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Publication Date: September 25, 2020
DOI:10.14738/assrj.79.8927.
Udeaja, E. A., Audu, N. P., & Obiezue, T. O. (2020). The Transmission Mechanism of Monetary Policy Shocks in Nigeria: The Interest and
Exchange Rates Channels. Advances in Social Sciences Research Journal, 7(9) 283-311.
The Transmission Mechanism of Monetary Policy Shocks in Nigeria:
The Interest and Exchange Rates Channels
Elias A. Udeaja
Assistant Director, Research Department,
Central Bank of Nigeria
Nathan P. Audu
Country Economist, West African Monetary
Institute, Accra, Ghana.
Titus O. Obiezue
Assistant Manager, Research Department,
Central Bank of Nigeria
ABSTRACT
This paper examines the effectiveness ofthe interest and exchange rates
channels of monetary policy transmission mechanism. The paper
employed several statistical cum econometric methodology in a
baseline structural vector autoregressive (SVAR) model to evaluate the
influence of policy shocks on selected endogenous variables; gross
domestic product (GDP), consumer price index (CPI), money supply
(MS), treasury bill rate (TBR) and nominal exchange rate (NER) for
Nigerian spanning 1981Q1 to 2020Q1. The contemporaneous
coefficients in the structural model reveals that key monetary
aggregates reacts positively to unexpected changes in the monetary
policy instruments. Furthermore, the variance decomposition results
indicate that shocks of the selected variables were found to be
important for interest rate growth in the short and longer horizons. The
exchange rate channel however appears to have a stronger impact on
prices. These results mean that depreciation of the nominal exchange
rate could be an external deflationary element, particularly for Nigeria.
Keywords: monetary policy, transmission, mechanism, structural shock.
INTRODUCTION
Monetary policy (MP) can be described as a central banks action aimed at influencing the
availability and cost of money and credit, as a means of achieving price stability and promoting
national economic goals. Specifically, MP is a mixture of actions considered to regulate the value,
supply and cost of credit in an economy in tandem with the anticipated level of economic activity.
Broadly, the objectives of monetary policy include; low interest rates, price stability, economic
growth, full employment, exchange rate stability, and balance of payments equilibrium.
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The monetary policy instruments currently in use in Nigeria include; the monetary policy rate
(MPR), open market operations (OMO), reserve requirements (cash and liquidity ratios), moral
suasion and exchange rate. The implementation of monetary policy revolves around the
manipulation of these instruments to influence the intermediate targets, such as, money supply,
interest rates, which would eventually impact on the real and external sectors of the economy. The
overall effect of these would result to changes in output growth, inflation rate and external reserve
position.
The linkages between monetary policy shocks and changes in output, employment and inflation are
known as the monetary policy transmission mechanism. This mechanism describes how changes in
monetary policy transmit through the financial system via interest rate, exchange rate and money
supply to the real economy. For example, in Nigeria changes in the Central Bank of Nigeria (CBN)
monetary policy rate may impact on other short-term interest rates which in turn may affect lending
rates in the medium to long run and may ultimately affect domestic demand. Other channels may
include exchange rate and money/credit. Under the indirect approach, the link between monetary
policy and money stock, which determined by the money multiplier is emphasized under the
monetary targeting framework, which the bank adopted. Since the introduction of OMO as the main
instrument of monetary policy in 1993, the interest rate and to a large extent, the exchange rate
channels have been explicitly prominent in transmitting monetary policy impulses to the real
economy. However, the effectiveness or otherwise of these two channels have not been subjected
to empirical investigation.
The challenges that resulted from the global financial and economic crises had compelled monetary
authorities to adopt plethora of monetary policy measures. In Nigeria, such challenges include the
dwindling external reserves due to falling crude oil prices in the international market, low fiscal
buffers sustained pressure in the foreign exchange market due to low supply of foreign exchange,
and excess liquidity in the banking system. These developments have serious implications for both
internal and external balance and had attracted several monetary policy measures aimed at
restoring economic stability. Importantly, the falling crude oil price led to a drastic decline in
Nigeria’s foreign exchange earnings which resulted to a depreciation of the naira exchange rates at
both the interbank and BDC segments. Accordingly, the monetary policy posture of the Bank was
mottled to reflect the prevailing developments. The monetary policy rate (MPR) fluctuated between
11.0 and 13.0 per cent in 2015, and 11.0 to 14.0 per cent in 2016. The cash reserve ratio (CRR) was
increased to 22.5 per cent in 2016 from 20.0 per cent in 2015.
