TABLE OF CONTENTS
Authorisation to Copy
Table of Contents
List of Tables
List of Figures
List of Appendices
CHAPTER ONE: INTRODUCTION
1.1 Background to the Study
1.2 Statement of the Research Problem
1.3 Research Questions
1.4 Objectives of the Study
1.5 Justification of the Study
1.6 Scope of the Study
CHAPTER TWO: LITERATURE REVIEW
2.1 Theoretical Literature
2.1.1 Theories of Exchange Rate
2.1.2 Theories of Interest Rate
2.1.3 Theories Linking Exchange Rate and Interest Rate
2.1.4 Theories of Manufacturing Output
2.2 Empirical Literature
2.2.1 Empirical Review on Relationship Between Exchange Rate and Interest Rate
2.2.2 Empirical Review on Exchange Rate and Manufacturing Sector
2.2.3 Empirical Review on Interest Rate and Manufacturing Sector
2.2.4 Empirical Review on Exchange Rate and Interest Rate Relationship with Manufacturing Sector Output
2.3 Summary of Gaps in the Literature
CHAPTER THREE: METHODOLOGY
3.1 Theoretical Framework
3.2 Model Formulations
3.3 Operational Definitions of Variables
3.4 Techniques of Estimation
3.6 Sources of Data
CHAPTER FOUR: APPRAISAL OF EXCHANGE RATE POLICIES, INTEREST RATE POLICIES AND MANUFACTURING SECTOR IN NIGERIA
4.1 Appraisal of Exchange Rate Policies in Nigeria
4.1.1 Pre-SAP Exchange Rate Management in Nigeria
4.1.2 Post-SAP Exchange Rate System in Nigeria
4.1.3 Allocation of Foreign Exchange to Sectors
4.1.4 Exchange Rate Fluctuations in Nigeria
4.2 Appraisal of Interest Rate Policies in Nigeria
4.2.1 Interest Rate Policy during Pre-SAP Period
4.2.2 Interest Rate Policy during Pre-SAP Period
4.2.3 Interest Rate Instability in Nigeria
4.3 Appraisal of Manufacturing Sector in Nigeria
4.3.1 Pre-SAP Industrial Policies
4.3.2 Post-SAP Industrial Policies
4.3.3 Sub-Sectors in Manufacturing Sector
4.4 Relationship among Exchange Rate, Interest Rate and Manufacturing Sector Output in Nigeria
4.5 Summary of Exchange rate, Interest rate and Manufactuirng Appriasal
CHAPTER FIVE: FINDINGS AND DISCUSSION OF FINDINGS
5.1 Descriptive Statistics of the Data
5.2 Correlation Analysis
5.3 Unit Root Results
5.4 Co-integration Results
5.6 Discussion of Findings
CHAPTER SIX: SUMMARY, CONCLUSION AND RECOMMENDATIONS
6.4 Limitations of the Study
6.5 Suggestions for Further Studies
6.6 Contributions to Knowledge
My deep appreciation goes to Almighty God, all thanks and praises be to Him for the grace, strength, wisdom and journey mercies during the course of this study.
My special appreciation goes to my supervisor, Prof. B. A. Folorunso. His academic excellence was all I needed to bring out the best out of little. He was there, every second that counted, to correct, proof-read, direct, teach, and add the professional touch that made this study worthwhile. He did not only painstakingly supervise this research, he mentored me in all aspect of life. I equally extend my special thanks to my co-supervisor, Dr. O. E. Falade, who was always there to correct, guide and redirect my steps on the study. I am very grateful.
My unreserved appreciation goes to the Head of Department, Prof. T. O. Akinbobola, who provided all the needed assistance that made the difference during the course of my programme. I would not fail to acknowledge great teachers of all times that gave me sound tutelage, to making me a better person: Professor J. O. Olusi (rtd), Professor S. I. Oladeji, Professor R. O. Soetan, Professor A. E. Akinlo, Professor A. A. Adebayo, Professor P. A. Olomola and Dr. R. A. Ajisafe, Dr, R. O. Olayeni. I also extend my profound gratitude to Dr. A. G. Aremo, Dr. A. A. Adegboye, Dr. D. Olayungbo and Dr. A. V. Adejumo for their academic supports they gave me unconditionally. I thank them all for their educative impact in my life.
The support of my darling wife was so enormous that there was no amount of words to qualify virtues and steadfastness she showed during the period of this programme. My little Ds, daddy’s pets, Delight, Divine, Daniella, Daniel (Jnr) and David. They are a delight to look at for inspiration and strengths and they beautified every moment I invested in this study. The joy of my livelihood goes to my parents, Pastor and Deaconess I. C. Onyejiuwa, who gave me all the qualities I possessed and the factor of success of which I will ever be grateful. Their encouragements, wise counsels and prayers to carry on was so overwhelming. My appreciation also goes to my siblings for the supports they gave to me in different dimensions.
My profound gratitude to my mentor, Elder (Dr.) Bisi Ogunjobi (OON); his deserving qualities which are scarce as diamond and I tapped from. My profound appreciation goes to the Vice-chancellor of Samuel Adegboyega University, Ogwa, Professor, B. E. Aigbokhan, for his unreserved impact in my life. His underlining educative impact is indelible. Also, I extend my appreciation to the Dean, College of Management and Social Sciences, Samuel Adegboyega University, Professor J. U. Idialu, for the unflinching support given to me. I also thank Rev. K. Ola, Dr. Akpati and Mrs. M. Adegboye, for their depth proof-reading and corrections made on this work. I also appreciate my dear colleagues and friends at Samuel Adegboyega University.
I owe special thanks to my course mates Dr. J. T. Dada, Dr. C. O. Olaniyi, Dr. N. O. Oladujoye, Dr. S. A. Ibitowa, Dr. I. O. Bankefa, Mr. O. Adesanya and Mr. E. Awoleye, who all contributed to the success of this study. I thank the non-academic staff in the department, Mr. S. A. Afe, Mr. O. Oni, Mrs. E. Fasanu, Mrs. O. Olasupo, Mrs. R. N. Ukaegbu, Mr. O. D. Famakinde and Mr. O. A. Amure, for their contributions towards the success of my programme. I extend my appreciation to Miss Rachel Fagboyo and Mr. Akinola Afolabi for their invaluable contributions. To all my friends, loved ones, class mates and colleagues who, in one way or the other, assisted me during the course of this study, I appreciate them all.
