Exchange Rate Volatility and Inflation Upturn in Nigeria: Testing for Vector Error Correction Model

Abstract This paper empirically examines the impact of exchange rate volatility on inflation in Nigeria using annual time series data from 1986 – 2012. The methodology employed includes: ADF, PP and KPSS test of unit root, Johansen Julius cointegration test, VECM, granger causality test, impulse response function and variance decomposition. The unit root test result shows that all variables are stationary at first difference, while Maxi-eigen value shows a long run relationship between the variables. VECM result established positive and significant relationship between inflation, exchange rate volatility, money supply and fiscal deficit, while gross domestic product show negative relationship. Granger causality outcome shows a bi-directional relationship between all the variables. Subsequently, exchange rate volatility is deduced to influence inflation in Nigeria. Therefore, it becomes imperative for the government to understand and control the various channels through which exchange rate transmits to affect inflation in Nigeria, check the growth of money supply, increase the level of productivity in the country and lastly cut down public sector expenditure and possibly make a shift from excessive consumption expenditure to capital expenditure believing this will reduce the burden of fiscal deficit and the rate of inflation.