In addition, the symmetric interest rate corridor that was put at +/–200 basis points around the
MPR for standing facility window was altered to an asymmetric corridor of +200/–700 basis points
around MPR in 2015. This measure was aimed at discouraging dumping of funds at CBN and
promoting credit availability to the real sector. The asymmetric interest rate corridor was narrowed
to +200/-500 basis points in 2016. The open market operation (OMO) continued to be the primary
tool for liquidity management and was supplemented by reserve requirements, repurchase
transactions as we as interventions in the foreign exchange market.
Apart from few theoretical and empirical attempts on the monetary policy transmission in Nigeria
such as that of the CBN Research Department (2010), Chukwu (2013) and Hassan (2015), no study
had specifically examined the effectiveness of the interest and exchange rates channels of monetary
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Udeaja, E. A., Audu, N. P., & Obiezue, T. O. (2020). The Transmission Mechanism of Monetary Policy Shocks in Nigeria: The Interest and Exchange Rates
Channels. Advances in Social Sciences Research Journal, 7(9) 283-311.
policy shocks. Therefore, in order to achieve the primary objective of price stability by CBN, a better
understanding of the monetary transmission process is required to develop instruments that can
reinforce the efficacy of monetary policy transmission in Nigeria. A good knowledge of the dominant
channels of transmission would be critical to effective design and implementation of monetary
policy. This study intends to fill the existing gap in empirical literature on monetary policy
transmission in Nigeria through the channels of interest and exchange rates. Specifically, this study
will investigate empirically how monetary policy actions are transmitted to the real sector (output
and prices) of the economy through the interest and exchange rates channels and evaluate the
effectiveness, strengths, speed of monetary policy transmission through these channels. The
outcome would guide the Management of the Bank on policy choices for effective monetary policy
implementation.
The rest of the paper is structured as follows; following the introduction, Section 2 provides the
theoretical underpinnings and review of empirical literature on monetary policy transmission
mechanism. Section 3 discusses the recent monetary policy frameworks and initiatives of the Bank
and its effects on the real sector, Section 4 is on the methodology, estimation and analysis of results
and the last section focuses on the policy implications of the results, conclusion and policy
recommendation.
THE MONETARY POLICY TRANSMISSION MECHANISM IN NIGERIA
Theoretical literature
The transmission of monetary policy is the process through which monetary policy
pronouncements affect the real economy, especially the price level. It is usually long, variable with
uncertain time lags. The main transmission channels of monetary policy are discussed below:
Interest rate channel
According to the expectation hypothesis of the term structure, a rise in the short-term nominal
interest rate leads to an increase in the longer-term nominal interest rates. Since prices are assumed
to be sticky in the short-term, a reduction in the long-term real interest rate decreases the cost of
capital, and the money paid on interest bearing deposits such as treasury bills. As the cost of capital
falls firms increase their investment expenditure and households increase their consumption of
durable goods. These increase the aggregate demand, output and employment. In the traditional
Keynesian IS-LM model, the main channel of monetary policy transmission is the interest rate
channel. An expansionary monetary policy transmission is captured as follows:
M↑ → ir↓→ I↑→Y↑
where M stands for expansionary monetary policy, ir equals real interest rate, I connotes investment
spending and household spending on durable goods, and Y means output. This depicts that an
expansionary monetary policy would lead to a decline in real interest rates, which reduces the cost
of capital and increase investment and consumption spending, thereby increasing aggregate
demand and output.
The fact that real and not nominal interest rate impacts on spending shows that monetary policy
can stimulate the economy, even in a liquidity trap where nominal interest rates hit a floor of zero
as in the global financial crisis of 2008. When nominal interest rates is zero, an increase in money
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supply (M↑) would increase the expected price level (Pe↑), thus, the expected inflation (πe↑), thereby
reducing the real interest rate (ir, ↓) and stimulating spending through the interest rate channel
above: M↑ → Pe↑→ πe↑→ ir ↓→ I↑→Y↑. This shows that monetary policy will still be effective, when
nominal interest rates have been reduced to zero by the monetary authorities.
Exchange rate channel
Exchange rate channel encompasses interest rate effects for the reason that when domestic real
interest rates decreases, domestic deposits in local currency becomes unattractive, when compared
to deposits denominated in foreign currencies. This leads to a depreciation of the local currency
(E↓). The depreciation of the local currency, makes the domestic goods cheaper than foreign goods,
thereby leading to a rise in net exports (NX↑) and, thus, in aggregate output. The monetary
transmission mechanism through the exchange rate is captured as:
M↑ → ir ↓→ E↓→NX↑→Y↑
The effectiveness of the exchange rate channel is contingent on the reaction of the exchange rate to
monetary shocks, the exchange rate arrangement of the country and the degree of openness of the
economy. Nevertheless, the increasing interaction among economies and adoption of more flexible
exchange rates has attracted monetary authorities to understand the monetary policy transmission
mechanism through exchange rate effects on net exports.