ONYEJIUWA Daniel Chibueze
LIST OF TABLES
1.1 Sectoral Contributions to Real GDP in Nigeria from 1986 to 2017
1.2 Exchange Rate, Interest Rate and Manufacturing Sector in Nigeria: 5-Year Average (1986 to 2017)
3.1 Summary and Definition of Variables
4.1 Exchange Rate in Nigeria from 1962 to 1985 for Selected Currencies
4.2 Exchange Rate in Nigeria Post-SAP Period for Selected Currencies
4.3 Sectoral Utilisation of Foreign Exchange for Transactions Valid for Foreign Exchange (US$' Million) from 1997 to 2017
4.4 Minimum Rediscount Rate, Lending and Savings Rates in Nigeria from 1961 to 1985
4.5 MRR, Lending Rate and Deposits Rate in Nigeria from 1986 to 2017
4.6 The Real Sector Output Percentage Contributions to Real GDP in Nigeria from 1960 to 1985
4.7 The Composition of Manufacturing Sector output from 1986 to 2017
4.8 Summary of National Development Plans and Policies and Manufacturing Contribution to Real GDP at Different Periods
5.1 Summary of Descriptive Statistics of the Variables
5.2 Correlation Analysis
5.3 Augmented Dickey-Fuller, Dickey-Fuller Generalised Least Square and Phillip-Peron Unit Root Tests
5.4 Unrestricted Co-integration Rank Test
5.5 Unrestricted Co-integration Rank Test (Maximum Eigenvalue)
5.6 FMOLS Regression for Effect of Exchange Rate and Interest Rate Interaction on Manufacturing Sector Output % Share in Real GDP
5.7 ARDL Model for Effect of Exchange Rate and Interest Rate on Manufacturing Sector Output % Share in Real GDP
5.8 ARDL Model for Effect of Exchange Rate Fluctuations on Manufacturing Sector Output % Share in Real GDP
5.9 ARDL Model for Effect of Interest Rate Instability on Manufacturing Sector Output % Share in Real GDP
5.10 ARDL Model for Effect of Exchange Rate Fluctuations and Interest Rate Instability on Manufacturing Sector Output % Share in Real GDP
5.11 Manufacturing Sector % Contribution to Real GDP Innovation
5.12 Agricultural Sector % Contribution to Real GDP Innovation
5.13 Construction Sector % Contribution to Real GDP Innovation
5.14 Trade Sector % Contribution to Real GDP Innovation
5.15 Service Sector % Contribution to Real GDP Innovation
5.16 ML-ARCH (Marguardt) Estimation of Non-Linear Regression of Sarel Threshold Model for Exchange Rate
5.17 ML-ARCH (Marguardt) Estimation of Non-Linear Regression of Sarel Threshold Model for Interest Rate
LIST OF FIGURES
4.1 Official Average US Dollar Exchange Rate in Nigeria from 1986 to 2017
4.2 Official Average (WDAS/RDAS), Inter Bank and BDC Exchange Rate in Nigeria from 2004 to 2017
4.3 Average Sectoral Allocation of Exchange Rate from 1997 to 2017
4.4 Exchange rate Fluctuations from 1986 to 2017
4.5 Interest Rate Spread Post-SAP Period from 1987 to 2017
4.6 Lending Rate from 1986 to 2017
4.7 Instability in Interest Rate from 1986 to 2017
4.8 The Manufacturing Sector Percentage Contributions to Real GDP in Nigeria from 1986 to 2017
4.9 Other Real Sector Percentage Contributions to Real GDP in Nigeria from 1986 to 2017
4.10 Growth Rates of Manufacturing Sector and Real GDP in Nigeria from 1986 to 2017
4.10 The Nigerian Manufacturing Sector Composition in 2017
4.11 Manufacturing Sector Output % Contribution to Real GDP and Exchange Rate in Nigeria (1986 -2017)
4.12 Manufacturing Sector Output % Contribution to Real GDP and Interest Rate in Nigeria (1986 -2017
5.1 Response of Manufacturing Sector % Contribution to Real GDP to Shocks from Exchange Rate and its Fluctuations and Interest Rate and its Instability
5.2 Response of Agricultural Sector % Contribution to Real GDP to Shocks from Exchange Rate and its Fluctuations and Interest Rate and its Instability
5.3 Response of Construction Sector % Contribution to Real GDP to Shocks from Exchange Rate and its Fluctuations and Interest Rate and its Instability
5.4 Response of Trade Sector % Contribution to Real GDP to Shocks from Exchange Rate and its Fluctuations and Interest Rate and its Instability
5.5 Response of Service Sector % Contribution to Real GDP to Shocks from Exchange rate and its Fluctuations and Interest Rate and its Instability
LIST OF APPENDICES
1 OLS Estimation (Robustness Check)
2 Fully Modified OLS Stability Test
3 ARDL Model Lag Selection Criteria and Diagnostic Test
4 Structural Break Test
5 Sarel Threshold Model Estimation
The study appraised different interest rate policies, exchange rate regimes and manufacturing sector in Nigeria from 1986 to 2017 and determined the effect of interest rate and exchange rate interaction on manufacturing sector output. It investigated the dynamic effects of exchange rate fluctuations and interest rate instability on manufacturing sector output, examined the response of manufacturing sector output to shocks from exchange rate fluctuations and interest rate instability. It also determined the threshold levels of exchange rate and interest rate that will spur manufacturing sector output in Nigeria. These were with a view to examining the relationship among exchange rate fluctuations, interest rate instability and manufacturing sector output in Nigeria.
The study used secondary data. Annual data from 1986 to 2017 on manufacturing sector output, exchange rate, interest rates, gross fixed capital formation, credit to manufacturing sector, real GDP per capita, agricultural sector output, construction sector output, trade sector output, service sector output, tax revenue, inflation rate and trade openness were obtained from the Central Bank of Nigeria Statistical Bulletin of various years and World Development Indicators of various years, published by World Bank. The data collected were analysed using tables, graphs, Fully Modified Ordinary Least Square estimator, Autoregressive Distributed Lag model, Vector Autoregressive model and Sarel Threshold model to achieve the stated objectives.
The resuts from the appriasal showed that exchange rate exhibited a high degree of fluctuations (mean = -4.40) and revealed a high interest rate instability (mean = -3.11) as a result of inconsistencies in exchange rate and interest rate policies adopted by the monetary authority. These inconsistencies in exchange rate and interest rate policies resulted in the low and unstable manufacturing sector output contribution to real GDP. The results showed a positive effect of interest rate and exchnage rate interaction (t = 4.01; p < 0.05) on manufacturing sector output. This indicated that there exist a strong effect of exchange rate, through the channel of interest rate, on manufacturing sector output. The results also showed a negative effect of exchange rate fluctuations (t = -2.55; p < 0.05) and interest rate instability (t = -2.89; p < 0.05) on manufacturing sector output. The results imply that exchange rate fluctuations and interest rate instability exert negative influence on manufacturing sector output. The results of manufacturing sector output response to shocks from exchange rate fluctuations showed an instant positive value of 11% at first period and increased to 13.01% at the end period, while the response of manufacturing sector output to the interest rate instabilty showed a negative movement of -8.34% at the first period and further declined to -13.93% at the end period. These results indicated that manufacturing sector responds positively to shocks from fluctuations in exchange rate and negatively to interest rate instability. Furthermore, the results revealed ₦154.40 to $1 (t = -214.61; p < 0.05) as the exchange rate threshold and 23.65% (t = -6.58; p < 0.05) as the interest rate threshold. These strongly suggested that the indicative threshold values for exchange rate and interest rate that would be detrimental for Nigerian manufacturing sector if exceeded.
The study concluded that exchange rate fluctuations and interest rate instabilty dampened manufacturing sector output in Nigeria.
