Exchange Rate Volatility, Currency Substitution and Monetary Policy in Nigeria

Abstract

JEL: E41, F31 KEY WORDS: Demand for money, Exchange Rate Volatility, Currency Substitution, MonetaryPolicy and Nigeria. IntroductionIn the last few years, a number of emerging market economics including Nigeria have moved from fixed to flexible exchange rates. This has in most cases led to instability in the exchange rates thereby creating an atmosphere of uncertainty exacerbated by speculative bubbles, which help to aggravate the problem of inflation in the economy. Under conditions of high inflation, the ability of national currencies to function adequately as a store of value, a unit of account, and a means of exchange are greatly hindered (Mizen and Pentecost, 1996).In these circumstances, the domestic currency tends first to be displaced as a store of value by a stable and convertible currency (usually in the form of interest-bearing foreign currency deposits). Long period of high inflation induce the public also to conduct transactions in foreign currency (Currency Substitution) 1 .Over time, Nigerian governments validated partial dollarization by allowing residents to open bank accounts denominated in dollars (domiciliary account). In addition, contracts foreign and domestic debts were valued and quoted in dollars while monetary compensation 1 Currency substitution or dollarization (as is often referred to in the literature) episodes became manifest in the late 1980s, and 1990s when most economies were experiencing rapid inflation and exchange rate instability 3 to athletics and footballers were made in dollar denominations. In fact, many big supermarkets in big cities, in Nigeria, quote the prices of their products in dollars and many estate agents and valuers only accept dollars as rents for houses in some reserved areas of Lagos, Abuja, Port Harcourt and other industrialized cities in Nigeria. All these developments point to the existence of currency substitution in Nigeria.Research attempts into causes and effects of currency substitution have been diverse and highly controversial especially in the developed, emerging market and transitional economies of the Latin America and Asia (see for example, Rogers, 1996;Sahay and Vegh, 1996; Savastano, 1996, Reinhart, Rogoff and Savastano, 2003, Yeyati, 2006. The volume of studies reflects the fact that currency substitution is a subject with global effects, which merits the attention of academics and policy-makers alike (Mizen and Pentecost, 1996;and Corrado, 2008). However in the African context, prominent attention has not been given to the study of currency substitution.For example, direct studies on currency substitution in Nigeria have been rare.Oresotu and Mordi (1992) tested the existence of currency substitution by including exchange rate as one of the explanatory variables in the aggregate money demand functions. Their result points to the existence of currency substitution in Nigeria. Specific studies addressed to the issue of currency substitution were Olomola (1999) and Akinlo (2003).The main feature of these studies is that they were d...

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