An Empirical Relationship between Foreign Exchange Rate, Inflation and Interest Rate in Nigeria

Abstract

This paper investigates the empirical relationship between naira/US dollar exchange rate, inflation and interest rate in Nigeria. The study uses annual time series data from 1970-2017. Augmented Dickey-Fuller unit root test, Johansen cointegration, fully modified least squares; Error correction model and Granger causality test based on Toda-Yamamoto procedure were employed in this study as methods of analysis. The results reveal that all variables are integrated of order one and hence cointegrated. The study finds inflation as having negative and significant impact on exchange rate while interest rate was found to have positive and significant impact on the foreign exchange rate in Nigeria in the long-run. The economic impacts of inflation and interest rate on the exchange rate in the short-run are found to be low, temporal and not long lasting. The ECM model has identified a moderate speed of adjustment by 50.39% for correcting disequilibrium annually for achieving long-term equilibrium steady-state position. The Granger causality test result shows statistical evidence of unidirectional causality between exchange rate and inflation and between exchange rate and interest rate in the short-run. There is also a unidirectional causality that runs from interest rates to inflation meaning that inflation is Granger caused by interest rates in Nigeria. The study recommends that lowering the lending interest rate and targeting inflation to single digit is a better exchange policy strategy for Nigeria.