Key Words: Exchange rate, interest rate, manufacturing, fluctuations and instability
1.1. Background to the Study
The manufacturing sector is a vital catalyst for economic growth in many developed and developing countries and has huge benefits that are essential for economic growth and transformation (Szirmai, 2012; Odior, 2013; Chete, Adeoti, Adeyinka, & Ogundele, 2014; Onakoya, Ogundajo, & Johnson, 2017). An increase in the share of manufacturing sector output in total output has the possibility and capability to increase GDP growth and contract growth volatility (Enu, Hagan, & Attah-Obeng, 2013). The manufacturing sector has also been seen as a leading sector in most advanced countries in many aspects. Some of these aspects are ways for increasing manufacturing output to substitute imports and contribute to export growth, promoting the growth in private investments, generating foreign exchange earnings, increasing employment and widening efficient and effective integration among various sectors in the economy (Charles, 2012).
The Verdoorn’s and Kaldor’s laws confirmed the strong contribution of the manufacturing sector to developing countries’ economy (Verdoorn, 1949; Kaldor (1975). The basic deduction from their laws is that an increase in manufacturing sector labour productivity and the productivity-enhancing innovations technologies employed in the sector lead to greater proportion in economies of scale and technical progress than any other sector (Szirmai, 2009; Arnold, Javorcik, & Mattoo, 2011; Thirlwall, 2013; Onakoya, 2018). Szirmai (2012) believed that the emergence of manufacturing sector as a major activity in many developing countries has shaped and structured the fundamental aspect of the economic growth and development.
Industrial development, through significant growth in manufacturing sector, can be traced back at the technological breakthrough by applying the techniques of steam power to textile production in Great Britain (Szirmai, 2012). This development was later referred to as industrial revolution in Great Britain, which evolved over time from science, technology and innovation development. With the emergence of modern manufacturing and the structure of the world economy, economic welfare experienced dramatic changes. As Szirmai (2012) put it “industrialisation became synonymous with economic development, wealth maximisation, political power, technological leadership and international dominance”. Experiences of countries such as: China, Brazil, South Korea, Singapore and Malaysia have proven that over the past five decades industrialisation has played critical role in transforming many less developing countries to middle-income countries. Notably, one of the main conditions to indicate that a country is industrialised is when about 75% of the industrial output arises in the manufacturing sub-sector of the industrial sector (Ojo, 2002).
Eze and Ogiji (2013), Chete, Adeoti, Adeyinka and Ogundele (2014) and Onakoya (2018) observed that Nigerian economy is under-industrialised and its capacity utilisation is also low. Over the years the sector also has become more dependent on the foreign sector for import of non-labour factor input in its production, which is greatly affected by fluctuations in exchange rate. In the quest to import therefore, any shock from external forces could lead to undesirable outcome in the manufacturing sector, and also has the capacity to impact negatively on economic growth. It is also important to note that Nigerian manufacturing sector has been stagnated and negligible over the years because of over-dependence on oil and poor performance of the agricultural sector which could have served as a source of raw materials input for the manufacturing sector (Onyejiuwa, 2016). The sector also has been relatively low in its output share to the GDP since pre Structural Adjustment Program (SAP) era and continued to record low value also during post SAP era.
The component of GDP during the past 31 post SAP years in Nigeria is presented in Table 1.1. The table shows the dominance of agriculture and oil and gas, which are classified as the primary sector. In 1986, the manufacturing sector recorded relatively low value of 9.01% share to GDP compared to agriculture, oil and gas, trade and services sectors contributions to real GDP. Manufacturing sector output’s contribution to GDP continued to fall to 7.55% in 1996, and slightly decreased again to 6.60% in 2001. Due to reforms and industrial policies that translated to improvement in the innovations in manufacturing sector especially in the economic reform agenda between 1999 and 2007 particularly within the framework of the National Economic Empowerment and Development Strategy (NEEDS), the value of manufacturing sector contribution to GDP improved (Chete, Adeoti, Adeyinka, & Ogundele, 2013).
In 2011, the value of manufacturing output share to the GDP increased to 7.33% and further increased significantly to 9.28 in 2016 but marginally dropped to 9.18 in 2017. In spite of the little improvements, the sector still recorded lower contribution to GDP than most of the main sectors. In 2017, the growth of the sector recessed with a negative value of -1.03% which was better than the previous year’s level of -2.78% (CBN, 2017). The data also showed that from 1986 to 2001, more than half of Nigeria’s output were generated by the primary sector, while trade and services took over the dominance from thence till 2017.
TABLE 1.1: Sectoral Contributions to Real GDP in Nigeria from 1986
Abbildung in dieser Leseprobe nicht enthalten
Source: CBN Statistical Bulletin of various years.
Many studies showed that poor performance of macroeconomic variables, infrastructure and disarticulation among sectors, especially between agriculture and manufacturing, are major factors that might have accounted for the low contributions of manufacturing sector output contribution to real GDP (Ake, 1981; Manufacturers Association of Nigeria, 2015; Odior, 2013; Onakoya el at., 2017; Onakoya, 2018). Others supported that economic policies are major hindrance to the growth of the manufacturing sector (Charles, 2012; Eze & Ogiji, 2013). This has made Nigerian Federal government over the years to introduce national development plans, industrial policies, initiatives, monetary and fiscal measures and sectoral developments to enhance the manufacturing sector (Chete, et al., 2014).
These plans, policies and initiatives included different periods of effective control and management of the exchange rate market among other policies and plans such as Nigeria Economic Empowerment Development Strategy (NEEDS), national industrial policy, privatisation policy, the creation of industrial estates in various cities in the country, establishment of Bank of Industry to provide cheap loans to Small and Medium Scale Enterprises and the national export strategy to improve competitiveness in the foreign market and create job . In addition, special policy measures directed towards supporting local (small-scale) industries in the manufacturing sector were also implemented. Road construction, rehabilitation of the railways, and other improvement in social amenities and social welfare packages towards alleviating poverty were other policy measures that were initiated to improve manufacturing sector in Nigeria. [Manufacturing Association of Nigeria, (MAN) 2015].
Considering the efforts of the government at different levels of governance and various National Development Plans targeted to improving the industrial sector, especially the manufacturing sector, one would expect the policies and programmes to yield positive results in increasing manufacturing sector output. However, when comparing Nigeria to Malaysia and South Africa, which they were at the same level of economic development with Nigeria in the 1960s and the early 1970s, in terms of manufacturing sector share to GDP from 1986 to 2016 (Ekpo, 2005), the fact showed a contrary expectation. Averagely, Malaysia showed 60.4%, and South Africa made 19.3% while Nigeria recorded 7.9% [World Development Indicators (WDI), 2017]. Although, Malaysia and South Africa may not have the same economic plan or system with Nigeria, the economy of each of the countries in the past showed that they were classified as developing or middle income countries like Nigeria. But over time, they have shown considerable stages of economic improvements.
The manufacturing sector's performance remained almost the same with barely no improvements. The sector began to increase again in 2010 but the growth rates were relatively low when compared to that of South Africa, Malaysia and most developing countries. Specifically, Malaysian manufacturing sector contribution to its GDP showed a great improvement over the years from 44.46% between the first five years (1986 to 1990) and later improved massively within the next decade 53.78% in 1990. This improvement continued to increase to 78.38% between 1996 and 2000, and later dropped marginally to 62.9% in the last five years. Although, South Africa manufacturing sector contributions to its GDP is comparably lower than Malaysia’s, it is higher than that of Nigeria (WDI, 2017).
