Interest Rate, Price Level, Exchange Rate and Aggregate Output in Nigeria
Aliyu Ahmad Yusuf Department of Economics Baze University, Abuja- Nigeria Email: [email protected]
Abstract: The objective of this paper to examine the dynamic relationships between interest rates, price level, exchange rate and economic growth in Nigeria using a quarterly time series data from 1988q1 to 2018q2. The study employed a Granger VECM model and suggests that in the short run, interest rate (INTR) can cause real gross domestic product (GDP) in Nigeria hence, a unidirectional causality runs from the interest rate (INTR) to the real gross domestic product (GDP) while there is no causality movement from consumer price index (CPI) and exchange rate (EXCH) to the real gross domestic product GDP. The result also indicates a short run causality running from real gross domestic product (GDP), consumer price index (CPI) and exchange rate (EXCH) to interest rate (INTR). On the other hand, the study suggests no short run causality running from real gross domestic product (GDP), interest rate (INTR) and exchange rate (EXCH) to consumer price index (CPI) and also found that the real gross domestic product (GDP), interest rate (INTR) and consumer price index (CPI) cannot cause exchange rate (EXCH) in the short run while in the long run, the study found the coefficient of the error correction term (ECT) as negative and statistically significant with the speed of adjustments as 5 percent per quarter. The study recommends a robust monetary policy should be pursued to encourage stability in both interest and exchange rates and as well consequent price stability for increased productivity in the economy.
Keywords: Interest rate, Price level, Exchange rate, GDP, Nigeria
Introduction.
Overtime, the relationship between interest rate, price level and economic growth has been a subject of interest in the academic discourse. The interplay among the variables has caused for various findings and conclusion by monetary authorities, economists and policy makers based on various arguments that stands on the spotlight of how economic growth can be influenced by these variables of interest rate and price level and how purchasing power is determined considering the interest and exchange rates volatility. The use of price level here could be synonymous to inflation while interest rate related to money supply as control variables and other macroeconomics variables related to various theoretical fronts in the fields of arguments put forward by both Classical and Keynesian economists. The classical economists argued that increasing quantity of money supply generally increase price level rather than income and employment. While the Keynesian economist emphasized on changes in money demand in relation to price level or income, or both the price level and income. These assertions established conflicting conclusions from the perspectives of various scholars.
65
However, on the ground of these arguments, various empirical studies have been conducted to examine the relationship between either interest rate, price level, money supply and economic growth or money supply, interest rate, inflation and economic growth (Urbanovsky, 2017; Bello and Saulawa, 2013; Kaplan and Gungor, 2017; Akinbobola, 2012; Njimanted, 2009; Cochraine, 1999; Nguyen, 2015; Masih and Abdulkarim, 2014;). The review of some of these studies suggest that general consensus is however difficult on the relationship amongst the variables owing to contradiction in the results from different studies.
The objective of this paper is mainly to evaluate the dynamic causal relationship between interest rate, price level, exchange rate and economic growth in Nigeria. The motivation for this study was to build on existing empirical literature and contribute to the growing research on how monetary policy can be adjudged to achieve price stability and fostering sustainable economic growth thereby stabilizing exchange rate and controlling interest rates to check the inflation level in the country. However, it is a well-known fact that interest rate volatility affects lending rate and price level with attendant consequences on investment and the economy. This paper, nevertheless, adds to the literature by incorporating interest rate, price level, exchange rate and economic growth into a dynamic model using a time series data from 1988q1 to 2018q4 to examine the relative impact of both interest rate and price level on economic growth and as well their causal effect on exchange rate volatility in Nigeria necessary for empirical and policy inferences.
After this section of introduction, the paper is organized in the following ways: Section 2 consists of empirical literature review followed by the methodology in section 3. While section 4 presents the results and discussion of the paper and the final section consists of conclusion and recommendations.
Theoretical Literature Review
There are several bodies of literature that embodied the theory of interest rate. Prominent among which include the neo- classical, the lendable, the Keynesian theory etc. The Neo-classical theory of interest rates otherwise, the lendable fund theory states that interest rates are affected by the factors of demand and supply of lendable funds whereby the demand for lendable funds has an inverse relationship with interest rate. Hence, they move in a non- convergence direction. This can therefore be explained that an increase in interest rates may negatively affect the cost of raw materials in the market leading to an increasing production costs that may exert a threat to aggregate output in the economy.
