IntroductionThis paper explores the Foreign Exchange and Monetary Policy nexus within the Nigerian economy. The choice of an exchange rate policy is vitally important to a country as it has important implications for the conduct of both its domestic and international economic policy. Exchange rate policy1 of a country has a profound consequence on its economy and wellbeing through its effects on balance of payments. The notion that demand and supply for Foreign Exchange (FX) is purely derived from rational economic response to interest rate, inflation, factor prices, income movements and a consideration of exchange rate risk2, which in turn, is dependent on the FX policy adopted in the country; is simplistic at best. The theoretical determination of exchange rates is based on capital flows in imperfect financial markets. Capital flows drive exchange rates by altering the balance sheets of financiers that bear the risks resulting from international imbalances in the demand for financial assets. Such alterations to their balance sheets cause financiers to change their required compensation for holding currency risk, thus impacting both the level and volatility of exchange rates.

This theory not only rationalizes the empirical disconnect between exchange rates and traditional macroeconomic fundamentals but also, has real consequences for output and risk sharing. Exchange rates are sensitive to imbalances in financial markets and may not perform the shock absorption role that is central to traditional theoretical macroeconomic analysis. In general terms, monetary policy refers to a combination of measures designed to regulate the value, supply and cost of money in an economy, in consonance with the expected level of economic activity. For most economies, the objectives of monetary policy include price stability, maintenance of balance of payments equilibrium, promotion of employment and output growth, and sustainable development. These objectives are necessary for the attainment of internal and external balance, and the promotion of long-run economic growth (Nnana, 2001).The quest for the appropriate FX regime for Nigeria has been an ongoing debate among economists and monetary policy authorities especially in the last decade. As the economic fortunes of the country have waxed and waned since independence, so has the search for a stable and sustainable exchange rate framework that will anchor policy required for the efficient functioning of the economy for growth and welfare.

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The financial crises of the last decade has further exacerbated the need to fashion an exchange rate policy to reflect the re-assessment of risks associated with financial sector and the effect of contagion within the West African region and globally. At the time of writing, many countries are just exiting the clutches of an international recession dubbed the ‘credit crises’ which is dramatically affecting the incomes of nations especially oil (export) dependent nations such as Nigeria. The legacies of the crisis and the effects of continued globalisation has significantly reshaped the global, regional economic and financial landscape. This new landscape is characterised by volatile capital flows, prompted by cyclical shifts in flows of funds in response to new risks and opportunities; greater interconnectedness, between financial institutions as well as between the real and financial sectors; lower global economic growth, with renewed focus shifting towards new markets in Africa, Asia and Latin America; and currency wars with potential for emerging markets currencies entering the accepted reserve currency range3.Central bankers are therefore, concerned with two major issues. First, volatile capital flows combined with greater financial interconnectedness4 will translate into a growing risk to financial stability; and second, the implications for management of the exchange rate policy in the economy given the increasingly large and volatile financial flows.

Nigeria being a free market economy, the Central Bank of Nigeria (CBN) like any central bank, has been confronted with the famous Mundell-Fleming policy trilemma (Mundell, 1963; Fleming, 1962) of choices among relatively unrestricted flow of capital, exchange rate management and monetary autonomy. Lanyi (1969) presents a discourse on the case for floating exchange rate regime. He opines that “the best exchange-rate system from an economic point of view is probably one with greater exchange-rate flexibility, and a greater reliance on the market, than is the best system from a political point of view”5. However, since the monetary authority will have the final say in the determination, overall growth and (possibly political) objectives for the country usually prevail. In this vein, Obadan (2009) argues that, “In order to reduce the uncertainties arising from the medium – or long-term swings of major currencies which have produced various problems for them, developing countries have had the inclination to adopt intermediate exchange rate regimes rather than the polar regimes of firmly fixed exchange rate and floating exchange rates”6. The exchange rate policy regime in Nigeria has historically been focussed on achieving optimal economic performance, therefore, successive policy makers have prioritised keeping the rate stable to enhance efficiency and facilitate a liquid and transparent Foreign Exchange Market7.

In a speech announcing the framework for the re-introduction of Managed Float Exchange Rate System in Nigeria, Emefiele (2016) argued that Nigeria grappled with destabilising global shock in year 2014 resulting in over 70 percent drop in the price of crude oil, which contributes the largest share of Nigeria’s Foreign Exchange Reserves; global growth slowdown and geopolitical tensions along critical trading routes in the world; and normalization of Monetary Policy by the United States’ Federal Reserve. These led to significant reduction in the country’s external reserves and created adverse macro-economic landscape in the country. In order to achieve improved economic performance in Nigeria, the monetary authority restored the automatic adjustment mechanism of the exchange rate system.

