Output, Inflation, and Exchange Rate in Developing Countries: An Application to Nigeria

Abstract

The three major explanations of inflation include fiscal, monetary, and balance of payments aspects. While in the monetary aspect inflation is considered to be due to an increase in money supply, in the fiscal aspect, budget deficits are the fundamental cause of inflation in countries with prolonged high inflation. However, the fiscal aspect is closely linked to monetary explanations of inflation since government deficits are often financed by money creation in developing countries. In the balance of payments aspect, emphasis is placed on the exchange rate. Simply, the exchange rate collapses bring about inflation either through higher import prices and increase in inflationary expectations which are often accommodated or through an accelerated wage indexation mechanism.

Several attempts have been made to conduct systematic econometric studies on the movements in output and inflation and their dynamics in Nigeria. However, many of these earlier studies were based on either simulation analysis or regression approach. Our study deviates from the previous ones in Nigeria by the adoption of vector auto-regression (VAR) and its structural variant in which movements in inflation and output are driven by several fundamental disturbances — monetary, exchange rates (official and parallel), interest rate, and income.