According to Keynes (1973), in his definition of liquidity preference theory stated that the rate of interest set forth in the general theory of employment, interest and money. That, “the rate of interest depends on the demand and supply of money” (Keynes 1937, 1973). In his view, the primary way in which interest rates influence the aggregate output level is through its effects on the planned investment spending through which the profit making firms invest in physical capital (machines, factories and the raw materials) with the expectation to attract more earning than the interest cost of a loan for investment financing. However, this paper is anchored on Keynes assertion on interest rates in relation to investment purposes thereby facilitating consumption pattern, saving and demand pattern in the economy.
Empirical Literature Review
A number of studies have been conducted that examined the interplay of some macroeconomic variables in monetary economics literature and the impact of these variables on economic growth and as well effectiveness of monetary policy. Two aspects of these studies can be identified based on the perspective of this study. On one hand, there are group of studies that are interested in the
66
relationship between interest rates and economic growth or interest rates, money supply, inflation and economic growth. This aspects of studies includes researches conducted by Shahzad (2011), Udoka and Roland (2012), Umaru & Zubairu, (2012), Saymeh and Orabi, (2013), Semuel and Nurina (2015), Bhunia (2016), Jelilov (2016), Maiga (2017), Kaplan and Gungor (2017), Utile, Okwori and Dooter (2018). In all of these studies, conflicting arguments and conclusions were established. While Maiga (2017) argued that the interest rate has a slight impact on growth and that the growth can also be improved by lower the interest rate which will increase the investment, Utile et al, (2018) conclude that interest rate has a negative and insignificant relationship with GDP. Also, Saymeh and Orabi (2013) observed that interest rate and inflation rates had a shock on economic growth rate.
On the other hand, other group of studies investigated the relationship between interest rate, price level, money supply and economic growth or interest rate and other macroeconomic variables.
This group includes studies carried out by Ahmad and Ali, (1999), Garcia, and Rigobon, (2004), Lenza, (2006), Benati, (2009), Oriavwote and Eshenake (2012), Thornton, (2014), Mahmoud (2015), Nguyen, (2015), Tafa, (2015), Diaz, Theodoulidis, and Dupouy, (2016), Kabuga and Yusuf, (2017) all these are group of studies for Nigeria who suggest control of demand for money supply and improved output and productivity in order to derive growth in Nigeria. Kabuga and Yusuf, (2017) for Nigeria, while Bhunia, (2016) for India found the most advantageous interest rate condition as the effective tool to promote economic growth. This means price level and inflation cannot be used to determine changes in the economy of the countries.
With the above reviewed literatures, it is evidently that there are relatively scanty studies on the relationship between interest rate, price level, exchange rate and economic growth conducted in Nigeria. Therefore, this paper is aimed at building on the available studies by incorporating missing variables and to address some shortcomings on the previous literatures. For instance, Udoka and Roland (2012) study was conducted using ordinary least square multiple regression technique from the period of 1970 to 2010. Kabuga and Yusuf (2017) relied on frequency quarterly data from 1986 to 2016. The underlying interest of this study is to provide the necessary vectors that will examine the relationship between interest rate, price level, exchange rate and economic growth in Nigeria using Engle- Granger VECM causality model.
Methodology
The paper adopts quarterly time series data within a period spanning from 1988q1 to 2018q2. The objective is to assess the relationship between interest rate, piece level, exchange rate and economic growth in Nigeria. The source of data was from World Bank Development Indicators (WDI) and CBN Statistical Bulletin.
Model Specification
The model of this study is meant to assess the relationship between interest rate, price level, exchange rate and economic growth in Nigeria, the model formulated is specified as:
LGDP = f(LINTR. LPRL, EXCH) (1)
Where;
LGDP = log of real GDP (proxy for aggregate output and economic growth) INTR = Real interest rate
LPRL = log of Consumer price index (proxy for Price level).