Asset Price Channel
The asset price channel is divided into two channels: the equity price channel, and the housing and
land price channel.
The Equity Price Channel
The equity price channel is further divided into two: Tobin’s Q theory and wealth effect.
Tobin’s Q Theory
In Tobin’s Q theory, Q represent the ratio of market value of firms to the replacement cost of capital.
Therefore, if Q is high, the replacement cost of capital is low compared with the market price of
firms, as such new machinery and equipment capital would be cheaper, when compared to the
market value of business firms. Thus, investment spending will increase as the firm buys more lots
of new investment goods with only a small issue of equity. However, when Q is low, firms will not
procure new investment goods as the cost of capital is high compared with the market price of firms.
According to the monetarist school of thought, an expansionary monetary policy reduces interest
rates, making bonds less attractive relative to equities, thereby raising the price of equities. Higher
equity prices leads to increase in Q and thus higher investment spending. This is captured as follows:
M↑ → Pe↑→ Q↑→ I↑→Y↑
Wealth Effects
The wealth effect was promoted by Franco Modigliani. In his life-cycle model, consumption
spending was determined by the lifetime resources of the consumer which is consist with human
capital, financial wealth and real capital (Modigliani, 1971). According to Modigliani, stock is a major
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Udeaja, E. A., Audu, N. P., & Obiezue, T. O. (2020). The Transmission Mechanism of Monetary Policy Shocks in Nigeria: The Interest and Exchange Rates
Channels. Advances in Social Sciences Research Journal, 7(9) 283-311.
cause of financial wealth. As stock prices rise, the value of financial wealth rises so the consumers’
lifetime resources or wealth and total consumption.
M↑ → Pe↑→ Wealth↑→ Consumption↑→Y↑
The Housing and Land Price Channels
Likewise, housing and land prices are significant component of wealth and are very important
channels of monetary policy transmission. An increase in housing and land prices increase wealth
and consumption. As described in the wealth and Tobin’s Q channel, monetary expansion which
raises land and housing prices, raises the level of aggregate demand
Inflation expectation channel
The success of policies (monetary and fiscal) hinges on the expectations of economic agents.
According to Blinder (1998), a successful monetary policy emerges as a result of the effective
management of expectations not overnight interest rates. Milton Friedman’s theory of adaptive
expectations (inflation expectations are modeled based on simple extrapolation of past inflations)
was the first attempt at explaining expectations in monetary policy. The inflation expectations of
economic agents are transmitted to the economy as individuals bargain for higher wages and as
firms amend their prices. When the concern of monetary policy to decrease inflation drastically,
then, its efficiency is enhanced by its potential to influence inflation expectations. Consequently,
expectations about the future posture of monetary policy by economic agents feed back into the
present (Mordi, 2010).
Credit Channel (bank lending and balance sheet)
Monetary policy impacts on the real sector through its effect on the financial sector. Credit is an
important macroeconomic variable that enhances economic activity. Bank lending and balance
sheet channels arise as a result of asymmetric information problem in credit markets.
In the bank lending channel, expansionary monetary policies increase the quantity of bank loans
available by increasing the bank reserves and bank deposits. As bank loans increase, investment
spending will also rise. M↑ → Bank deposits↑→ Bank loans↑→ I↑→Y↑
As depicted above, unlike big firms that can directly access credit markets through bond and stock
markets without going through the banks, then the credit channel impacts more on smaller firms as
they are more dependent on bank loans. Bernanke & Blinder (1988) state that the lending channel
is effective when the following conditions are met:
1. Firms must not be perfectly indifferent between borrowing money from financial
institutions through borrowing money and loans from the general public by way of bonds. If
firms are unmoved between the two types of financing, then the reduction in supply of loans
would affect the firms.
2. The central bank should be able to influence the supply of loans through the use of monetary
instruments.
The balance-sheet channel operates through the net worth of business firms. Reduction in net worth
means that lenders have fewer indemnity for their loans, therefore, fatalities from adverse selection
are higher. A decline in net worth raises the adverse selection problem, thus, leading to a reduced
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lending to finance investment spending. Reduction in net worth of business firms also upsurges the
moral hazard problem as owners have reduced equity stake in their firms.
