Assessment of real exchange rate through vector error correction model (VECM) in Nigeria

Abstract

Despite the fact that exchange rate (REXR) is an integral part of macro economy and economic outlook of Africa, many Africans operate without an excise understanding of its operations. Hence, this study examined the assessment of real exchange rate (REXR) through Vector Error Correction Model (VECM) in Nigeria for the period of 1979-2014. Cointegration test, Vector Error Correction Model (VECM) technique and Granger causality test were employed in the analysis. The variables utilized in the study include real exchange rate (REXR), real gross domestic product (RGDP), and inflation rate (INFLR) and real interest rate (RINTR). Stationarity test was conducted and the results indicated that all the variables were stationary at level. The co-integration test result revealed that long run relationship exists among the variables understudy. More so, the long term co-integration vector suggests that real interest rate (RINTR) and real inflation rate (RINFLR) have a negative impact on the exchange rate, while ln(RGDP) have a positive on the exchange rate. Finally, the Granger causality results indicated multi-directional relationship between REXR to RGDP, REXR to RINFL and REXR to RINTR. Based on the findings above, it is recommended that government should ensure a stable interest rate, as an unstable interest rate will have an effect on real exchange rate, hence the exchange rate should reflect market realities to promote efficiency in resource allocation and productivity growth. Also, maintenance of a stable exchange rate regime should be prioritized through strong monetary policies by government so as to help in improving standard of living.