LEXCH = log of real exchange rate
67 Unit Root Test
The study introduces a unit root test by adopting the famous Augmented Dickey Fuller (ADF) and Phillip Peron models. The test usually uses the null hypothesis of non-stationarity of the time series. The general forms of this test are stated below:
t i
t i t i
t t y v
Y = + + + +
= −
−
1 1 1
0 (2)
yt = a0+ a1t+ a1yt-1+ dt (3)
In this caseimplies parameters of the model, vtis assumed to be a white noise, yt and denotes lag differences of the variable of interest with p lag. The following hypotheses are also considered to test the stationarity of the variables.
] 0 1 [
), (
:1 Nullhypothesis where1 = − = Ho
) (
0
: 1 Alternativehypothesis Ha
The purpose of employing this test is to determine the stationarity of the series. Once the data is stationary, or it has been confirmed to be non-stationary and normalized by taking first difference, then justification to proceed to test for the existence of co-integration between non-stationary variables is confirmed.
Co-integration Technique
The paper also uses Johansen`s (1988) cointegration approach in order to confirm long run relationship among the variables of interest. The technique applied if two series are integrated of the same order. This method of cointegration is based on maximum likelihood estimation of the vector error correction model (VECM), as given by the formula:
t t p t 1 p t 1 p 2
t 2 1 t 1
t z z z z x u
z =+ + + + + + +
− − − − + − (4)
where zt is given as a vector of I(1) endogenous variables, zt = zt-zt-1, xt is vector of I(0) exogenous variables, and pand i reflect (n n) matrices of parameters with i=-(I-A1-A2- -Ai), (i=1, ,k-1), and p=I-p1-p2- -pk. This specification offers information about the short-run and long-run adjustments to the changes in zt through the estimates of and ˆ respectively. The term zt−k also gives information about the long-run equilibrium relationship between the variables in zt. Information about the number of cointegrating relationships among the variables in zt is provided by the rank of the p-matrix: if p is of reduced rank, the model is subject to a unit root; and if 0<r<n, where r is the rank of p, p can be decomposed into two (n r) matrices a and b, such that p=ab' where b'zt is stationary. In this respect, a is the error correction term and measures the speed of adjustment in Dzt and b contains r distinct cointegrating vectors which forms the relationships between the non-stationary variables cointegrated.
Results and Discussion
The paper incorporates the analysis of the empirical estimation of the time series data by determining the level of stationarity and order of integration of the variables of interest. The results of ADF and PPtests as displayed in Table 1 indicate that each variable is integrated of order one at 1% significant level.
ˆ i
68 Table 1: Unit-root test
ADF test. PP test.
Variables level 1st Diff Inference level 1st Diff Inference
LGDP 0.909 -2.138** I(1) -0.829 -5.529*** I(1)
INTR 0.424 -4.065*** I(1) -0.104 -5.538*** I(1)
CPI 0.178 -2.478** I(1) -0.744 -2.272** I(1)
EXCH 0.842 -9.885*** I(1) -0.373 -10.174*** I(1)
Source: Extraction from estimation output using E-views 10. Note:* **and ** denotes show how at 1%
and 5% level of significance respectively the null hypothesis is rejected.
The result in Table 1 shows that all the variables are found not to be stationary at levels but stationary in their first difference at 1% level of significance meaning that the null hypothesis has been rejected which implies that the individual series have a unit root. In inferences, we therefore, accept that the series are integrated of order one (I(1)). This gives an avenue to proceed with the test for long run relationship between interest rate, price level, exchange rate and economic growth using Johansen cointegration test.
Table 2: The Johansen Co-integration Test Results
The cointegration test results are presented in Table 2. The result suggests there is long run relationship amongst interest rate, price level, exchange rate and economic growth in Nigeria as evident in the cointegration test using both trace statistic and the maximum eigenvalue which reported existence of at least one co-integrating equation at 5% level of significance.
Table 2: Cointegration test results
Null hypothesis Alternative Jtrace Jmax
r=0 r<1 45.644** 35.231**
(0.013) (0.001)
r=1 r<2 10.413 8.527
(0.826) (0.648)
r=2 r<3 1.886 1.651
(0.959) (0.956)
r=3 r<4 0.235 0.235
(0.686) (0.686)
Note: P-values in parenthesis (). ** means 5% significance level.