This research will focus on effect of monetary policy on exchange rate and assess the extent to which FX demand changes as a result of changes in monetary policy. It will also focus on uncovering possible underlying FX demand trends and asymmetric responses to monetary policy within the Nigerian economy.  Theoretical BackgroundForeign exchange (FX) rates have an impact on the production decision of firms, on portfolio allocation, on a country’s prices, and more generally on its competitiveness. Hence, the need of having reliable models to track the current evolution of exchange rates and predicts their future behaviour, especially in times of uncertainty and financial stress. In fact, exchange rate volatility has changed over the years. It has fallen after the price shocks and inflationary pressures of the 1970s, and it has increased again in the last decade, possibly as a consequence of the quantitative easing measures enacted by central banks around the world. Trade exerts a downward effect on the naira.

The collapse of the manufacturing sectors in Nigeria has shifted consumption to imports of foreign goods. This puts a downward pressure on the local currency as increased amounts of foreign currency is sought to meet the large volumes of imports. According Rose (1991) and Fagerberg (1988), assuming Marshall-Lerner conditions hold a weaker currency should make Nigeria’s exports competitive and ultimately strengthen the naira. Unfortunately, inflation induced high cost of doing business has constrained even further attempts at reinvigorating local production for export in order to balance the current account.     In Nigeria, demand for foreign exchange seems to operate through the liquidity demands occasioned by interest rates, trade and inflation channels. Economic actors prefer to hold foreign exchange to purposes of transaction and speculation. Persistent inflation over the last decade has eroded people’s saving and returns on the investments.

In line with the ex ante purchasing power parity, a country with persistent high level of inflation must see its currency depreciate against its trading partners. This effect works through the current account mechanism. A high inflation makes a country’s good unattractive on the world markets and worsens its terms of trade with its trading partners. As the country’s trade position deteriorates, it experiences current account deficits which have to be financed by external borrowing. This leads to a depreciation of its currency.

There is the tendency for people to want to hold money in foreign currencies to preserve its value. As this goes on, the value of the local currency falls even further. Starting from the late 90s following the Gulf War, there has been a structural change in the supply of foreign exchange by the central bank. In a tightly managed foreign exchange regime, aligning supply with demand keeps the exchange rate stable.

This is possible if the central bank has enough reserves relative to demand from the rest of the economy. In the 70s and 80s, high export prices for crude oil ensured the CBN has the fire-power to meet foreign currency demand and maintain equilibrium. Today, a fluctuating global oil price, disruptions in export volumes and increased dollarization of the economy has upset this balance.  The FX market embodies a multifaceted financial process consequently modelling exchange rate is a complex issue; made all the more difficult by the need to capture the effect of relative price levels8, interest rates and income growth rates  for each country pairs. In the past decades, extensive research has been done in the area of exchange rate and monetary policy nexus. Most authors recognized that prices and exchange rates are determined simultaneously.

A minority, however, argued that there exists a causal relationship between prices and exchange rates.Theoretically, the foreign exchange rate of US dollar in the Nigerian market is determined by supply and demand condition reflected in the Balance of Payments (BOP)9 such as international trade, international investment, international tourism and investments income. Interest rate differentials, inflation rates differentials, and Income growth differentials as well other factor such as tariffs, quotas, other trade barriers, expectations, taxes, uncertainty, tastes, etc.

Arguably, the exchange rate (like any other price) is determined in general equilibrium by the interaction of flow and stock conditions. Frankel (1976) discussed the determinants of the exchange rate and develops a monetary view of exchange rate determination and gave special attention to simultaneous roles played by expectations and monetary policy in determining the exchange rate. He found that rate of change of exchange rate depends on the rate of monetary expansion. Furthermore, an acceleration of the rate of monetary expansion induces an equal and proportionate contemporaneous acceleration in the rate at which the currency depreciates (pp 207).Ukeje (2014) traces the history of monetary policy developments in Nigeria and imperatives for foreign exchange policy and showed that money markets interest rates are linked to the demand for domestic currency, which determines, in part, the purchase of foreign assets. Stockman (1980) posits that, demand for domestic money is a derived demand because it allows people to transact in domestic markets to purchase goods, and foreign exchange is demanded by importers because it is used to finance imports and purchase foreign assets, thus demand for foreign exchange depends on the exchange rate10.Nigeria, being a free market economy, the Central Bank of Nigeria (CBN) like any other central bank, has been confronted with the famous Mundell-Fleming policy trilemma of choices among relatively unrestricted flow of capital, exchange rate management and monetary autonomy.

