An Econometric Analysis of the Nexus of Exchange Rate, Inflation and Budget Deficit: Case of Nigeria 1981 – 2016

Abstract

Depreciation of the naira has a role to play in Nigeria's recent inflationary process. Concomitant with this is the substantial budget deficit operated annually by the Federal Government in the last decade or so. Part of the budget deficit is finance through bank credit which directly affects the money base. This also exerts upward pressure on the general price level. All this suggests that there are many sources of the current inflation. While the channels through which exchange rate depreciation affects prices are known, the extent to which this phenomenon engenders price inflation in Nigeria is still not well researched. As part of the attempt to fill this gap, this study examines the quantitative effects of exchange rate depreciation on budget deficit and inflation in Nigeria. This is achieved in two stages. First, a structural model of the interaction between exchange rate, budget deficit, inflation, and government revenue and expenditure is constructed. In doing this, the study is influenced by SVAR cointegration and the error correction model. This result presents trends in the relationship between exchange rate, budget deficit and inflation and the impact exchange rate on inflation and budget deficit are positive but not statically significant and incomplete. The findings from this study have a number of policy implications for Nigeria government. A major policy implication of the results of the study is that concerted effort should be made by the Nigeria’s government to strengthen the production capacity of domestic firms and industries in order to reduce the level of the imported consumer and capital goods. This will help improve the level of exchange rate impact on other macroeconomic variables in Nigeria.