Based on the results in Table2, the null hypothesis of no cointegration can be rejected suggesting a possibility of co-movement between interest rate, price level, exchange rate and economic growth which also implies that, if a set of variables are cointegrated, the influence of a shock on one variable spreads to the other variables possibly with lags in time in order to effect a long run relationship between the variables of interest.
Table 3: Long Run Vector Estimates result
LGDP C INTR CPI LEXCH
1.000000 -7.791 -0.087 (0.020) [-4.33]
0.007 (0.001) [ 5.417]
-0.056 (0.048) [ -1.167]
Source: Computed by the author using E-views. Version 10 (2018)
69
The result of the numerical values of the long run cointegration vectors in Table3 suggests that there is a negative relationship between interest rate (INTR) and economic growth (GDP). In other words, this implies that a1percent increase in interest rate would have a negative effect on economic growth by at least 0.08% in the long run.
While with respect to consumer price index (CPI) which is a proxy to price level, the result suggests a positive relationship between price level and economic growth in Nigeria. This also means that, in the long run, as the price of commodities increases by at least 1%, the economic growth would be affected by 0.01% in the long run.
The result also implies that real exchange rate (EXCH) is statistically insignificant having inverse relationship with economic growth in the long run meaning that, a one percent increase in the real exchange rate would lead to a change in economic growth by at least 0.06%.
However, the short run analysis aimed at examining how economic growth (GDP) responds to its own lagged value and the lagged value of interest rate, price level and exchange rate in the short run. This is obtained with the motive to determine whether the short run dynamics is influenced by the estimated long run equilibrium effects, otherwise the cointegration vectors.
Table 4: Granger VECM Causality Result
Independent Variables
Dependent variables
x2 statistics of lagged 1st differenced term [P-value]
ECTt-1 Coefficient (t-ratio)
ΔLGDP ΔINTR ΔCPI ΔLEXCH
ΔLGDP 6.369** 0.443 0.918 -0.0005
[0.002] [0.506] [0.338] (0.065)
ΔINT 6.259** 5.349** 4.659** -0.873***
[0.012] [0.021] [0.031] (3.896)
ΔCPI 1.066 0.018 0.111 0.5025
[0.302] [0.895] [0.739] (1.104)
ΔLEXCH 0.128 2.407 0.165 0.0364
[0.720] [0.121] [0.685] (0.716)
Note: ***, **, * Statistical significance at the 1%, 5% & 10% levels, Source: computed by the author using E-views 10.
From table 4, the result shows that in the short run, a unidirectional causality runs only from the interest rate (INTR) to the real gross domestic product (GDP) with the intertest rate having a positive coefficient and statistically significant at 5% level meaning that interest rate can cause GDP in Nigeria in the short run whereas consumer price index (CPI) and exchange rate (EXCH) do not have causality running from them to the real gross domestic product GDP in the short-run.
The result also indicates that there is a short run causality running from real gross domestic product (GDP), consumer price index (CPI) and exchange rate (EXCH) to the interest rate (INTR).
70
This indicates that real gross domestic product, consumer price index and exchange rate were statistically significant at 5 percent level and positively related to interest rate in the short run.
While on the contrary, the result in table 4 also shows no short run causality running from real gross domestic product (GDP), interest rate (INTR) and exchange rate (EXCH) to consumer price index (CPI). Also, the result indicates no causality running from real gross domestic product (GDP), interest rate (INTR), consumer price index (CPI) to exchange rate (EXCH) in the short run though all the variables have positive coefficients but are not statistically significant.
While in the long run, the table 4 results also indicate that the coefficient of the error correction term is -0.05 and statistically significant values which imply that the speed of adjustment is approximately 5 percent per quarter. The negative sign and significant coefficient are indications that co-integrating relationship exists between the variables. The size of the coefficient on the error correction term (ECT) denotes that 0.05 percent of the disequilibrium caused previous year’s shock which converges back to the long run equilibrium in the current year. This means that the speed of adjustment from the short run to the long run equilibrium is 5 percent.
Conclusion
This study suggests that interest rate (INTR) can cause real gross domestic product (GDP) in Nigeria hence, a unidirectional causality runs only from the interest rate (INTR) to the real gross domestic product (GDP) in the short run while there is no causality movement from consumer price index (CPI) and exchange rate (EXCH) to the real gross domestic product GDP in the short-run. But the result also indicates that there is a short run causality running from real gross domestic product (GDP), consumer price index (CPI) and exchange rate (EXCH) to the interest rate (INTR).