Monetary policy can affect the balance sheet of firms in various ways: Contractionary monetary
policy (CMP), that leads to a fall in equity prices (Pe) reduces the net worth of firms and leads to
lower investment spending (I) and aggregate demand (Y), because of the rise in adverse selection
and moral hazard problems (Taylor, 1995). This can be represented as follows:
M↓ → Pe ↓→ adverse selection↑ & moral hazard↑ →lending ↓→I↓→Y↓
Literature review
Monetary policy transmission channels provide central banks with precise valuation of the timing
and effect of their policies on the economy. A real-world grasp of how monetary policy actions are
transmitted to the real economy has been a major challenge to economists and policy makers. Some
early empirical research in this area were carried out by Bernanke & Blinder (1992), Sims (1992),
Taylor (1995), Grilli & Roubini (1995), Eichenbaum & Evans (1995), Mishkin (1996), Clarida &
Gertler (1997), and Christiano et al. (1998).
Kim & Roubini (2000) using estimated SVAR models proffered solutions to empirical anomalies (the
liquidity, price, exchange rate and forward discount bias puzzles) encountered by early research
that employed VAR in studying the effects of monetary policy in closed and open economies. The
monetary policy model developed by Kim & Roubini (2000) allow exchange rates to be
concomitantly affected by all the factors in the model, which transmits more to the floating exchange
rate regime of advanced economies. They find the effects of non-US G-7 monetary policy shocks on
exchange rates and macroeconomic variables to be consistent with the forecasts of a broad set of
theoretical models.
Using VAR and structural models, Angeloni et al. (2003) in their comprehensive study of how
monetary policy affects the euro area economy, find evidence of broad credit channels for many of
the Euro area countries. They find plausible euro-area wide monetary policy responses for prices
and output that are similar to those generally reported for the U.S. However, investment (relative
to consumption) seems to play a larger role in euro area monetary policy transmission than in the
U.S. Dungey and Pagan (2000) present an SVAR model of the Australian economy which models
macro-economic outcomes as transitory deviations from a deterministic trend.
In extension of their original work, Dungey and Pagan (2009) modified their original model by;
relating it to an emerging literature on DSGE modelling of small open economies and; allowing for
both transitory and permanent components in the series to show how this modification has an
impact upon the design of macroeconomic models. Nevertheless, they exclude bank credit variables
in their models. Using an SVAR approach also, Berkelmans (2005) examines the endogenous
relationship between credit and monetary policy of the Australian economy. They find that credit
shock results in higher inflation for about two years, but it is moderated as a result of monetary
policy’s response. Also, they suggest that a positive shock to policy interest rate lowers both
inflation and credit.
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Udeaja, E. A., Audu, N. P., & Obiezue, T. O. (2020). The Transmission Mechanism of Monetary Policy Shocks in Nigeria: The Interest and Exchange Rates
Channels. Advances in Social Sciences Research Journal, 7(9) 283-311.
Catao & Pagan (2010) find that changes in interest rate have a faster effect on output and prices in
Brazil and Chile relative to advanced economies, and exchange rate dynamics play an important role
in monetary transmission mechanisms in both countries. The active roles of interest and exchange
rates in monetary policy transmission are attributed to the floating exchange rates and significant
levels of capital account openness in both countries. However, the monetary transmission literature
on developing countries finds mixed evidence for the effectiveness of monetary policy. While
Disyatat & Vongsinsirikul (2003) and Ahmed & Islam (2006) find a weak bank lending channel for
Thailand and Bangladesh, respectively, Aleem (2010) finds that the banking sector plays a dominant
role in transmitting monetary policy to the real sector in India. Also, Afrin (2016) find that exchange
rate channel is less effective in the transmission process in Bangladesh, suggesting a high degree of
intervention in the foreign exchange market.
Given the floating nature of exchange rate regimes in the US and Australia, their SVAR structures
may not always be appropriate for developing countries like Nigeria, where exchange rates are
either following a managed float or pegged. This paper follows the block recursive approach of Afrin,
2016; considering that in Nigeria and Bangladesh, the exchange rate may synchronously impact on
other factors, such as real sector variables and monetary policy. The variables are not self-affected
contemporaneously. However, with monetary policy, a separate foreign exchange market can be
put in place for intervention to stabilize the exchange rates by the apex bank. In a developing
country like Nigeria, exchange rate cannot be allowed to be simultaneously affected by other
variables employed in the model. Also, for emerging small open economies, Nigeria and Bangladesh
have similar attributes. As such, the factors employed in our structural vector Autoregression
identification scheme are similar to that of Afrin (2016) for Bangladesh.
Also, the literature on exchange rate pass through (ERPT) approach employed the recursive
structural vector autoregression with Cholesky decomposition. Monacelli (2005), Smets and
Wouters (2002), Adolfson (2001) and Devereux (2001), in their separate study on a small open
economy with an optimal monetary policy opined that this may positively affected level of the
exchange rate pass through. The ordering of factors in the exchange rate pass through literature
were output gap, oil price, wholesale and consumer price inflation, exchange rate and import price
inflation. In their ordering, consumer price instead of the exchange rate was contemporaneously
affected by all foreign and domestic variables. This situation are commonly found in emerging and
developing countries as it reflects the nature of managed of exchange rate regimes they adopt.