Their seminal work provides a background for monetary policy effect in the determination of exchange rate. Mundell argues that monetary policy has no impact on employment under fixed exchange rates while fiscal policy has no effect on employment under flexible exchange rates. On the other hand, fiscal policy has a strong effect on employment under fixed exchange rates while monetary policy has a strong effect on employment under flexible exchange rates. Also, monetary policy under fixed exchange rates becomes a device for altering the levels of reserves, while fiscal policy under flexible exchange rates becomes a device for altering the balance of trade, both policies leaving unaffected the level of output and employment. Under fixed exchange rates, open market operations by the central bank result in equal changes in the gold stock, open market purchases causing it to decline and open market sales causing it to increase. And under flexible exchange rates, budget deficits or surpluses induced by changes in taxes or government spending because corresponding changes in the trade balance.Historically, the country has tried many policy options to manage the exchange rate. It has moved from maintaining a seemingly fixed exchange rate regime under free capital flow to managed float with more monetary autonomy.

Lanyi (1969) presents a discourse on the case for floating exchange rate regime. He opines that “the best exchange-rate system from an economic point of view is probably one with greater exchange-rate flexibility, and a greater reliance on the market, than is the best system from a political point of view”11. However, since the monetary authority will have the final say in the determination, overall growth and objectives for the country usually prevail. Egwaikhide et al (2015) using a VAR estimation technique to determine the behaviour of monetary policy under alternative exchange rate regimes; the study concluded that all monetary policy variables were responsive to shocks under fixed exchange rate regime, while the impact was far less than was displayed under the floating exchange rate regime, which supports the use of the managed floating exchange rate policy. Also, Chang and Velasco (2000) found the “classical case for exchange-rate flexibility especially strong for countries that are buffeted often by large real shocks from abroad. Conventional wisdom holds that, if shocks to the goods markets are more prevalent than shocks to the money market, a flexible exchange rate is preferable to a fixed” A number of reasons have been assigned for the fear of floating a country’s currency. The most convincing among them is the hypothesis put forward by Calvo and Reinhart (2002).

They argued that many emerging countries are mindful of the disruptive effect of currency volatility associated with a floating currency regime. The excessive fluctuations of the foreign exchange market make planning difficult; induce inflation and causes economic uncertainty. The monetary authorities therefore take step to minimise the disruptive effect of gyrations on the foreign currency market (Haussmann et al., 2002).

The plan of this paper is therefore as follows: Section 2 details the methodology used in the study; Section 3 presents the data and estimation results; with Section 4 providing a summary of the findings and some general conclusions. 1 For further analysis, see David, et al (2016) for an introduction to exchange rate regimes in Nigeria2 These are in addition to other factors such as tariffs, quotas, other trade barriers, expectations, taxes, uncertainty and tastes, amongst others. 3 Njuguna Ndung’u (2013). Exchange rate and monetary policy nexus 4 Chinazzi and Fagiolo (2015) provides an excellent survey of financial contagion5 Lanyi A.

, (1969), The Case for Floating Exchange Rate Reconsidered, pp 346 Obadan, M.I., (2009),  Exchange Rate Regimes for Developing and Emerging Markets7 For a further analyses, see Central Bank of Nigeria (2011) Monetary Policy Framework., Nnana (2001), Ukeje (2015), Mordi (2015) Jimoh (2015) for a comprehensive discussion of monetary policy and exchange rate regimes in Nigeria8 The foreign exchange rate is set so that one currency has purchasing power parity with any other currency in terms of goods and services that it can buy, by setting the quantity of one currency to the quantity of another currency, such that they will buy the same intrinsic value of goods and services.9 Balance of Payments (BOP): BOP = Current Account (CA) + Capital Account (KA)CA = Net Exports of goods and services (main component) + Net Investment Income + Net TransfersKA = Financial capital inflows – Financial capital outflowsThe BOP = 0, then the CA is financed by the KA.

10 Stockman, A.C. (1980) A Theory of Exchange Rate Determination pp 69311 Lanyi A., (1969), The Case for Floating Exchange Rate Reconsidered, pp 34