Meaning that the real gross domestic product, consumer price index and exchange rate can cause interest rate in the short run hence, they have positive coefficients and were statistically significant at 5 percent related to the interest rate.
On the contrary, the result suggests no short run causality running from real gross domestic product (GDP), interest rate (INTR) and exchange rate (EXCH) to consumer price index (CPI).
The study also found that the real gross domestic product (GDP), interest rate (INTR) and consumer price index (CPI) cannot cause exchange rate (EXCH) in the short run meaning there is no causality running among them.
In the long run, the result shows the coefficient of the error correction term having the required negative sign but statistically insignificant with the speed of adjustment from short run disequilibrium caused by the previous year’s shock to the long run equilibrium as approximately 5 percent per quarter contrary to the findings of Njimanted (2009) with the adjustment speed at 62.5%..
The study therefore recommends that a robust monetary policy should be pursued that will encourage stability in both interest rate and exchange rate resulting also to price stability in both consumer goods for improved consumer welfare and as well as factor inputs to reduce the cost of production in the economy.
71 References
Ahmad, E., and Ali, S. (1999). Relationship between Exchange Rate and Inflation. Pakistan Economic and Social Review, 139-154. Bank of Albania. (n.d.). Retrieved from http://www.bankofalbania.org/web/Time_series_22_2.php?evn=periudha&evb=agre gate &periudha=1
Akinbobola, T. O. (2012). The dynamics of money supply, exchange rate and inflation in Nigeria.
Journal of Applied Finance & Banking. Vol. 2. No.4. Pp. 117-141
Bello M. Z. and Saulawa M. A. (2013). Relationship between Inflation, Money Supply,
Interest Rate and Income Growth (Rgdp) in Nigeria 1980-2010. an Empirical Investigation.
Journal of Economics and Sustainable Development. Vol.4, No.8, 2013. ISSN 2222-1700 (Paper) ISSN 2222-2855
Benati, L. (2009). Long‑run Evidence on Money Growth and Inflation. European Central Bank Working Paper Series, No. 1027. Frankfurt Main: ECB.
Bhunia A. (2016). How Inflation and Interest Rates Are Related to Economic Growth? A
Case of India. Journal of Finance and Accounting, 2016, Vol. 4, No. 1, 20-26 Available online at http://pubs.sciepub.com/jfa/4/1/3 ©Science and Education Publishing.
DOI:10.12691/jfa-4-1-3
Cochraine J.H. (1999). Money as stock: Price level determination with no money demand, University of Chicago, Federal Reserve Bank of Chicago and NBER. 1101 E. 58th St.
Chicago IL 60637. 773 702 3059,
http://www-gsb.uchicago.edu/fac/john.eochrane/research/Papers
Diaz, D., Theodoulidis, B. And Dupouy, c. (2016). Modelling and forecasting interest rates during stages of the economic cycle: A knowledge‑discovery approach. Expert Systems with Applications, 44: 245–264.
Garcia, M. and Rigobon, R. (2004). A risk management approach to emerging market’s sovereign debt sustainability with an application to Brazilian data. National bureau of economic research working paper no. 10336. [Online]. Available at:
http://www.nber.org/papers/w10336.pdf. [Accessed 2016, January 20].
Jelilov, G. (2016). The Impact of Interest rate on Economic Growth example of Nigeria.
African Journal of Social Sciences. Vol. 6. No. 2. Pp. 51-64. ISSN 2045-8452 (Print) ISSN 2045-8460 (Online)
Johansen, S. 1988. Statistical analysis of cointegration vectors, Journal of Economic Dynamics and Control 12: 231-254.
Kabuga N.A. and Yusuf A.A. (2017). Money Supply, Price Level and Output: Evidence
from Short and Long run Vectors in an Error Correction Model, Lafia Journal of Economics and Management Sciences. Vol. 2. No. 1. Pp. 209- 219.