More importantly, the realisation of viable and developed manufacturing sector depends largely on the performance of macroeconomic factors. Odior (2013) and MAN (2015) argued along this line that manufacturing sector in Nigeria seems to be at the crossroad with fluctuations in exchange rate, high cost of borrowing (interest rate), unstable price in the markets and balance of payment difficulties. These are some of macroeconomic issues that can affect the growth in the manufacturing sector. In the face of conflict in achieving stable prices, exchange rate control and growth in the economy, the Central Bank of Nigeria (CBN) has maintained a high monetary policy rate of 14%, cash reserve ratio of 25% and liquidity ratio of 30% (Monetary Policy Committee, 2016) since 2016. The CBN based its decision on incomplete fiscal reforms which raise risk and uncertainty, and reducing interest rate and other banking rates which will spur credit growth in all sectors that may likely put pressure on price level and foreign exchange market (Monetary Policy Committee, 2016). The interest hedging by CBN can moderate inflation and also attract foreign investments into the country through capital inflow. The CBN was of the view that in the past, the reduction in monetary rates could only stimulate consumption and investment spending, rather than deploying the available liquidity to provide credit to agriculture and manufacturing sectors. For instance, the increase in the monetary policy rate (MPR) value of 11% in 2013 to 14% in 2016 led to an increase in the cost of borrowing for manufacturing activities (Monetary Policy Committee, 2016).
Recently, the CBN held the MPR at 14% to pursue a tightening of liquidity in their Monetary Policy Committee (MPC) meeting held on 22nd November, 2018. The decision was to curb the threat of rising inflation by foreseeing injection from the fiscal authority. The CBN argue that reducing the rate could reverse the gains of lowered importation (which invariably will increase the cost of intermediate and capital goods) in the face of high exchange rate, and support moderate growth in sectors (Monetary Policy Committee, 2017). This position was earlier highlighted by Dash (2004) who held the view that the high interest rate would reduce the inflationary expectations and prevent the vicious cycle of inflation and exchange rate depreciation. However, the fact that Nigeria is under-industrialised, the benefit of high interest rate might not translate to high inflow of capital, which has been the argument of Mundell Fleming theoretical point of view.
These issues of uncertainty and instability in interest rate posed serious challenges to the manufacturing sector. Nwokoro (2017) posited that interest rate is the cost of credit. More so, interest rate is the channel that the financial sector linked with the manufacturing sector. From the borrowing angle, lending rate, which is referred to as cost of loanable fund, have negative relationship with investment in the sector. When lending rates are high, private investment are discouraged and vice versa. The implication is a high monetary policy rate and interbank rate can lead to high lending rates which in turn contract investment in the manufacturing sector (Acha & Acha, 2011). Therefore, a situation where manufacturing firms pay double digit lending rate in their loans and advances is not profitable and friendly (MAN, 2015).
The stabilization of the rate of foreign exchange in Nigeria is very crucial in manufacturing sector output growth (Omotola, 2016). Most of the inputs of manufacturing sector production are imported and any fluctuations in the foreign exchange, the cost of these inputs will be very difficult to determine their cost function, especially in the short-run. Similarly, the devaluation of the Naira, its consistent depreciation, the closure of the Real Dutch Auction System (RDAS) and Weighted Dutch Auction System (WDAS) foreign exchange cause the import bills for raw-materials to increase over the period as manufacturers were forced to purchase their foreign exchange needs at the Inter-Bank and parallel markets (MAN, 2015). Moreover, some manufacturing companies who had earlier drew letters of credit from international financial institutions at a more favourable exchange rate before any new policy was implemented and as the letters mature, they are likely to repay them at a higher exchange rate because of likelihood of Naira depreciation. As a result, the challenges of exchange rate fluctuations affect macro-economic management, and changes in the rate of exchange rate have huge implications on real output, for a country’s Balance of Payments equilibrium attainment and its income distribution and economic growth in general. By implications, records have shown that exchange rate has been depreciating over the years. The persistent depreciation has also been identified in Obadan (2001 and 2002), Folorunso (2000) and Aigbokhan (1991).
As indicated in Table 1.2, between 1985 and 1990, Naira average exchange rate was ₦5.20 to USD dollar with a percentage (%) change of 61.90%. Within five years average, the value at which Naira exchange to USD Dollar increased from ₦18.61 to ₦52.09 between 1996 and 2000. This showed a % change of 24.92% and 66.75% respectively. The depreciation became worrisome between 1995 and 2000 with the highest % change, coupled with the high interest rate of 22.85 in the same year and meagre value manufacturing sector contribution to GDP of 6.82 leading to the worst recession in five years average with a value of -3.9. The exchange rate recorded a high depreciating value of ₦179.49 to 1$ and interest rate of 25.11 between 2011 and 2016. The situation worsens in 2017 with exchange rate and interest rate of ₦305.79 and 30.68 respectively (CBN, 2017). From Table 1.2, the % change showed the level at which depreciation of Naira in relative to US dollar fluctuates. Likewise, the interest rate (maximum lending rate) showed an unstable value during the period. From 1986 to 1990, the interest rate revealed an average value of 20.22% and later rose to 25.98% on average between 1991 and 1995. The five-year average witnessed a reduction in interest rate from 1996 to 2010, and upsurge to 25.11% between 2011 and 2016. Before the end of 2017, the interest rate stood at 30.68%. The manufacturing sector output % contribution to real GDP disclosed an average value of 9.27% within 1986 to 1990. This later dropped to 8.65% between 1991 and 1995. The value of the extent manufacturing sector contributes to real GDP continued to drop from 1996 to 2005, and later gained momentum by increasing to 6.59% between 2006 and 2010. The value maintained an increase from thence and stood at 9.18 in 2017 (CBN, 2017). These fluctuations and instabilities in exchange rate and interest rate respectively might be due to inconsistencies in monetary policies (Osmond, Egbulonu, & Emerenini, 2015; Onakoya, Ogundajo, & Johnson, 2017).
Comparing these data with Malaysia and South Africa situation, it showed that these developing countries have a considerable strong exchange rate and low interest rate. Malaysian exchange rate in respect to USA Dollar was L129.32 between 1986 and 1990, and appreciated to L118.99 in the following five years. The appreciating trend in Malaysia exchange rate improved to L98.58 between 2011 and 2016. Malaysia lending rate showed a declining rate from 9.34% between 1986 and 1990 to 4.70% in the last five years. South Africa also showed a significant improvement in exchange rate and interest over the years. Their foreign exchange via USA Dollars appreciated from R111.89 within 1986 and 1990 to R85.62 between 2011 and 2016 (WDI, 2017).
TABLE 1.2: Exchange Rate, Interest Rate and Manufacturing Sector in Nigeria: 5 Year Average (1986 to 2017)
Abbildung in dieser Leseprobe nicht enthalten
Source: Central Bank of Nigeria Bulletin, 2017 growth rates for exchange rate, interest rate and manufacturing sector contribution to Real GDP is calculated from 2016 and 2017 data.