McCarthy (2007) observed that exchange rate pass through have decreased considerably in the
economies of sub Saharan African countries since the mid-1990s. He also opined that there is a drop
of about 50 percent in exchange rate pass-through from the estimated coefficients. Razafimahefa
(2012) also finds that the pass-through is incomplete for SSA. For Nigeria, Adeyemi and Samuel
(2013) find a significantly huge exchange rate pass-through to inflation. They find that Nigeria’s
rising inflation was significantly attributed to exchange rate than actual money supply. Their study
employs a SVAR model for the Nigeria's economy which is in tandem with literature for a unified
SVAR identification akin to Bhattacharya et al. (2011) identification methodology for India
economy. Bhattacharya et al. (2011) assume that the exchange rate of a small economy is not
allowed to move contemporaneously with other macro variables; rather, price is affected by
exchange rate and other variables as in highly intervened foreign exchange markets.
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The main objective of monetary policy in Nigeria is the conservation of domestic exchange rate and
price stability for the promotion of sustainable economic growth and external sector viability. This
goal has however, been undermined by persistent liquidity overhang, fiscal dominance, oligopolistic
banking system, and dualistic financial markets (Nnanna, 2001). Ndekwu (2013) employed an OLS
and a dynamic logarithmic form VAR to study monetary policy transmission mechanism to the real
sector of the Nigerian economy from 1981 to 2008, find that the credit channel is the corner stone
of monetary policy transmission to the real sector economy, while exchange and interest rates
channels had a feeble impact on the real sector economy. However, Abdullahi (2014) in assessing
the effectiveness of monetary policy transmission mechanisms in Nigeria from 1980 to 2010 find
that credit channel is inefficient and exchange rate channel is weak, while interest rate channel was
found to be the greatest determinant channel for monetary policy transmission in Nigeria.
Obafemi and Ifere (2015) using quarterly data from 1970:1 – 2013:4, employed FAVAR model with
53 variables to evaluate the channel of transmission of monetary shocks in Nigeria, they found that
credit and interest rates channels were the most important channels for transmission of monetary
shocks, then the money and exchange rate channels. In addition, stock channel was insignificant in
explaining transmission shock process in Nigeria. Uma et al. (2014) also show that exchange rate,
credit and interest rate channels were amongst the channels of monetary policy transmission to the
Nigerian economy.
To crown it all, the review of extant literature on Nigeria shows gaps that the interest and exchange
rates channel of monetary transmission policy has not been explored thoroughly. Thus, the whole
monetary policy transmission mechanism in remains Nigeria unclear and deserves more empirical
studies.
STYLIZED FACT OF NIGERIA’S EXCHANGE RATE AND MACROECONOMIC FUNDAMENTALS
Trend analysis of naira–US dollar exchange rate
The trend analysis of quarterly Nigeria’s naira–US dollar exchange rate for the period 1985Q1 –
2017Q1 is presented in Figure 1. The naira–US dollar exchange rate hovered around N0.89 and
N9.87 to a US dollar during the period 1985Q1 – 1992Q2, before it depreciated sharply to
N29.61/US$1 in 1994Q4. This led to the liberalization of the foreign exchange market in Nigeria,
Following the liberalization of the exchange policy in 1995, the naira–US dollar exchange rate
further appreciated to N80.74/US$1 in 1995Q2 from N29.61/US$1 in 1994Q4. It however remained
relatively stable around N80.74/US$1 – N87.58/US$1 till 1999Q4.
From 2000Q1, it depreciated steadily to N135.19/US$1 in 2004Q2 before appreciating to
N117.67/US$1 in 2008Q3. Since then, the naira–US dollar exchange rate has maintained a sharp
depreciation, though it steadied and averaged N306.20/US$1 between 2016Q3 and 2019Q4, before
depreciating further to N361.20/US$1 in 2020Q1, occasioned by the devaluation of the naira to curb
speculative attacks and the depleting reserves as a result of the plunge in oil price in the
international market as well as the harmonization of the country’s various exchange rates.
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Hamilton (1994), opined that in order to recuperate the mechanical parameters from the abridged
form model, the order condition must be fulfilled. This implies that the total number of factors in
the covariance matrix must be the same. The variance covariance matrix of the abridged form is
shown in equation (3).
? = 6(;$;7) @A ? = (!"
=>)? (!"