Kaplan F. and Gungor S. (2017). The Relationship Between Money Supply, Interest Rate and Inflation Rate: an Endogeneity-Exogeneity Approach. European Scientific Journal. January 2017 edition Vol.13, No.1 ISSN: 1857 – 7881 (Print) e - ISSN 1857- 7431
Lenza, M. 2006. Does Money Help to Forecast Inflation in the Euro Area? Mimeo, European Central Bank.
Mahmoud L. O. M. (2015). Consumer price index and economic growth: a case study of Mauritania 1990 – 2013. Asian Journal of Empirical Research. Published by: Asian
Economic and Social Society ISSN (P): 2306-983X, ISSN (E): 2224-4425. Vol. 5. No. 2.
2015,
Maiga F. K. (2017). Impact of Interest Rate on Economic Growth in Nigeria. Pyrex Journal of Business and Finance Management Research. Vol. 3. No. 3. pp. 98-111. March, 2017, ISSN: 2550-7877
72
Masih M.. and AbdulKarim F. (2014). Dynamic causal chain of money, output, interest rate, exchange rate and prices: Nigeria as a case study. MPRA Paper No. 58240,
Nguyen, V. B. (2015). Effects of fiscal deficit and money M2 supply on inflation: Evidence from selected economies of Asia. Journal of Economics, Finance and Administrative Science, Vol. 20. No. 38. Pp. 49 – 53.
Njimanted, G. F. (2009). Money supply, interest rate, and economic growth in cameroon: a time series analysis, department of economics and management, faculty of social and management sciences, university of buea, p.o box 63, south west province, Cameroon.
Journal of the Cameroon Academy of Sciences. Vol. 8. No. 2/3. (2009)
Oriavwote, V., & Eshenake, S. (2012). Real Exchange Rate and Inflation: An Empirical Assessment of the Nigerian Experience. Mediterranean Journal of Social Sciences Perron, P. (1989). The great crash, the oil price shock, and the unit root hypothesis.
Econometrica, 57, 1361- 1401.
Saymeh, A. F and Abu Orabi, M. M. (2013). The Effect of Interest rate, Inflation rate, GDP, on Real Economic Growth rate in Jordan. Asian Economic and Financial Review, 2013, Vol.
3. No. 3. Pp. 341-354
Shahzad, H. (2011). Inflation and economic growth: Evidence from Pakistan. International Journal of Economics and Finance. Vol. 3. No. 5. Pp. 262-276.
Semuel, H. and Nurina, S. (2015). Analysis of the Effect of Inflation, Interest Rates, and
Exchange Rates on Gross Domestic Product (GDP) in Indonesia. Proceedings of the International Conference on Global Business, Economics, Finance and Social Sciences (GB15_Thai Conference), Bangkok, Thailand, 20-22 February 2015 Paper ID: T507, 1-13.
Tafa J. (2015). Relationship between Exchange Rates and Interest Rates: Case of Albania.
Mediterranean Journal of Social Sciences. MCSER Publishing, Rome-Italy. Vol 6 No.
4. July 2015. ISSN 2039-9340 (print). ISSN 2039-2117 (online)
Thornton, D. L. (2014). Monetary policy: Why money matters (and interest rates don’t).
Journal of Macroeconomics, 40: 202 – 213.
Udoka, C. O. and Roland, A A. (2012). The Effect of Interest Rate Fluctuation on the Economic Growth of Nigeria, 1970-2010. International Journal of Business and Social Science. Vol. 3.
No. 20 [Special Issue – October 2012]
Umaru, A., & Zubairu, J. (2012). The effect of inflation on the growth and development of the Nigerian economy: An empirical analysis. International Journal of Business and Social Science, 2(4), 187-188.
Urbanovsky T.(2017) Granger causalities between interest Rate, price level, money supply and Real gdp in the czech republic, Department of Finance, Faculty of Economics and Administration, Masaryk University in Brno, Lipova, Acta Universitatis Agriculturae Et Silviculturae Mendelianae Brunensis, Vol. 65/ 79. No. 2, 2017
Utile, B. J., Okwori, A. O. and Dooter I. M. (2018). Effect of Interest rate on Economic
Growth in Nigeria. International Journal of Advanced Academic Research. Social &
Management Sciences. Vol. 4, Issue 1 (January 2018). ISSN: 2488-9849
73