted
from fixed exchange rate to flexible exchange rate to the various types of the
floating regime since 1986 following the adoption of the Structural Adjustment
Programme (SAP) (Sanusi, 2004). This floating was determined by the market
forces of demand and supply. Since then, the naira rate of exchange against the
dollar has experienced significant fluctuations such that naira/ dollar rate of
exchange moved from 0.6091, 0.6369, 3.3166, 9.001, 84.5, 92.52, in 1980, 1981,
1986, 1990, 1995, and 1999 respectively to 132.6, 147.6 and 156.35 in 2004,
2009, and 2013 respectively. In the 1970’s and 1980’s, the naira appreciated
against the dollar but in the recent time, naira lost its value up to the
extent that a dollar was 500naira. Some of the policies employed by the
government to stabilize the exchange rate include: Second Tier Foreign Exchange
Market (SFEM), Autonomous Foreign Exchange Market (AFEM), inter-bank foreign
exchange market (IFEM), the Dutch auction market (DAS). The policies were
unable to provide a solution to exchange rate stability. The naira continued to
depreciate against the American dollar. Some economists have attributed the
recent depreciation to the decline in the nation’s foreign exchange reserve,
over dependency on importation, heavy debt burden, weak balance of payments
position and the market activities of speculators and banks and capital
flight.
Exchange
rate has maintained consistent fluctuations in Nigeria over the years and these
changes are accountable to some macroeconomic variables. It becomes pertinent
to estimate the various factors that influence and determine exchange rate in
Nigeria. In the light of these, this study is aimed at carrying out an
empirical analysis of the determinants of exchange rate in Nigeria covering the
period 1980-2016.
1.2 Statement
of the problem
Foreign
exchange is said to be an important element in the economic growth and
development of a nation because foreign exchange policies influence the
economic activities and to a large extent, dictate the direction of the
macroeconomic variables in the country. The mechanism of exchange rate
determination are different systems of managing the exchange rate of a nation’s
currency in terms of other currencies and this should be properly done in a way
that will bring about efficient
allocation of scarce resources so as to achieve growth and development. Jhingan
(2005) suggested that to maintain both internal and external balance, a country
must control its exchange rate.
Over
the years, exchange rate fluctuations and volatility in Nigeria has been a
major macroeconomic issue and this has resulted to the introduction of many
macroeconomic policies to reduce the damage caused by exchange rate
fluctuations in the economy. A major and significant issue is to capture to
major macroeconomic variables that influence the variations and changes in
exchange rate as this will go a long way in controlling the changes. Some of the
policies employed by the government to stabilize the exchange rate include:
Second Tier Foreign Exchange Market (SFEM), Autonomous Foreign Exchange Market
(AFEM), inter-bank foreign exchange market (IFEM), the Dutch auction market
(DAS). The policies were unable to provide a solution to exchange rate
stability. It was in this light that this study is motivated to evaluate the
determinants of exchange rate in Nigeria covering the period 1980-2016.
1.3 Objectives of the study
The main objective of this study is to
ascertainthe determinants of exchange rate in Nigeria covering the period
1980-2016. In line with this general objective, the following specific
objectives will be pursued:
1. To
ascertain if interest rate is a major determinant of exchange rate in Nigeria.
2. To
find out if inflation is a major determinant of exchange rate in Nigeria.
3. To
ascertain if balance of payment is a major determinant of exchange rate in
Nigeria.
4. To
ascertain ifReal Gross Domestic Product (GDP) is a major determinant of
exchange rate in Nigeria.
1.4
Research Questions
The
following research questions will guide this study:
1. To
what extent has interest rate determined exchange rate in Nigeria?
2. To
what extent has inflation determined exchange rate in Nigeria?
3. To
what extent has balance of payment determined exchange rate in Nigeria?
4. To
what extent has real gross domestic product determined exchange rate in
Nigeria?
1.5 Statement of Hypotheses
The
following hypotheses will be tested in the course of the study.
H01:
interest rate is not a major determinant of exchange rate in Nigeria.
H02: inflation is not a major
determinant of exchange rate in Nigeria.
H03:
balance of payment is not a determinant of exchange rate in Nigeria.
H04:
Real Gross Domestic Product is not a major determinant of exchange rate in
Nigeria.
1.6
Significance of the Study
This
research work shall be beneficial to future economic researchers for this shall
be a very good reference material to source information on, it will equally
benefit the government in making informed decision on the issues relating to
exchange rate for policy prescriptions and intervention.As exchange rate is a
pure financial variable, the banking sector will find this research relevant
given that it will provide clear information on exchange rate.
1.7
scope of the study
The focus of this study is to estimate the
major determinants of exchange rate in Nigeria. Some of the proposed
determinants of exchange rate in Nigeria for the study are interest rate,
inflation rate, balance of payments and Real Gross Domestic Product (RGDP)
covering the period 1980-2016.
1.8
Limitations of the study
The
challenges the researcher faced in the process of this research work include:
Time
constraint: it was difficult for the researcher to
combine her lectures, exams and the research work. Furthermore, trying to gather material for
this study was not an easy task as emphasis was placed on where to source the
right material for the work as different textbooks and journals were consulted.
Financial
constraint: the researcher found it very difficult
to raised fund for her research work.
1.9
Definitions of terms
Gross
domestic product: this is the monetary
value of all the finished goods and services produced in a country’s borders in
a specified period usually one year.
Inflation:
this can be defined as the persistent and sustained increase in the general
price level of goods and services in an economy over a period of time.
Balance
of payment: this is the record of all economic
transactions between the residents of the country and of the world in a
particular period usually one year.
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