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1 TITLE PAGE THE IMPACT OF EXCHANGE RATE VARIATIONS ON AGGREGATE DEMAND IN NIGERA (1979 -2008) SUMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENT FOR THE AWARD OF BACHELORS DEREE (B.SC) IN ECONOMICS BY OCHENI AJUMA EC/2006/247 DEPARTMENT OF ECONOMICS FACULTY OF MANAGEMENT AND SOCIAL SCIENCES CARITAS UNIVERSITY, AMORJI-NIKE, EMENE ENUGU STATE AUGUST, 2010. 2 APPROVAL PAGE I Certify that this research was carried out by Ocheni Ajuma, Reg No: EC/2006/247 of the Department of Economics, Caritas University, Amorji-Nike, Emene, Enugu state. ________________________ Date _________________________ UGWU JOHNSON ______________________ Date_________________________ PETER ONWUDINJO H.O.D Economics Department _______________________ External Examiner Date _________________________ 3 DEDICATION This research work is dedicated to God Almightily, who has seen me through to this point in my academic endeavors. To Him alone be glory, honour and adoration (Amen). 4 ACKNOWLEGEMENT First and foremost, all thanks go to God Almighty for sparing my life and seeing me through to the final stage of this project. My gratitude also goes to my beloved parents, Hon. Mr. and Mrs. Ocheni for their love, encouragement and support in all forms and to my ever loving siblings. I shall not forget my supervisor Mr. Ugwu Johnson whose friendly and tireless effort contributes to making this project a reality. Lastly to all my friends “Big thanks to you all”. 5 ABSTRACT The study is a critical Evaluation of the impact of Exchange rate variation on Aggregate Demand in Nigeria. These study made use of the ordinary least square (OLS) regression technique in analyzing the impact of Exchange Rate Variation On Aggregate Demand in Nigeria. There are also other variables that determine the impact of Exchange Rate Variations on Aggregate Demand in Nigeria: 1979 -2008. Findings from the paper show that all the variables included in the models contributes in explaining the role of exchange rate on aggregate demand in Nigeria. These massive contributions of these variables may strongly depend on the circumstances in Nigerian economic environment. The starting point in reclaiming and re-inventing project in Nigeria is to squarely admit that oil and the manner we have designed to utilize it have constituted a stumbling block in Nigeria’s progress. Accordingly, there is need to pay specific attention to the contest of action and the production relations in the various sections of the economy. 6 TABLE OF CONTENTS Title Page = = = = = = = = = i Approval Page = = = = = = = = ii Dedication = = = = = = = = iii Acknowledgement = = = = = = = iv Abstract = = = = = = = v = = = = = = = vi = = = = = = = 1 1.1 Background of the Study = = = = = 1 1.2 Statement of Problems = = = = = = 5 1.3 Objective of the Study = = = = = = 6 = = Table of Content CHAPTER ONE Introduction = 7 1.4 Statements of Hypothesis 1.5 1.6 = = = = 7 Scope and Limitations of the Study = = = 7 Significance of the Study = = = 8 = = = CHAPTER TWO: LITERATURE REVIEW 2.1 Review of Theoretical Literature = = = = 10 2.2 Exchange ate Determination Models = = = 11 2.2.1 Flexible Price Monetary Model = = = = 12 2.2.2 Sticky Price Monetary Model = = = = 13 = = 14 = = 15 = = 16 2.2.3 Equilibrium Model and Liquidity Model 2.2.4 Portfolio Balance Model 2.3 = = = An Overview of Exchange Rate Regimes 2.3.1 The Gold Standard Regime = = = = = 17 2.3.2 Flexible Exchange Rate Regime = = = = 18 8 2.3.3 The Crawling Peg Regime = = = = = 19 2.3.4 The Managed Float Regime = = = = = 20 2.3.5 The European Monetary System = = = = 21 An Evaluation of Exchange Rate Regimes in Nigeria = 22 2.4 2.4.1 The Pre – Sap ara = = = = = = 23 2.4.2 The Post –Sapara = = = = = = 24 = = = = 26 2.5 Exchange Rate Determinants 2.5.1 Interest Rate = = = = = = = 28 2.5.2 Transaction Motive = = = = = = 29 2.5.3 Volume of International Transaction = = = 29 2.5.4 Political Instability = = = = = = 30 2.5.5 Policy Actions = = = = = = 31 Review of Empirical Literature = = = = 32 2.6 = 9 2.6.1 Empirical Literature on the Study using Foreign Data set = = = = = = = = = = = = = = = = = = = = = == = 32 2.6.2 Empirical Literature on the Study Using Nigerian Data set = = = = = = == = = = = = = = = = = = 34 CHAPTER THREE: METHODOLOGY 3.1 An Overview of the Model = = = = = = = = = = = = = = = 49 3.2 Model Specification = = = = = = = = = == = = = = = = = = 50 3.3 Unit Root Test = = = = = = = = = = = = = = = = = = = = = = 52 3.4 Co Integration and Error Correction = = = = = = = = = = = 53 3.5.1 Economic Criteria = = = = = = = = = = = = = = = = = = = = 54 3.5.2 Statistical Criteria = = = = = = = = = = = = = = = = = = = = 54 3.5.3 Economics = = = = = = = = = = = = = = = = = = = = = = = = 54 10 CHAPTER FOUR: PRESENTATION AND ANALYSIS OF RESULT 4.1 ADF Test for Stationary = = = == = = = = = = = = = == = 58 4.2 CO Integration Test = = = = = = = = = = = = = = = = = = = 60 4.3 Result from Modeling log of GDP by OLS = = = = = = = 62 4.4 Economic Interpretation = = = = = = = = = = = = = = = = =63 4.5 Statistical Criteria = = = = = = = = = = = = = = = = = = = = 69 4.5.1 T. Value = = = = = = = = = = = = = = = = = = = = = = = = = 70 4.5.2 F- Test = = = = = = = = = = = = = = = = = = = = = = = = = = 70 4.6 Evaluation based on econometric Criteria = = = = = = = = 71 4.6.2 Test for Hetrosedasticity = = = = = = = = = = = = = = = = =71 