Monetary models and exchange rate determination: The Nigerian evidence

Abstract

This paper estimates three different monetary models of exchange rate determination for the Nigerian economy using time series data. These include the Monetary Flex-Price Model, Sticky Price Model and the Hybrid [Flex-Sticky Price] models. Our estimates reveal that the Monetary Flex-Price Model dominates other models in the determination of exchange rate in Nigeria. The model shows that relative money supplies, income levels and real interest rate differentials provide better forecasts of the naira-US dollar exchange rate. The empirical validity of our MFPM estimates is buttressed by the fact that the coefficient of the difference between the domestic and foreign money supply is close to unity. Thus, a one percent increase in the amount of currency supplied in the country stimulates 1.242 percent increase in the nominal exchange rate (depreciation). The empirics of the results are straight forward; a domestic economy that inflates her money supply at a faster rate than does her trading partner can expect to suffer depreciation in the external value of her currency. Consequently, any change in the money supply has as a
proportionate effect on the exchange rate and hence on the price level. Thus, the money supply process should be stable; otherwise, the exchange rate system in the country will be unstable. The policy significance in this regard is that monetary policy should be positively predicted.

Keyword: Flex-Price Model, Sticky-Price Model, Hybrid Model, Monetary Models, Exchange Rate,