Asymmetric Effects of Currency Valuation and Oil Price Movements on Inflation in Nigeria

Abstract

This study examines how currency valuations (exchange rates) and oil prices affect inflation in Nigeria from 1986 to 2024. The research uses time series data to understand the relationships between these important economic factors. The main goal is to find out if changes in currency value and oil prices cause inflation to go up or down in Nigeria. The study uses several testing methods to analyze the data. The BDS nonlinearity test finds strong evidence of non-linear patterns in both inflation and exchange rate data, with z-statistics of 18.39 and 17.36 respectively, both significant at the 1% level while the Kapetanios, Shin and Snell test confirms that both inflation and exchange rates have unit roots even when allowing for nonlinear behavior. This means inflation, exchange rates, oil prices, money supply, and interest rates move together over long periods. The main findings come from the Nonlinear Autoregressive Distributed Lag (NARDL) model, which shows important differences between how exchange rate increases and decreases affect inflation. In the symmetric model, a 1% increase in exchange rate (currency getting weaker) leads to a 0.55% increase in inflation in the long run. However, the asymmetric model reveals stronger effects. When the currency gets weaker by 1%, inflation increases by 1.17% in the long run, which is more than double the symmetric effect. Interestingly, when the currency gets stronger, it does not significantly reduce inflation, showing an unbalanced relationship. Money supply also affects inflation positively in the symmetric model, where a 1% increase in broad money (M2) causes a 0.36% rise in inflation in the long run. Real interest rates have a negative effect on inflation, with a coefficient of -0.041 in the symmetric model, meaning higher interest rates help control inflation. Surprisingly, oil prices do not significantly affect inflation in the long run, despite Nigeria being an oil-producing country. In the short run, exchange rate changes immediately affect inflation. A 1% currency depreciation increases inflation by 0.17% right away in the symmetric model and 0.12% in the asymmetric model. Past exchange rate changes also matter, with a lagged effect coefficient of 2.29. The error correction terms are -0.46 and -0.35 for the symmetric and asymmetric models respectively, showing that about 46% and 35% of any imbalance gets corrected each year. The study concludes that exchange rate changes, especially when the currency gets weaker, are the main drivers of inflation in Nigeria. The effects are not balanced - currency weakness causes much more inflation than currency strength reduces it. This happens because Nigeria depends heavily on imported goods, and when the currency loses value, these imports become more expensive, pushing up local prices. Oil prices do not directly affect inflation, possibly because of government fuel subsidies that protect consumers from global oil price changes. These findings have important policy implications for Nigeria. The Central Bank should focus on keeping the exchange rate stable to control inflation.