=>)7
C B$
(3)
C
For identification to be achieved, it is expected that the factors in ( and !" are convalesced from
the abridged form. In equation (3) E encloses F(F + 1)/2 factors, and has F(F + 1) free variables
in equation (3), we then imposed 2FH − F − F(F + 1)/2 constraints on ( and !". The imposition
of F(F − 1) constraint is meant to constrain ( to be transverse, there by attaining an identification
of at least F(F − 1)/2 constraints are enforced on !". When modeling the Cholesky decomposition
in the VAR, !" is measured as a deltoid. Nevertheless, a structural VAR !" can take any form until
it has sufficient constraint.
The Structural Vector Autoregression Estimates (SVAR) Model for Nigeria
We adopted the augmented Kim and Roubini’s (2000), non-recursive SVAR methodology to
investigate the effectiveness of monetary transmission mechanisms in Nigeria. The shocks in a
mechanical SVAR can be identified by imposing some constraints in the baseline SVAR. A typical
SVAR for the Nigeria economy contains seven equations and factors as shown by the Xt vector in
equation (4):
&$ = (JKL$ , NLO$ , PQRL$ , JLS$ , NT$ , UVO$, P6O$, ) (4)
From equation (4), COPt represent the world crude oil price in terms of the US dollar, MPRt refers to
the Central Bank of Nigeria monetary policy rate, NGDPt is the nominal gross domestic production, CPIt
means the consumer price index, MSt connotes the monetary aggregate, TBRt represent the monetary
policy instrument (as three-month TBRs), and NERt means the nominal exchange rate.
From equation (4), the first identification arrangement is the standard approach which imposes a
recursive structure of the VAR that shows the connection in the abridged-form inaccuracies (errors)
and the structural disturbance is presented in equation (5).
(5)
Unlike the recursive identification, in identifying the structural VAR, the authors employed Amisano
and Gianini (1997) strategy. In Amisano, et al framework, sufficient constraints are imposed on
21
31 32
41 42 43
51 52 53 54
61 62 63 64 65
71 72 73 74 75 76
1 0 0 0 0 00
1 0 0 0 00
1 0 0 00
1 0 00
1 00
1 0
1
COP COP
t t
MPR MPR
t t
NGDP NGDP
t t
CPI CP
t t
MS
t
TBR
t
NER
t
u
u
u
e b e b b e
bbb e
e bbbb
e bbbbb
e bbbbbb
é ù é ù ê ú ê ú
ê ú
ê ú
ê ú
ê ú = ê ú
ê ú
ê ú
ê ú
ê ú
ê ú ë û ë û
I
MS
t
TBR
t
NER
t
u
u
u
u
é ù
ê ú
ê ú
ê ú
ê ú
ê ú
ê ú
ê ú
ê ú
ê ú
ê ú
ê ú ë û
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Udeaja, E. A., Audu, N. P., & Obiezue, T. O. (2020). The Transmission Mechanism of Monetary Policy Shocks in Nigeria: The Interest and Exchange Rates
Channels. Advances in Social Sciences Research Journal, 7(9) 283-311.
matrix !" and (. The system can be said to be justly identified, if requires 4(34 − 1) / 2 or
24H– 4(4 + 1) / 2 or 176 = 2(11H) − 11(11 + 1) / 2 constraints on !" and (. We are required
to impose 70 constraints on ( which is presumed the diagonal matrix in our model), also, additional
21 constraints must be placed on !" before the system can be justly identified.
The constraints imposed on the non-recursive simultaneous associations amongst the factors are
presented in equation (6). The left-hand side of equation is the baseline SVAR while the constants
[\] show that factor j instantaneously affects parameter i. Equation (5) shows the justly identified
system !";$ = (3$ .
(6)
The crude oil price represents external shocks. The domestic factor shocks do not have any
consequence on the exogenous variable simultaneously. Yet, the monetary policy rate reacts
positively and instantaneously to the movement in crude oil price. This is because the Nigerian
Central Bank tightens monetary policy whenever it encounter crude oil price shock. The exchange
and interest rates as well as the aggregate money are expected to affect the level of economic activity
(output) with a one period lag. The price level responds instantaneously to the GDP and nominal
exchange rate.
We included exchange rate in our model because it is lead indicator for price stability adjustment
in Nigeria. Furthermore, as crude oil price is determined by the government below the international
level, the domestic price is not supposed to react at the same time to the oil price. As Nigeria is the
seventh largest exporter of the crude oil, dollars play a crucial role in the economy of the country. It
is expected that GDP positively responds to crude oil price. Money demand is expected to respond
simultaneously to the interest rate (TBR), the price level (CPI), and GDP. The next factor is broad
money supply (MS). The monetary authority which sets the interest rate after considering the
current values of the crude oil price, money, exchange rate, and more significantly the country’s
anchor interest rate and the lagged values of all parameters in Xt.