Therefore, the study is motivated by the need to investigate the inter-relationship and interaction among the manufacturing sector output, exchange rate fluctuations and interest rate instability in Nigeria.
1.2. Statement of the Research Problem
Since the post SAP era, Nigeria has attempted to transform and diversify its economy through various policy measures that were geared towards making non-oil sector of the economy to be more productive thereby reducing the dependence on oil. The manufacturing sector in particular has been identified by most studies as vital to nations’ growth and development, and its huge contribution to the aggregate economic growth is non-contending (Odior, 2013; Szirmai, 2012; Vazakidis & Adamopoulos, 2009; Ovia, 2008; Idowu, 1993). However, it has been argued in the litertature that a viable manufacturing sector depends largely on the performance of macroeconomic factors, mainly exchange rate and interest rate and any distortions or uncertainty in these macroeconomic factors will send shocks to the real output of manufacturing sector, and generally, to the economy (Nwokoro, 2017; Odior, 2013; Ibrahim and Amin, 2005).
Studies have shown that domestic currency is highly sensitive to interest rate, and when interest rate rises relative to foreign interest rate, domestic currency tends to be stregnthened against foreign currency and vice versa (Fernald, Mertens, & Shultz, 2017; Batten & Thornton, 1985; Dash, 2004; Hacker, Kim, & Mansson, 2010; Yung, 2017). Consequently, interest rate has been seen as policy tools to manage and control the fluctuations in exchange rate in most developed and developing countries (Dash, 2004; Yung, 2017). Theoretically, the effect of interest rate on real output through the channel of exchange rate has been identified by Mundell-Fleming model and classical monetary theory. The position of the CBN supported the view of classical or traditional monetary policy transmission mechanism which posited that reducing interest rate could induce appetite for imports through increase in investment, consumption and income, thereby depreciate the value of Naira. From the point of view of Mundell-Fleming model, increase in interest rate could attract inflow of capital and appreciation of the domestic currency, thereby making the domestic output less competitive in the foreign market or on the contrary reduce interest to make domestic output more competitive.
Particularly, the Central Bank of Nigeria (CBN) has attempted to manage the foreign exchange market in Nigeria through monetary measures and other control elements. However, considering the rigidities of getting foreign exchange at official rate in regulated market and flexibilities in getting it at a market determined rate in parallel market, the activities in foreign exchange markets in Nigeria therefore have led to uncertainties, variability and fluctuations in exchange rates. As such, the CBN policies to curb the effects of outcome of foreign exchange markets through interest rate hedging and other controls may seem to be difficult to achieve. The current decision of the CBN to hold the MPR at 14% followed the argument of Dash (2004) that the stabilisation of the exchange rate is conditioned on the management of interest rate. It is also a necessary condition to curb inflationary pressure and thereby aids to avoid many adverse economic consequences on real output.
Similarly, Sachez (2005) discovered that interest rate can be raised to limit the adverse effect of depreciations and lowered in the face of expansionary effect of exchange rate on real output. He opined that if the CBN pursued tight interest rate policy to prevent the contractionary effect of Naira depreciation or to be lowered in the situation of expansionary effect of Naira depreciation, then, interest rate could be a veritable tool to manage exchange rate in achieving growth in the real output. Therefore, it is expected that interest rate should complement exchange rate to enhance growth in the manufacturing sector. However, the interactive effects of interest and exchange rates on manufacturing sector output have not been given much attention in the literature. The studies of Durham (2002) and Alfaro, Chanda, Kalemli-Ozean, and Sayek (2004) had suggested the use of interaction model to remove simultaneity bias between variables that can be determined simultaneously, and have interactive power to determine another variable.
More importantly, addition has been made in the subject matter of exchange rate and interest rate relations with real manufacturing output by several authors (carlino and Defina, 1998; Gertler & Gilchrist, 1993; Dale & Haldane, 1995; Arnold & Vrugt, 2002; Ibrahim & Amin 2005). Some advanced the argument of sector-specific responses to shocks from exchange rate fluctuations and instability in interest rate have distributional consequences (Ayeomoni, Olajide, Agbaje & Aladejana, 2016). These consequences are possible because of the interactions and inter-relations of sectors among themselves. However, Kandil and Mirzaie (2002) posited that sectors of the economy have diverse degrees of exposure to exchange rate and interest rate. Bahmani-Osokooee and Mirzaie (2000) contended that most effects of exchange rate on real output manifest through high cost of variable and fix inputs in the production process of sectors. The study of Obianuju and Nwachukwu (2017) suggested that fluctuations in exchange rate have a negative influence on sector economic growth in Nigerian and its volatility affects their performance. In the case of interest rate, Carlino and Defina (1998) argued that liquidity and interest rate channels of monetary transmission mechanisms lead to differential effects of interest rate shocks to sectors.
Thus, due to sector-specific attributes, sectors may react differently to exchange rate and interest rate shocks, and at some different level of degrees depending on the sector dependence on demands for foreign exchange and credit. Ibrahim and Amin (2005) argued along this line that exchange rate and monetary shocks on sector specific is pluasible among most developing countries. In nigeria, the contribution of manufacturing sector has shown a low value, and as part of the drive to achieve growth and developemnt by increaseing the competetiveness of the sector in the global trade, these macroeconomics factors are of great importance. As such, exchange rate fluctuations and interest rate instability may show a greater magnitude effects on manufacturing sector output than examining the aggregate effect. Stuides have shown empirical evidences of manufacturing sector output responses to shocks from of exchange rate and monetary shocks (carlino & Defina, 1998; Ibrahim & Amin 2005) and the distribution sector effects of monetary disturbances (Gertler & Gilchrist, 1993; Dale & Haldane, 1995; Arnold & Vrugt, 2002; Ibrahim & Amin 2005). This provides a unique opportunity to empirically investigate the sector-specific degree of responses by evaluate the exchange rate and interest rate uncetainties shocks on manufacturing sector output, while comparing the distribution effects of shocks from fluctuations in exchange and interest rates on other sectors in Nigeria with that of manufacturing sector output in Nigeria.
Another important issue in the relationship between manufacturing sector output and exchange rate fluctuations is whether a U-shaped relationship exist or not. Gadanecz and Mehrotra (2013) suggested that there is a U-shaped relationship between exchange rate fluctuations and real output in emerging economies. The contending issues in literature on exchange rate have been whether effects from exchange rate depreciation are expansionary or contractionary. Krugman and Taylor (1978) posited that currency depreciation stimulates real output by making a country’s export more competitive in the international markets. It is also possible that exchange rate depreciation can contract a country’s export through its effects on the costs of production, income distribution among factor income, real balances, and trade balance which was also advanced by Edwards (1986). In his own part, Sachez (2005) opined that there are situations exchange rate can be expansionary and there are indications of exchange rate been contrationary, depending on the nature of the reaction of aggregate demand or real output to the value of the domestic currency. In the case of Nigeria, Omotola, (2016) argued that exchange rate depreciation stimulates real output of the manufacturing sector in Nigeria. However, the studies of Opaluwa, Umeh, and Ameh (2010) and Abdul-Mumuni (2016) argued on the contrary and concluded that excahnge rate depreciation has an adverse effect on manufaturing output in Nigeria.
