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How Exchange Rate and Oil Price Shocks are Fueling Inflation in Nigeria

The growth of economic openness between countries around the world has also resulted in increased scrutiny in how economic variables interact and their impact on the world today. One example is the effect of volatile exchange rates and oil price shocks on inflation. For instance, a sudden oil price increase or decrease could be viewed as good or bad news for any nation depending on what side of “oil demand and supply” coin a nation finds itself. The extent of the relationship between the stated economic variables is particularly important to nations like Nigeria because of its overreliance on oil export as its major source of foreign earnings.

Apart from other internal factors, the reason for rising inflation in Nigeria can be attributed to volatility in oil prices and exchange rates. For example in 2015, the international community experienced a precipitous fall in the price of oil, which as expected, resulted in a decline in Nigeria’s foreign exchange rates. Also during that period, inflation rate rose from 12.5% in first quarter to about 13% in second quarter even with attempts by the Central Bank to pin the Naira to a fixed value. For any meaningful monetary policy to be effective, leaders need to understand the interrelationship of these variables in the “Nigerian” context.

To address this problem, Ikechukwu Kelikume, in his paper, “Do Exchange Rate and Oil Price Shocks Have Asymmetric Effect on Inflation? Evidence from Nigeria” investigates some critial questions like“What effect does volatile exchange rate and oil price shocks have on inflation in Nigeria? “and “Is there any asymmetry in its effects?” By answering these questions, Kelikume aims to provide insightful knowledge beneficial to policy makers in the understanding of the macroeconomic behavior in Nigeria and the extent to which oil price and exchange rate shocks affects domestic inflation.

Kelikume used a model known as the estimated vector autoregressive error correction model (VECM) using data spanning a decade in Nigeria (2006-2016) to show a corelation in the effect of volatile oil price and exchange rate on inflation. The model accounts for analyzing economic variables like unemployment, monetary shocks, and exchange rate anomalies and also takes into account some critical features of the Nigerian economy that impact inflation. Kelikume further revealed that depreciation has more significant impact on inflation than appreciation. However, contrary to the author's expectation, an increase in oil price has a more significant impact on inflation than a decrease in oil price does. Thus establishing an asymmetry in the effects of exchange rate and oil price shocks on inflation.

The key implication? Nigeria must diversify the basis of its economy and find new areas for investment. Part of that, he argues, will require the Nigerian government to creat new policies to reign in inflation in order to ensure the stability of the country’s currency, which in turn will have an indirect impact on geopolitical stability. Without those changes, the Nigerian economy will continue to be held ransom by the dynamics of the world’s oil supplies. 

The paper was published in Journal of Developing Areas.