Exchange Rate Volatility, Currency Substitution and Monetary Policy in Nigeria

Abstract

This article analyses the implications of currency substitution and exchange rate volatility for monetary policy in Nigeria. It adopts the unrestricted portfolio balance model of currency substitution, incorporating exchange rate volatility within the framework of the Vector Error Correction (VEC) technique. Results from both impulse response and the forecast error variance decomposition functions suggest that exchange rate volatility and currency substitution responds to monetary policy with some lags, meaning that monetary policy may be effective in dampening exchange rate volatility and currency substitution in the medium horizon but might not be effective in the short horizon. The study concludes that currency substitution is not an instant reaction to the slightest policy mistake; rather it is a fallout from a prolonged period of macroeconomic instability. The major sources of this instability in Nigeria are untamed fiscal deficits leading to high domestic inflation, real parallel market exchange rate volatility, and speculative business activities of market agents in the foreign exchange rate market and poor/inconsistent or uncertainty in public policies. In terms of policy choice, our result favours exchange rate - based monetary policy as against interest rate based monetary policy for stabilisation in dollarised economies like Nigeria. Key words: Demand for money, Exchange Rate Volatility, Currency Substitution, Monetary Policy and Nigeria.