4.6.3 Test for Multicollinearity = = = = = = = = = = = = = = = = =73 4.6.4 Normality Test = = = = = = = = = = = = = = = = = == = = = 74 4.6.5 Test for Adequacy of the Model = = = = = = = = = = = = = 75 4.7 Evaluation of the Hypothesis = = = = = = = = = = = = = = = =76 11 CHAPTER FIVE 5.1 Summary = = = = = = = = = = = = = = = = = = = = = = = = = 78 5.2 Conclusion = = = = = = = = = = = = = = = = = = = = = = = = = 79 5.3 Policy Implications = = = = = = = = = = = = = = = = = = = = = 81 Bibliography = = = = = = = = = = = = = = = = = = = = = = = = = = 85 12 CHAPTER ONE INTROUDCTION 1.1 BACKGROUND OF THE STUDY All over the world, policy makers have always been on the move to ensure that there is sustainable growth rate in the economies of the world. As a result, a lot of economic factors have been brought to the fore to examine and investigate how they could be relevant in the achievement of their economic objectives. In Nigeria, several government regimes have experimented on many economic factors (macroeconomic aggregates) to determine how economic growth could both be attained and sustained. Prior to the introduction of the structural adjustment programme (SAP) of 1986, that had exchange rate devaluation as one of its policy measures, the economy of Nigeria ‘headed for the rocks’ and was highly distressed. This led to a decline in the 13 country’s external reserves at a disturbing rate. The country’s debt stool was accumulated to an unfavorable level among others. In spite of this the naira exchange rate was overvalued leading to dexterous effect on the economy. It was opinioned that exchange rate policy embarked upon by the Nigeria government, in August 1986,was to eliminate the observed distortions in the economy and bring about a sustainable growth in the economy. Since exchange influences the interaction of household, business firms, private financial institutions and the central bank, it implies that it could also affect aggregate demand in Nigeria. Knowing fully well that exchange rate is a real phenomenon; variations in relative prices affect both economic performance and aggregate demand. Hence, exchange rate is a relative price between domestic currency. For instance, if the exchange rate between British Pounds sterling and Nigeria Naira is N250 per 14 Pound, it follows that one pound exchange for N250 in the world foreign (currency) exchange market. Exchange rates are of two broad categories. They include: 1. The fixed exchange rate and 2. The flexible exchange rate The fixed exchange rates are pegged rates within narrow range of values by the central bank on trade of currencies while the flexible exchange also called FLOATING exchange rate is the rate that is determined by the forces of demand and supply. Government has little direct control on the foreign exchange market that is flexible in nature. Variation of exchange rates over the years are known to have ripple effects on some other macroeconomic variables like aggregate demand. This fact underscores the pertinence of exchange rate to the economic well being of countries that open 15 their doors to international trade (Kombe, 2004). Due to the impact exchange rate regimes have on economies of the world, economists consider it vital to verify how their countries exchange rate are determined since different regimes of exchange rate show different economic effects (Kujis, 1998). Exchange rate determination varies from country to country. Part exchange rate regimes in Nigeria have been directed to control the use of foreign exchange at official determined rates. However, current policy options have shown an interest in market- determined exchange rate most current records show that the CBN has adapted an exchange rate regime that is neither pegged nor floating but a combination of both regimes called the MANAGED FLOAT exchange rate. This research work intends to look into the determinants of exchange rate in Nigeria and the 16 impact exchange rate variations exert on aggregate demand in Nigeria. 1.2 STATEMENT OF PROBLEM Economic and political analysts have reached a consensus on what a good exchange rate is as well as how it could both be operated and sustained. In most economic papers and literature, the major issues have been the need for competitive exchange rate stability and structural adjustments in the promotion of this competitiveness. However, since exchange rate reveals competitiveness of exports from domestic economies to the outside world, the economic implication of its variations need to be ascertained so that good exchange rate policies that will be realistic in consonance with aggregate demand could be formulated, adopted and operated. 17 Therefore, this study aims at providing answers to the questions stated below in order to ensure that viability reigns in the market. 1) Are exchange rate and aggregate demand variable stationary? 2) Does exchange rate variations have affect any impact on aggregate demand? 3) To what extent does exchange rate affect aggregate demand in Nigeria? 1.3 OBJECTIVES OF THE STUDY The specific objective of this economic study are: 1. To ascertain the impact of exchange rate variations on aggregate demand. 2. To estimate if there exists any casual relationship between exchange rate and aggregate demand. 