Inflation dynamics in a developing economy : an error correction approach

This paper explores the dynamics of inflation in a developing economy. Using a rational expectation framework, a reduced form error correction relationship between price, money, and exchange rate is derived from the two competing views of the monetarists and structuralists. An econometric model that employs a battery of cointegration analysis is applied to examine the empirical plausibility of the alternative views in Nigeria. The cointegration tests support the existence of a long-run relationship between price, money and exchange rate. The error correction estimates also indicate that in a condition of disequilibria arising, for an example, through an increased money stock, the long run equilibrium level is restored through a combination of inflationary adjustment and its consequent exchange rate depreciation. (Afr Rev Money Financ Bank/DÜI)