The inclusion of exchange rate variable in the model, is meant to capture the pass through effect.
The reason for the addition of exchange rate and money the interest rate function simultaneously
is that the data on these variables are available instantaneously. However, for the monetary
authority, the data of important variables such as output and the price level are not available at
once, so these factors were not built-in in the monetary authority reaction function. The interest
rate is expected to responds positively to nominal exchange rate and money supply. In conclusion,
21
31
43 47
53 54 56
61 62 65 67
71 72 73 74 75 76
1000000
100000
010000
00 100
00 1 0
00 1
1
COP COP
t t
MPR MPR
t t
NGDP NGDP
t t
CPI CPI
t t
MS MS
t t
TBR T
t t
NER
t
u
u
u
u
u
u
u
e b e b e
b b e
bb b e
bb b b
bbbbbb
é ùé ù ê úê ú
ê ú
ê ú
ê ú
ê ú = ê ú
ê ú
ê ú
ê ú
ê ú
ê ú ë û ë û
BR
NER
t
e
e
é ù
ê ú
ê ú
ê ú
ê ú
ê ú
ê ú
ê ú
ê ú
ê ú
ê ú
ê ú ë û
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Udeaja, E. A., Audu, N. P., & Obiezue, T. O. (2020). The Transmission Mechanism of Monetary Policy Shocks in Nigeria: The Interest and Exchange Rates
Channels. Advances in Social Sciences Research Journal, 7(9) 283-311.
Figure 8: Responses to a positive monetary policy rate
The peak impact occurs by 1.0%, this was found after 10 quarters of the shock and the response are
both long-lasting and statistically significant. The response on the price level is small, though
statistically significant. Prices do not begin to decline until about two quarters and rise, before
falling in a hump-shaped. The peak impact was reached after 3 quarters. In literature, the initial
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
1 2 3 4 5 6 7 8 9 10
Response of MPR to COP
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
1 2 3 4 5 6 7 8 9 10
Response of MPR to MPR
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
1 2 3 4 5 6 7 8 9 10
Response of MPR to NGDP
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
1 2 3 4 5 6 7 8 9 10
Response of MPR to CPI
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
1 2 3 4 5 6 7 8 9 10
Response of MPR to MS
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
1 2 3 4 5 6 7 8 9 10
Response of MPR to TBR
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
1 2 3 4 5 6 7 8 9 10
Response of MPR to LNER
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Advances in Social Sciences Research Journal (ASSRJ) Vol.7, Issue 9, September-2020
positive response of prices to a tightening monetary policy shock is referred to as the “price puzzle”.
Moreover, monetary aggregate falls after the shock and bottoms out just after one quarter, in
addition to NER’s rising and peaking after five quarter and falls immediately.
Figure 3 shows the impulse response functions for all variables are affected by oil price shocks.
Following negative oil price shock, output in Nigeria declined, the impact of oil price shock on output
occurs one quarter after the shock. Also, COP has negative effects on MPR. Furthermore, price level
is affected simultaneously by oil price shock, price decreases slowly one quarter after oil price
shock. Oil price innovation also has negative response to TBR. Impulse response shows TBR falls
due to oil price shock. Moreover, an oil price shock has both negative effects on monetary aggregate
and positive effects on NER. However, MS falls and NER rises one quarter after the sock.
Figure 4 depicts the impulse response functions for all variables are affected by MPR shock. As
predicted, MPR has a positive influence on TBR of Nigeria as this country is pegged to USD.
Furthermore, MPR shock has negative effects on output. Twenty two basis points of MPR shock
increases GDP of 0.02% at 10 quarters after the shocks. Meanwhile, MPR innovation has a negative
effect on MS and CPI, and a positive effect on NER.
Table 6 reveals each variable’s variance decompositions at forecasted horizons of two through 10
quarters. Variance decompositions display percentage shares of variable movement encountering
different shocks. Columns of variance decomposition show percentage changes of each variable that
faced with shock and now the percentage change is adding up to 100%.