These arguments may suggest a non-linearity between exchange rate and manufacturing sector output, and might indicate threshold level beyond which high cost of foreign exchange becomes detrimental to manufacturing output contribution to real GDP (Doguwa, 2012). This position was supported by Wimanda (2014) who argued that there is a threshold at which exchange rate could be adverse or beneficial to real output, especially manufacturing output. Therefore, it is imperative to identify the threshold level at which exchange rate can promote the real manufacturing output contribution to real output in Nigeria.
Also, in the case of interest rate, some studies have discovered that increase in interest rate has a contractionary effect on real manufacturing output growth (Udoka & Anyingang, 2012; Odior 2013; Jelilov, 2013, Nwandu, 2016), while Monnin (2015) believed low interest rates increase the competitiveness of credit, and stable interest rates are more beneficial for investments in manufacturing sector. Thus, there is no consensus on the exact effect of interest rates on real output growth. For instance, Sanchita and Rina (2011), Sanusi (2012), Okpara and Nwoha (2010) and Adofu and Audu (2010) all agreed that there is a positive and significant relationship between monetary policy instruments such as interest rate and economic growth. While, Osadume (2018) discovered an inverse effect of interest rate on real output, yet Olubusoye and Oyaromade (2008), Omofa (1999) and Salisu (1993) held that the relationship is not significant. More worrisome is the result of the findings of Ditimi, Nwosa and Olaiya (2011) that there is no relationship whatsoever. Nevertheless, Oosterbaan (2019) suggested an inverted U-curve resemblance in the relationship between real interest rates and real output growth, while David, Umeh, and Abu (2010) submitted that a non-linear relationship exists between interest rate and real output growth for developing and emerging countries.
Furthermore, Keynesians proponents believed a real output can be influenced by discretionary change in money supply. Athukorala (1998) reiterates that it can be possible by lowering the rate of interest and through the marginal efficiency of capital, which will stimulate investment and output growth. This position has been confirmed by the studies of Agu (2008), Sanchita and Rina (2011), Obamuyi, Edun and Kayode (2012), Sanusi (2012), Udoka and Anyingang (2012), Imoughele and Ismaila (2014), among others studies carried out in Nigeria. However, McKinnon and Shaw (1973) in their hypothesis of finance led growth contradicted Keynesian stance. They promoted the inducement of higher interest rate through market force induced, would increase savings and channel these savings to productive investment and stimulate real output growth such as the manufacturing output. They argued further that expansionary actions in the real interest rate will have strong positive contribution on savings which can be utilised in investment. This is because those with excess liquidity will be encouraged to save because of the high interest rate.
Thus, financial institutions will have surplus funds to lend to the public for investment purpose thereby raising the volume of production in the real sector. Their empirical works have shown evidence that high interest rate induced investment in developing countries. Following these arguments, one important question that arises is whether the instability in interest rate observed in Nigerian data is expected to have a positive or negative effect on the manufacturing sector output.
Thus, in the case of interest rate reduction to pursue expansionary monetary policy, the concern would be whether it will stimulate the manufacturing sector output, or on the contrary? On the other hand, in the situation of a tight monetary policy, where the interest rate is relatively high, would it lead to a decline in the manufacturing output level or not? Sergi (2008) and Alade (2015) justified the need to identify the interest rate threshold beyond which an increase would be detrimental to growth in real sector. Also, Pai, and Pedersen (1999) suggested that the best efficient way to empirically fit the effect of interest rate on real output, is to use a threshold model.
This study attempts to fill the identified gaps by studying the situation in Nigeria and providing more empirical evidences on the interactive effect of interest rate and exchange rate on manufacturing sector output and dynamic relationship among exchange rate fluctuations, interest rate instability and manufacturing sector output. The study adopts sector-specific distribution shocks effects by examining the manufacturing sector output degree of response to shocks from exchange and interest rate uncertainties and compared the outcome with the distribution shock effects of these variables shocks to other sectors’ output. The study also examined the threshold values of exchange rate and interest rate that could have enhancing effect on manufacturing sector output.
1.3. Research Questions
In the light of the above research problem, the main research questions the study attempted to investigate were as follows.
i. In what ways exchange rate, interest rate and manufacturing sector have been managed over the years in Nigeria?
ii. What is the outcome of interest rate and exchange rate interaction on manufacturing sector output growth in Nigeria from 1986 to 2017?
iii. What are the dynamic effects of exchange rate fluctuations and interest rate instability on manufacturing sector output in Nigeria for the period under review?
iv. How has manufacturing sector output responded to the shocks emanating from uncertainties inherent in exchange rate and interest rate in Nigeria for the period under review?
v. What threshold levels of exchange rate and interest rate will spur manufacturing sector output growth in Nigeria?
1.4. Objectives of the Study
The broad objective of this study was to examine the exchange rate fluctuations and interest rate instability interaction with manufacturing sector output in Nigeria between 1986 and 2017. In line with the broad objective, the specific objectives were to
i. appraise different interest rate policies, exchange rate regimes and manufacturing sector in Nigeria from 1986 to 2017;
ii. determine the effect of interest rate and exchange rate interaction on manufacturing sector output in Nigeria for the period under review;
iii. investigate the dynamic effects of exchange rate fluctuations and interest rate instability on manufacturing sector output in Nigeria for the period under review;
iv. examine the response of manufacturing sector output to shocks from exchange rate fluctuations and interest rate instability in Nigeria for the period under review;
v. determine the threshold levels of exchange rate and interest rate that will spur manufacturing sector output in Nigeria for the period under review.
1.5. Justification of the Study
Manufacturing sector is a major driving force of any economy in the world, most especially developing countries, like Nigeria (Szirmai, 2012). Exchange rate and cost of credit are important factors that are often considered in economic policy formulation and framework for growth in any sector, and more importantly, manufacturing sector. Many studies that have attempted to investigate the nature of relationship existing among exchange rate, interest rate and manufacturing output revealed a mix results (Ibrahim & Amin, 2005; Dogruel, Dogruel, & Izmen, 2010; Charles, 2012; Enekwe, Ordu, & Nwoha, 2013; Odior, 2013) and are either single-equation or panel analysis, without investigating various shocks transmission of exchange rate fluctuations and interest rate instability to manufacturing sector output and distribution effects. More so, studies available were silent on the interaction of interest rate and exchange rate effect on manufacturing sector output and threshold of foreign exchange and interest rates on manufacturing sector.
This created a need to fill these gaps in knowledge by providing more empirical evidences on the interaction effect of interest rate and exchange rate on manufacturing sector output and dynamic relationship among exchange rate fluctuations, interest rate instability and manufacturing sector output. The study will take advantage of formulating a Vector Autoregressive (VAR) model to investigate the degree of manufacturing sector response to shocks in interest and exchange rate and examine the feedback effects of the two policy variables. In addition, the study identified the threshold of exchange and interest rates that will spur manufacturing sector output.
