CHAPTER ONE
INTRODUCTION
- BACKGROUND
OF THE STUDY
The need for
appropriate adjustment mechanism to structural imbalances in many developed
countries, especially after the Great Depression of 1929-1933, culminated in
extensive researches on exchange rate pass-through (ERPT) with the primary
objective of determining a nominal anchor for inflation and inflation
expectations. It is widely believed that an understanding of the impact of
exchange rate movement on prices would help to gauge the appropriate monetary
policy response to currency movements. The increased openness of most developed
economies and the incidence of large fluctuations in nominal exchange rates
have led to a need for a better understanding of the determinants of the
transmission of exchange rate changes into import prices.
Exchange rate
pass-through refers to the change in domestic prices that can be attributed to
a prior change in the nominal exchange rate. In other words, it is the effect
of a change in the exchange rate on domestic prices. Balance of payment
postulations normally assume a one-to-one response of import prices to exchange
rates, which is known as complete exchange rate pass-through (Peter, 2003). A
one-to-one response of import prices to exchange rate changes is known as
complete ERPT while a less than one-to-one response is known as partial or
incomplete ERPT. The rate of ERPT has important implications for the effect of
monetary policy on domestic prices as well as for the transmission of
macroeconomic shocks and the volatility of the real exchange rate.
According to An, (2006)
understanding of exchange rate pass-through is of extreme importance for three
key reasons: First, the knowledge of the degree and timing of pass-through are
essential for the proper assessment of monetary policy transmission on prices
as well as for inflation forecasting. Second, the adoption of inflation
targeting requires knowledge of the size and speed of exchange rate
pass-through into inflations. Finally, the degree of exchange rate pass-through
has important implication for “expenditure switching” effects from the exchange
rate. In other words, a low degree of exchange rate pass-through would make it
possible for trade flows to remain relatively insensitive to changes in
exchange rates, though demand might be highly elastic.
In general, three
factors may determine the extent of pass-through of exchange rate to domestic prices;
the pricing behavior by exporters in the producer countries, the responsiveness
of mark-ups to competitive conditions and the existence of distribution costs
that may drive a wedge between import and retail prices (Oliver, 2002; Campa
and Goldberg, 2005). For instance, when exchange rate changes, foreign firms
can choose to pass exchange rate change fully to their selling prices in export
markets (complete pass-through), to bear exchange rate change to keep selling
prices unchanged (zero pass-through), or some combination of these (partial
pass-through). In reality, exchange rate pass-through is far from complete,
Goldberg and Knetter (1997) argued that “a price response equal to one half the
exchange rate change”. They discovered that only around 60 percent of exchange
rate changes are passed on to import prices in the United States.
The main explanation
for incomplete pass-through is that many importing and exporting firms choose
to hold their prices constant and simply reduce or increase the mark-up on
prices, when the exchange rate is changing. Dornbusch (1987) justified
incomplete pass-through as arising from firms that operate in a market characterized
by imperfect competition and adjusts their mark-up (and not only prices) in
response to an exchange rate shock. Burstein et al (2003) instead emphasized
the role of (non-traded) domestic inputs in the chain of distribution of
tradable goods. Furthermore, Burstein et al (2005) pointed out the measurement
problems in CPI, which ignores the quality adjustment of tradable goods to
large adjustment in the exchange rate. Another line of reasoning stresses the
role that monetary and fiscal authorities play, by partly offsetting the impact
of changes in the exchange rate on prices (Goagnon and Ihrig, 2004).
In Nigeria, the
emphasis on knowing the exchange rate pass-through is underpinned by the fact
that the Nigerian economy is external sector driven such that the shocks from
global commodity markets have serious implications on the economy. In addition,
the need to make the external sector competitive through appropriate exchange
rate adjustment has made the study of exchange rate pass-through in Nigeria
imperative. Recent developments in the external sector of the Nigerian economy
revealed that the naira exchange rate depreciated by 24.0 percent between
October 2008 and February 2009 and the pressure is still on as crude oil
receipts continue to dwindle due to both demand and supply factors (CBN, 2010).