Table 6: Variance Decomposition: Interest and Exchange rate Channel
Variance
Decomposition Period COP MPR NGDP CPI MS TBR NER
NGDP
2 2.22 0.02 22.28 61.68 7.50 1.42 4.89
4 2.07 0.01 23.71 59.91 8.49 1.73 4.08
8 1.84 0.01 26.59 56.19 9.79 2.10 3.48
10 1.82 0.01 28.50 53.75 10.35 2.31 3.24
CPI
2 0.67 0.00 43.12 54.50 1.50 0.07 0.13
4 0.58 0.00 46.02 51.57 1.70 0.05 0.08
8 0.45 0.00 49.94 47.70 1.62 0.11 0.18
10 0.36 0.00 54.60 43.08 1.37 0.17 0.42
MS
2 0.21 0.01 37.05 61.14 0.00 0.51 1.07
4 0.15 0.01 38.37 60.00 0.00 0.45 1.03
8 0.15 0.00 38.90 59.61 0.01 0.40 0.93
10 0.19 0.00 37.98 60.64 0.05 0.35 0.79
TBR
2 0.05 0.05 44.75 29.18 0.21 0.49 25.27
4 0.05 0.05 48.79 30.18 0.20 0.47 20.25
8 0.10 0.06 46.80 31.78 1.94 0.57 18.75
10 0.39 0.04 42.41 40.88 2.62 0.54 13.12
NER
2 0.61 0.00 44.73 52.90 0.14 1.31 0.32
4 0.50 0.00 47.55 50.23 0.12 1.23 0.38
8 0.45 0.00 50.65 47.14 0.11 1.13 0.51
10 0.45 0.00 53.43 44.31 0.11 1.03 0.67
Note: Factorization – Structural, Source: Author's Compilation using Eviews
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Advances in Social Sciences Research Journal (ASSRJ) Vol.7, Issue 9, September-2020
Figure 9: Responses to a positive interest rate
-.10
-.05
.00
.05
.10
.15
1 2 3 4 5 6 7 8 9 10
Response of NGDP to TBR
-4
-2
0
2
4
1 2 3 4 5 6 7 8 9 10
Response of CPI to TBR
-.08
-.04
.00
.04
.08
1 2 3 4 5 6 7 8 9 10
Response of LMS to TBR
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
1 2 3 4 5 6 7 8 9 10
Response of TBR to TBR
-10
-5
0
5
10
1 2 3 4 5 6 7 8 9 10
Response of NER to TBR
Response to Cholesky One S.D. Innovations ± 2 S.E.
Page 27 of 29
URL: http://dx.doi.org/10.14738/assrj.79.8927 309
Udeaja, E. A., Audu, N. P., & Obiezue, T. O. (2020). The Transmission Mechanism of Monetary Policy Shocks in Nigeria: The Interest and Exchange Rates
Channels. Advances in Social Sciences Research Journal, 7(9) 283-311.
Figure12: Responses to a positive monetary policy rate on Nigeria
CONCLUSIONS
The role of the interest rate and exchange rate channel in Nigeria was assessed in this paper. The
authors adopted an open-economy methodology to estimate SVAR model with contemporaneous
restrictions to analyze the effects of each channel. Comparison of recursive VAR results and non- recursive SVAR results indicates that better forecasting and estimation is obtained when SVAR
method is applied. Contemporaneous coefficient of monetary policy reaction reveals that Nigeria's
monetary agency raises the interest rate when encountering the unexpected increases in MS,
although Nigeria exchange rate is pegged to US dollar, monetary aggregate decreases with an
unexpected increase in interest rates.
The analysis of the results shows that shocks to interest rate effect output, and also has a major
impact on prices over the sample period. These findings are generally consistent with findings in
other countries, using the similar methodology. However, significant fluctuations in movements of
economic activity relating to systematic reaction to monetary aggregate and foreign stocks such as
the crude oil price. The authors find that a depreciation shock in the nominal exchange rate leads to
a rise or an increase in the price level, although the impact of an interest rate shock on prices is not
strong in Nigeria.
However, as in many developing countries like Nigeria the exchange rate channel appears to have a
stronger impact on prices. These results mean that depreciation of the NER could be an external
deflationary element, particularly for Nigeria. Allowing more flexibility in the exchange rate can
-.2
-.1
.0
.1
.2
1 2 3 4 5 6 7 8 9 10
Response of LNER to LCOP
-.2
-.1
.0
.1
.2
1 2 3 4 5 6 7 8 9 10
Response of LNER to MPR
-.2
-.1
.0
.1
.2
1 2 3 4 5 6 7 8 9 10
Response of LNER to LNGDP
-.2
-.1
.0
.1
.2
1 2 3 4 5 6 7 8 9 10
Response of LNER to LCPI
-.2
-.1
.0
.1
.2
1 2 3 4 5 6 7 8 9 10
Response of LNER to LMS
-.2
-.1
.0
.1
.2
1 2 3 4 5 6 7 8 9 10
Response of LNER to TBR
-.2
-.1
.0
.1
.2
1 2 3 4 5 6 7 8 9 10
Response of LNER to LNER
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Advances in Social Sciences Research Journal (ASSRJ) Vol.7, Issue 9, September-2020
strengthen the exchange rate channel for Nigeria that pegging the naira - US dollar, can open more
doors for autonomy for the Central Bank of Nigeria.
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