This will enhance deep understanding of exchange rate, interest rate and manufacturing output relationship in Nigeria and provide development of vibrant macroeconomic stability and also productive policies to further intensify the growth and development in Nigerian economy. The study would also enhance the efficiency and effectiveness of policy instruments in the effort to improving the productive capacity of Nigerian manufacturing sector. However , apart from the reason of importance of manufacturing sector to Nigeria’s economic growth as noted above, the focus of the study provides a unique opportunity to indirectly evaluate the distribution effects of exchange rate fluctuations and interest rate instability disturbances on sector-specific. The results should be relevant for less developed countries that are aiming to develop their manufacturing sector. Understanding specific responses of the manufacturing sector on exchange rate fluctuations and interest rate instability should prove useful for designing or making policy prescriptions especially during adverse shocks in the system. The knowledge from this work will give economic players in Nigeria the in-depth knowledge on how to develop the manufacturing sector. It will also add to stock of literature in the field of sector output. Hence, it will enable planners to consider policies for a specific component from both specific and overall point of view in the economy.
1.6. Scope of the Study
The study covers the period of 1986 to 2017 in to examining the relationship between exchange rate fluctuations, interest rate instability and manufacturing sector output as well as their threshold values. The choice of the period is not only limited to the availability of relevant data, but more importantly, 1986 preceded a period of structural changes in the economy. During this period, Nigeria adopted the international programmes of Structural Adjustment Programmes (SAP). This policy led to the deregulation of the financial system, adoption of various policies of exchange rate and establishment of various institutions to diversify the economy. The study focused more on exchange rate and interest rate as a monetary policy tools that has been discovered by extant studies to have a strong influence on manufacturing sector output.
The manufacturing sector output comprise aggregate output of sub-sectors under manufacturing sector such as oil refining, beverage and tobacco, chemical and pharmaceutical products, textile, apparel and footwear, cement, food, pulp, paper, and paper products, electrical and electronics, non-metallic products, plastic and rubber products, motor vehicles assembly basic metal, iron and steel, wood and wood products, and other manufacturing. The official average exchange rate is used because of its policy consistency and availability of the data over the period under study. The maximum lending rate was used to represent interest rate because it is more reliable than the prime lending rate due to its frequently application by banks on loan advances.
2. LITERATURE REVIEW
This section focused on the theoretical and empirical literature that linked exchange rate and interest rate variables with manufacturing sector. It described economic theories underpinning the study and reviewed related empirical literatures. The review of the existing related literature became relevant to understanding the dynamic interaction among exchange rate and interest rate and manufacturing output. Apart from the preamble, the sections include: section 2.1 which examined relevant theories, section 2.2 presented the empirical review, while section 2.3 discussed summary of gap in knowledge.
2.1. Theoretical Literature
2.1.1. Theories of Exchange Rate
There are various theories and approaches that are associated with determinants of exchange rate. Among the theories of exchange rate are:
220.127.116.11. Mint Parity Theory of Exchange Rate
This theory is related to the currency determination of the international gold standard. The gold standard was in operation before 1917 and lasted till 1930. In this system, gold was used in determining the value of currency that is used and this was converted into gold at a fixed rate. The value of the currency is being determined in terms of the weight of gold and this was measured by ounces of gold per naira or per pound sterling as the case may be. In this exchange rate determination, the Central Bank of the country usually bought and sold gold at a specified price at a rate which was convertible into gold. Under the mint parity theory, exchange rates are fixed, and all countries tie their currencies to gold and allow unrestricted import and export. However, the actual exchange rate could be higher or lower than the mint parity. This is as a result of the cost of moving the gold between the two countries. Thus two currencies on the gold standard will automatically have a fixed relationship with each other as determined by their gold content. As such, their exchange rate will be the ratio of their mint price of gold.
This theory was based on some assumptions. Among these are the price of gold is fixed by a country in terms of the currency; the country buys and sells gold at the fixed price; gold is moved between countries; the mechanism is adjusted automatically. However, the theory has some criticisms: it assumes no cost of buying and selling of gold; it assumes flexible prices contrary to the independent domestic price policies adopted by different government; the gold standard stop existence since 1930 (Jhingan, 2010).
18.104.22.168. Purchasing Power Parity Theory of Exchange Rate
The purchasing power parity (PPP) theory was developed by Swedish economist Gustav Casell in 1920. It was aimed at determining the exchange rate between two countries on inconvertible paper currencies. According to Suranovic (1997), Purchasing Power Parity is a theory of exchange rate determination as well as a comparison between the average cost of goods and services between countries. It believes that price levels between two countries should be equal to one another after exchange-rate adjustment. This implies that the exchange rate between the two countries should be proportional to the inflation rate of each country (Yahya, Bary-Ariffin, & Abdulhadi, 2011). According to Investopedia (2016), the foundation of this theory is the law of one price, which argues that for a country like Nigeria, should a naira price of a good be multiplied by the exchange rate, with respect to US Dollar, then it will result in an equal price of the good in US dollars. Thus, the cost of the same good should be equal around the world. From this theory, an arbitrage opportunity is created due to a large difference in price between two countries for the same product after exchange rate adjustment. The reason been that the product can be gotten from the country that sells it for the lowest price. The theory assumes that the importers and exporters actions in the international market are motivated by cross country price differences which leads to changes in the spot exchange rate. Therefore, under the assumption of law of one price (LOP), the PPP theory states that for product ‘g' 2.4 where is the domestic price of product ‘g', denotes the foreign price of product ‘g' and St is the nominal exchange rate of the domestic currency in terms of the foreign currency. If the assumptions hold and it is applied to tradable items, the nominal exchange rate is determined as , 2.5 where represents the ratio of weighted average of foreign price of all goods and weighted average of domestic price of all foreign goods (Yaaba, Bawa, and Idrisa 2012). The theory posits that the equality of the relative change in relative prices in the two countries determines the equilibrium exchange rate between the two countries on inconvertible paper currencies. There are basically two versions of the theory: the absolute and the relative versions. The absolute version explains the equality ratio of the price indexes in the two countries which determines the exchange rate, while the relative version compares the effects of inflation on an initial equilibrium rate of exchange. This second version of the PPP theory states that the exchange rate is determined at a point that determined the equilibrium between the respective purchasing powers of the two currencies, and this is refer to as a comparative-static proposition, which is not fixed but a moving par. Anyawu, (1993) noted that when the two versions have go through inflation, the nominal rate of exchange will be equal to the old rate multiply by the quotient of the degree of inflation in one country. In the purchasing power parity theory, there are no inflation differentials on their effects on the goods between countries because the PPP will automatically adjust to equal the ratio of the two countries price levels. The mechanism by which the adjustment will take place is that the currency of the country with the higher rate of inflation will depreciate, while the currency of the other country will appreciate by approximately the inflation difference (Anyawu, 1993).
22.214.171.124. Balance of Payments Theory of Exchange Rate
The Balance of Payments of a country comprises of two parts: the current and the capital. The balance of payment theory of exchange rate is only concerned with the current account which deals on the trade of tangible goods. This theory states that under the free exchange rate system, the exchange rate of a country’s currency depends on its Balance of Payments (BoPs). The exchange rate is determined by the demand and supply of foreign exchange through the demand and supply of tangible goods (Jhingan, 2010), and the exchange rate appreciates with a favourable Balance of Payments. For instance, a country having a huge current account surplus or deficit indicated that its exchange rate will not be in equilibrium.
