This chapter examines the degree and speed of exchange rate pass-through (ERPT) to consumer price in Nigeria using quarterly time series data from 1986Q to 2013Q4. The impact of the changes in exchange rate on the consumer prices was apparent in Nigeria during the period under review. From the adoption of floating exchange rate regimes in 1986, Nigeria witnessed fluctuations in the exchange rate and persistent consumer prices inflation (See Chapter two). It was observed from our review (in Chapter two) that greater consumer price inflation rates were witnessed during periods of high Naira exchange rate depreciation. The transmission of changes in the exchange rate to domestic consumer price is one of the challenges faced by developing countries like Nigeria. One of the main challenges of economic policy management in Nigeria since 1986 is that of maintaining a stable exchange rate and preventing the impact of exchange rate changes on the consumer prices. There is a consensus in both theoretical and empirical literature on the fact that exchange rate changes affect the level of consumer price inflation, especially in open economies with floating exchange rate like Nigeria (for example see Menon (1995), Kara and Nelson (2002) and Devereux and Yetman (2008) among others reviewed in chapter three).
The impact of exchange rate changes in macroeconomic adjustment is mainly determined by its effect on consumer prices and the speed of its transmission. When there is a high level of pass-through, the variation in the exchange rate will affect the relative prices of goods, thus causing a quick adjustment in trade balances. For
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instance, when there is a high level of ERPT, imports will be expensive, the demand for imports will decline, and consumers will switch to locally-produced goods. Conversely, with a small degree of ERPT, the changes in the exchange rate will not have a significant impact on local consumer prices and trade balances (Bada et al., 2016).
Considering that Nigeria just like most developing countries pursues an export-led growth strategy (see Chapter two), exchange rates policy plays a significant and vital role in the economy. Nigeria like most developing countries also imports technology and other capital goods for its exporting industries. Nigeria is also one of the major oil producing countries and generates more than 90% of its foreign exchange (forex) earnings from selling oil (see Chapter two). Given the volatility of the oil price, any shock in the international oil price affects the forex supply in the economy which reflects in the exchange rate. Then the movement in the exchange rate is ultimately transmitted to the consumer prices through direct and indirect channels (see Chapter three).
Therefore, understanding the nature of exchange rate pass-through is of great importance considering that the degree and timing of pass-through are critical to correct assessment of monetary policy impact on prices and forecasting inflation (An, 2006). It is also indispensable for policy formulation, particularly for central banks, which are in-charge of managing exchange rate and stability of price in the economy.
Although there is extensive empirical literature on ERPT, only a small number of the studies examined it from the context of developing economies. There are some empirical studies on ERPT in Nigeria, but there is no agreement on the degree and
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speed of the pass-through. For instance, Aliyu et al. (2009) and Zubair et al. (2013) shows a small partial and slow pass-through while Essien (2005) found a full pass- through in the long-run. However, the studies used different methods and sample periods. Hence, the need for up to date study to contribute to the literature by examining the degree and speed of ERPT in Nigeria.
The remaining sections of the chapter are organised as follows. Section two presents the theoretical model of ERPT. Section three presents the empirical model of the study. In section four we present and discuss the empirical results and Section six provides the conclusion of the chapter.
6.2 Theoretical ERPT Models
Our model is based on partial equilibrium micro-based markup equation which brings in some general equilibrium at aggregate price levels, following Campa and Goldbergβs (2005) model on ERPT. We included the role of domestic costs of the importing country in our model as follows.
The import price Pm of a country can be described as the price PX of the exporter to
that country when converted to local currency using the exchange rate E.
ππ = ππ₯β πΈ (6.1)
When expressed in logs, represented by lower case letters we get:
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Expressing the exporterβs prices ππ₯ as a mark-up (MUx) over the exporterβs marginal
costs MCx.