Concerns are what the magnitude and interrelationship of exchange rate
pass-through, monetary policy and price stability in Nigeria would be.
- STATEMENT
OF PROBLEM:
Traditional
monetary theory regards excessive money creation as a common source of
instability in both the exchange rate and price levels. In the presence of
large monetary shocks, price inflation, and exchange rate depreciation should,
therefore, be closely linked. Generally, scholars have accepted that,
understanding the impact of exchange rate movement on prices is critical from a
policy perspective in order to gauge the appropriate monetary policy response
to currency movement. Empirical studies (Peter, 2003; Oladipo, 2007) have shown
that movement in exchange rate and prices is diverse in the short to medium
run. An extensive theoretical literature, which has developed over the past
three decades, has identified various explanations why exchange rate
pass-through (ERPT) to import and consumer prices is incomplete. Empirical
analyses have also provided evidence of considerable cross-country differences
in the ERPT. A major argument in this respect was suggested by Taylor (2000),
who puts forward the hypothesis that the responsiveness of prices to exchange
rate fluctuation depends positively on inflation.
In Nigeria, Oladipo (2007) examined exchange
rate pass-through for Nigeria’s imports using a Johanson cointegration technique
to a sectoral data between 1970 and 2004. He used the mark-up approach which
sets export prices as a mark-up on production costs. He finds incomplete
pass-through at varying degrees across sectors. He finds that pass-through was
much larger in the long-run than in the short-run.
Taking a brief
over-view of the studies, the literature has demonstrated the various attempts
developed to explain the lack of macroeconomic adjustment from simple to more
complex models. One important conclusion obtainable from the review is that
virtually all the models have common variables as determinants of either
domestic price or import price. Certainly, the market structure and prevailing
macroeconomic environment go a long way in determining the suitability of these
models to any economy. In general, the literature suggests that pass-through to
destination currency prices will be higher in more competitive markets, with
more homogeneous products, or where foreign exporters dominate a particular
market.
Most of the earlier studies reviewed have
focused mainly on the effect of exchange rate movement on prices without
considering exchange rate pass-through, monetary policy, and price stability in
Nigeria. This research work will attempt to fill the gap by incorporating exchange
rate pass-through, monetary policy and price stability in Nigeria. In other
words, our study will be broader than Oladipo’s paper by incorporating both
prices (domestic and foreign).
In view of the above discussion, this
research work intends to address the following questions. However, reserve
requirement as used in this study stands for external reserve.
- How does exchange rate pass-through
impact on reserve requirement, and price stability in Nigeria?
- How does exchange rate pass-through
influence open market operation, and price stability in Nigeria?
- How does exchange rate pass-through
impact on interest rate, and price stability in Nigeria?
1.3 OBJECTIVES OF THE STUDY:
This research work is primarily concerned
with investigating how exchange rate pass-through impact on reserve requirement,
open market operation, interest rate, and price stability in Nigeria.
Specifically, it sets out to achieve the following objectives.
- To investigate the impact of exchange
rate pass-through on reserve requirement, and price stability in Nigeria.
- To investigate the influence of exchange
rate pass-through on open market operation (omo), and price stability in
Nigeria.
- To trace the impact of exchange rate
pass-through on interest rate, and price stability in Nigeria.
- To ascertain if there is a long-run
relationship between exchange rate pass-through, reserve requirement, open
market operation, interest rate, and price stability in Nigeria.
- HYPOTHESIS
OF THE STUDY.
The following working
hypotheses will guide the study.
Ho1: Exchange
rate pass-through has no impact on reserve requirement in Nigeria.
Ho2: Exchange
rate pass-through does not influence open market operation in Nigeria.
Ho3: There
is no impact of exchange rate pass-through on interest rate in Nigeria.
Ho4: There
is no long-run relationship between exchange rate pass-through, reserve
requirement, open market operation, interest rate, and price stability in Nigeria.
ELECTRICITY SUPPLY AND INDUSTRIAL GROWTH – THE NIGERIAN CASE STUDY
