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Exchange Rate Volatility, Currency Substitution and Monetary Policy in Nigeria

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  • Yinusa, D. Olalekan

Abstract

This study analyzes the implications of currency substitution and exchange rate volatility for monetary policy in Nigeria. It adopts the unrestricted portfolio balance model of currency substitution, incorporating exchange rate volatility within the framework of the Vector Error Correction (VEC) technique. Results from both impulse response and the forecast error variance decomposition functions suggest that exchange rate volatility and currency substitution responds to monetary policy with some lags meaning that monetary policy may be effective in dampening exchange rate volatility and currency substitution in the medium horizon but might not be effective in the short horizon. The study concludes that currency substitution was not an instant reaction to the slightest policy mistake rather; it was fallout from prolonged period of macroeconomic instability. The major sources of this instability in Nigeria were untamed fiscal deficits leading to high domestic inflation, real parallel market exchange rate volatility, and speculative business activities of market agents in the foreign exchange rate market and poor/inconsistent or uncertainty in public policies. In terms of policy choice, our result favours exchange rate based monetary policy as against interest based monetary policy for stabilization in dollarized economies like Nigeria.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 16255.

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Date of creation: 07 Oct 2008
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Publication status: Published in Botswana Journal of Economics Issue 9.Vol. 5(2008): pp. 61-83
Handle: RePEc:pra:mprapa:16255

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Keywords: Demand for money; Exchange Rate Volatility; Currency Substitution; Monetary Policy and Nigeria;

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References

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  1. Bernanke, Ben S. & Mihov, Ilian, 1995. "Measuring Monetary Policy," Economics Series, Institute for Advanced Studies 10, Institute for Advanced Studies.
  2. David O. Cushman & Tao Zha, 1995. "Identifying monetary policy in a small open economy under flexible exchange rates," Working Paper, Federal Reserve Bank of Atlanta 95-7, Federal Reserve Bank of Atlanta.
  3. Branson, William H. & Henderson, Dale W., 1985. "The specification and influence of asset markets," Handbook of International Economics, Elsevier, in: R. W. Jones & P. B. Kenen (ed.), Handbook of International Economics, edition 1, volume 2, chapter 15, pages 749-805 Elsevier.
  4. Carmen M. Reinhart & Kenneth S. Rogoff & Miguel A. Savastano, 2003. "Addicted to Dollars," NBER Working Papers 10015, National Bureau of Economic Research, Inc.
  5. Jon Faust & Eric M. Leeper, 1994. "When do long-run identifying restrictions give reliable results?," Working Paper, Federal Reserve Bank of Atlanta 94-2, Federal Reserve Bank of Atlanta.
  6. Andrea Brischetto & Graham Voss, 1999. "A Structural Vector Autoregression Model of Monetary Policy in Australia," RBA Research Discussion Papers, Reserve Bank of Australia rdp1999-11, Reserve Bank of Australia.
  7. Girton, Lance & Roper, Don E, 1981. "Theory and Implications of Currency Substitution," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 13(1), pages 12-30, February.
  8. Germana Corrado, 2008. "An open economy model with currency substitution and real dollarization," Journal of Economic Studies, Emerald Group Publishing, Emerald Group Publishing, vol. 35(1), pages 69-93, March.
  9. Sims, Christopher A, 1980. "Macroeconomics and Reality," Econometrica, Econometric Society, Econometric Society, vol. 48(1), pages 1-48, January.
  10. Eduardo Levy Yeyati, 2006. "Financial dollarization: evaluating the consequences," Economic Policy, CEPR;CES;MSH, CEPR;CES;MSH, vol. 21(45), pages 61-118, 01.
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Cited by:
  1. Yinusa, D. Olalekan, 2009. "Macroeconomic Fluctuations and Deposit Dollarization in Sub-Saharan Africa: Evidence from Panel Data," MPRA Paper 16259, University Library of Munich, Germany, revised 2009.

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