To achieve equilibrium in the current account, the exchange rate will need to adjust over time. This is achieved when the demand for foreign exchange is equal to the supply at a given exchange rate and the value of payment made to the foreign country for goods and services purchased is equal to the receipts. On the other hand, when there is unfavourable BoPs, the exchange rate depreciates because the demand for foreign exchange is more than the supply and the value of payment made to the foreign country for goods and services purchased is more that receipts (Jhingan, 2010).
A situation the exchange rate depreciate, exports will increase and over time, eliminate the deficit in the Balance of Payments and restores of equilibrium in the Balance of Payments. Thus, any outcome in the conditions of the demand or supply of goods and services will influence the exchange rate and the BoPs.
126.96.36.199. Dombusch’s Overshooting Model of Exchange Rate
In 1976, Rudiger Dombusch extended the Mundell-Fleming model of exchange rate dynamics in an open economy with a perfect capital mobility to include rational expectations (Yaaba, et. al., 2012). The Dombusch’s model was developed to analyse the effect of exchange rate on real variables. This implies that real exchange rate is much less volatile when nominal exchange rate is fixed than when they are floating (Yakub, Ismail, & Belonwu, 2012). The model states that in a standard open economy where the economic agents have rational expectation (that is, perfect foresight where there is no uncertainty), the nominal exchange rate can “overshoot” its values in the long run. Therefore, some basic assumptions of the model are that the exchange rates and assets markets adjust faster than the goods market and the flexible prices is replaced with sticky prices. In the Dombusch’s model, uncovered interest rate parity and the monetary equilibrium of the simple monetary model are retained (Yakub, et. al., 2012). Two relatioships explain the Dombusch’s overshooting model. The first is the monetary equilibrium condition: 2.6 where mt is the money supply, pt is the domestic price level, it is the interest rate and yt is the domestic output, in this case manufacturing sector output. Equation 2.5 summarised the monetarist view which holds that higher interest rate increases the opportunity cost of holding money and thereby lower the demand for money according to the monetarist (Yakub, et. al., 2012). The second condition is the uncovered interest rat parity condition, given as: 2.7 where is the domestic interest rate, is the foreign interest rate and denotes the expected rate of depreciation of the exchange rate. According to Dombusch model, with sticky prices, an adjustment mechanism is necessary for an economy to converge to its equilibrium path in which full employment is realised. A fundamental assumption in the model is that if the real exchange rate is over valued, the demand for domestic goods will increase and vice versa. From this assumption, the third condition is an adjustment mechanism of the demand for domestic goods, which is expressed by solving the equation 2.6 and 2.7 simultaneously. Thus we arrive at 2.8 whereare logarithms of the domestic and foreign price levels respectively, are demand for domestic and foreign goods respectively and is a constant greater than zero. Kanmori and Zhao (2006) and Yakub, et. al. (2012) deduced that the one constant change in the supply of money necesitate a proportionte change in the exchange rate and price level in the long-run. However, the nominal exchnage rate is expected to overshoot its long-run equilibrium, while the price level is fixed in the short-run. Furthermore, the influence of a monetary shock on the exchnage rate is greater when prices are fixed than when they float. Following an initial overhooting after shock, the exchnge rate converges to its flexible-price equilibrium value. In summary, the model states that the exchange rate policy is unpredictable with the independence of monetary policy to some extent (Yakub, et. al., 2012).
188.8.131.52. The Traditional Flow Model of Exchange Rate
The traditional flow model of exchange rate viewed the rate of exchange of a particular domestic currency as the outcome of the market forces between the demand for, and the supply of foreign exchange. The model states that exchange rate is in a state of equilibrium at a point where supply and demand for foreign exchange are equals. Simply put, it is determined by the interaction of demand and supply of foreign exchange. Hence, any deviation in the exchange rate equilibrium will translate into current account imbalance (Iyoha, 2002). Equation 2.9 shows the summary of the model by presenting the factors of the real exchange rate (RER) as follows; 2.9 The independent variable I and r can also be defined as 2.10 2.11 where Rx = Exchange Rate, Yd = disposable income , Id = domestic rate of inflation, If = foreign rate of inflation, rd = domestic interest rate, rf = Foreign Interest Rate, r = domestic interest relative to foreign interest rate and I = inflation rate relative to foreign inflation rate. From the model above, it is prescribed that a country intending to strengthen its exchange rate, must choose a tight monetary policy by increasing its interest rate, reduce real income level and lower prices.
184.108.40.206. The Market Equilibrium theory of Exchange Rate
Kandil and Marzaie (2005) developed the Market Equilibrium theory. The theory states that at full employment, equilibrium in the domestic market requires both aggregate demand for and aggregate supply of domestic output to be equal. In this theory, two components determine shifts in demand and supply curves. These components are anticipated (steady-state) component and unanticipated (random) component. The random component explains the relations of demand and supply channels in the market and the movement of exchange rate. More evidently, real output, in relation of combination of aggregate demand and supply, depends on unanticipated movements in the exchange rate, government expenditure, general price level and the money supply. Additionally, on the demand-side channels, an increase in aggregate demand depends on unanticipated rise in the money supply or government expenditure, which generate positive price shocks and, therefore, lead to a rise in output and price in the short-run. On the other hand, the steady-state component describes the supply-side channels. This Supply-side channel establishes that output diverges with expected changes in the rate of exchange and the general price level in the short-run. The complexity of demand and supply channels that may determine the outcome of exchange rate fluctuations can be felt in the real market and money market. In the real market, an unanticipated exchange rate appreciation of the domestic currency will lead to exports to be less competitive and imports more attractive in the international market.
As a result, export will be more expensive in the international markets, thereby the demand for domestic goods will fall, which will lead to decrease in domestic output. However, an unanticipated temporary appreciating exchange rate shock to the domestic currency stimulate market agents to hold less domestic currency in the money market. These responses in the market will lead to a fall in the rate of interest. This channel tries to control the drop in aggregate demand and, hence, the contraction in output and price in the situation of shock from exchange rate appreciation. In addition, an unexpected shock from exchange rate appreciation reduces the cost of imported intermediate and capital inputs, lessening the cost of production and increase domestic output on the supply side.
220.127.116.11. Asset Market Model of Exchange Rate
The Asset Market Model also refer to as the portfolio balance model considered the activities of foreign investors that bring foreign exchange in form of inflow into a country for the purpose of acquiring financial instruments such as stocks, bonds and other securities. It considered the diversification of investors’ financial assets with the aim of decreasing the level of financial risk through investing among different financial instruments both domestic and foreign capital markets. A huge foreign investment inflow is expected to appreciate the exchange rate through the interactions of demand and supply of the domestic currency. This is because foreign investors will demand more of the local currency, hence, the price of the domestic currency, vis a vis foreign currency, will increase. The portfolio balance model compared the capital account of the Balance of Payments to the current account (Investopedia, 2016).