ππ₯ = πππ₯ ππΆπ₯ (6.3)
When expressed in logs, represented by lower case letters, and substitute Equation (6.3) into Equation (6.2), we get:
ππ= ππ’π₯+ πππ₯β π (6.4)
It is assumed that the markup, is inversely related to the price elasticity of demand in the destination market, hence, depends on the shape of the demand curve. The markup is a function of the real exchange rate and other macro-variables. The relationship between the markup and the real exchange rate described as the nominal rate modified by the price of unit labour costs in the exporting country (π€π₯) and expressed in logs, can be simply approximated by:
ππ’π₯ = π + π(π β π€π₯) (6.5)
The value of Ο ranges between 0 and 1: when Ο = 0 there is producer currency pricing (PCP); and when Ο = 1 there would be complete local currency pricing (LCP) where the markup varies one-for-one with the exchange rate given that marginal costs were fixed. The constant is represented by ΞΌ in the equation. To simplify, equation (6.5) exclude the influence of other factors, like demand conditions in the importing country. The marginal costs of the exporter are assumed to increase by a weighted average of market wages in the exporting country, wx, and
other commodity prices like oil prices, poilx, and with the demand conditions in the
exporting country, yx, and the demand conditions in its destination market, ym. This
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πππ₯ = π1π€π₯+ ( 1 β π1)πππππ₯+ π3π¦π₯+ π4π¦π (6.6)
From the equations above, import prices at the point of entry to the destination country, prior to the further cost of distribution and local taxes, can be specified as:
ππ = π β (π)π + π1π€π₯+ ( 1 β π1)πππππ₯+ π3π¦π₯+ π4π¦π (6.7)
Equation (6.7) generalises the model by including the importing countryβs domestic costs into the markup function, and exogenous commodity costs into the exporterβs marginal cost function. It is important to note that this illustrates a long-run relationship and is not concerning temporary price stickiness.
The long-run ERPT coefficient is π½ = β(π), capturing the exchange rate elasticity of import prices. When π = 1 which means π½ = β1, there is producer currency pricing (PCP). It means the import price varies one-for-one with the exchange rate; therefore, there is full ERPT. At the other extreme, when π = 0, and π½ = 0, then, there is zero ERPT to prices. Hence, there is a complete local currency pricing (LCP), where the exporters fully absorb any exchange rate changes by cutting down their mark-ups, giving importers a stable price.
A long-run ERPT to import prices log-linear regression specification can be expressed as follows:
πππ‘= π + πππ‘+ π1π€π₯π‘+ π2πππππ₯π‘+ π3π¦π₯π‘+ π4π¦ππ‘+ ππ‘ (6.8)
where ππ is the domestic currency import price, Ξ» is a constant, e is the (nominal) exchange rate, π€π₯ is a control variables representing exporter costs, πππππ₯ captures a further element of exporterβs costs stemming specifically from commodity prices,
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like oil prices, and π¦π₯ and π¦π are control variables for demand in the exporterβs
market and the destination market.
Equation (6.8) captures the ERPT to import price known as Stage 2 ERPT. While Stage 2 ERPT, is from import prices to consumer prices.
To arrive at the consumer price through the distribution chain, we add a further local currency cost variable as inputs into the production of goods or retailed directly to the consumer or for domestic wholesale and retail prices. The resulting reduced- form equation for overall ERPT to consumer prices can be expressed as follows:
ππππ,π‘= π + πππ‘+ ππππ‘+ π1π€π₯π‘+ π2πππππ₯π‘+ π3π¦π₯π‘+ π4π¦ππ‘+ ππ‘ (6.9)
6.3 Empirical Model Specification and Identification 6.3.1 Empirical Model Specification
This section starts with specifying the empirical model followed by the identification of the structural VECM. Based on our theoretical model developed in the last section, we will examine the speed and degree of ERPT in Nigeria during 1986 to 2013 using quarterly data. A VECM model is applied to examine the short- run and long-run ERPT. To start with a five-variable vector autoregressive (VAR) model is set up based on the theoretical model presented in the previous section. The five-variable VAR is expressed as follows.
π₯π‘β² = (ππππ‘, πππ‘, π’πππ‘, πππππ‘, π¦π‘ ) (6.10)
Where cpit denotes the natural log of consumer prices, ππππ‘ is natural log of import