18 1.4 STATEMENT OF HYPOTHESIS The following null hypothesis are to be stated for the statistical significance and non – significance of data. Hi: Exchange rate instability has no impact on aggregate demand in Nigeria. H2: There is no casual relationship between exchange rate and aggregate demand in Nigeria. 1.5 SCOPE AND LIMITATIONS OF THE STUDY The length of period within which this study covered is thirty years. This falls between the periods of 1976 and 2006. This essence of this is to enable the observation for the research work compensate for degree of freedom that could be cost. 19 1.6 SIGNIFICANCE OF THE STUDY Research work of this kind is usually treated directly with the variables lifted from their sources. However, in this study, the directives of Philips (1986), which states that they are statutory, will be adopted to be assured that the result from this work is reliable for other policy works. Thus, the findings of this study will be of great importance to a lot of people. Firstly, researchers carrying out research work on the influence of exchange rate in Nigeria would find this research work helpful. Secondly, policy makers who wish to formulate policies on the effects of exchange rate instability would find this research work handy. Thirdly, business firms and investors as well as exporters who need to know when it is convenient to operate in business and when it is not, would find this research work a present- help in their periods of economic 20 decision- making. Again, the central bank of Nigeria, the monetary authorities (financial ministries and policy formulators would find this research work vital in regulating exchange rate regimes appropriately in terms of intervention of the government into the economic system through the central bank. Finally, due to revolutionary steps taken in this research work, the end product of this study would add to knowledge, no matter how infinitesimal, as a contribution for a sustainable economic growth in Nigeria. 21 CHAPTER TWO LITERATURE REVIEW 2.1 REVIEW OF THEORETICAL LITERATURE The importance of exchange rate policies in economic adjustments cannot be overemphasized as it has become the subject of considerable debate in many economies in the word today. Several economists in the world today have discovered that in the bid to achieve certain objectives, that are economy wide in nature, the issue of exchange rate cannot be handled lightly. They try to see if exchange rate instabilities affect other macroeconomic aggregates positively or negatively over time. Efforts have also been made to see if the economic problems of the Less Developed Countries (LDCs) could be tackled employing 22 exchanging ate policy as a vital instrument. To this end, several exchange rate models were propounded by different economies in the world to suggest how exchange rate could, in the first place, be determined. 2.2 EXCHANGE RATE DERMINIATION MODELS exchange rate determination has been a crucial issue in economic research. As a result, several schools of though propounded different ways by which exchange ate could be determined. Before the 1970’s the Keynesian model, which was developed by James Meode (1951), dominated the scene. In 1962 and 1963, it was amended by Marcus Fleming and Robert Murdell respectively to be known as the Mudell-Fleming model. However during the 1970s, other exchange rate models, which were based 23 on considerations of stock equilibrium in the financial market internationally, were developed. 2.2.1 FLEXIBLE PRICE MONETARY MODEL The flexible price approach defines exchange rate as “The relative price of two currencies”. It went ahead to model the relative price in terms of the relative supply of and demand for the currencies. The model assumed a continuous purchasing power parity (PPP). It stipulates that since domestic money supply determines the domestic price level, the exchange rate is, thus, determined by the RELATIVE MONEY SUPPLY. Hence, a rise in domestic money stock ceteris paribus. So, to increase their real money balances, households reduce their expenditure which will cause general price level to fall up to the point where equilibrium is established in the money market, invariably, the domestic currency apprecitates in terms of the foreign currency. 24 From the fore-going this approach is a market clearing model of the general equilibrium in which continuous purchasing power parity is assumed However, the assumptions of the purchasing power parity was altered due to the high volatility of real exchange rate in the 1970’s. This led to the development of two other classes of models, namely: the sticky-price monetary model and the equilibrium model. 2.2.2 STICKY-PRICE MONETARY MODEL The sticky-price monetary model is the exchange rate model that allows for short term increases of the nominal and real exchange rates over their long run equilibrium levels. Usually, the interest rate compensates for stickiness in other aggregates that operate as jump variables in the exchange rate system. 25 The sticky nature of price in the shorten translate to an initial fall in real money supply and a consequent rise in interest rate to clear the money market. This increase in domestic interest rate cause capital inflow and an appreciation of the nominal exchange rate. A short run equilibrium would be sustained if the expected rate of depreciation is equal to the interest rate differentials. To alleviate pressure in the money market, in the medium run, domestic prices begin to fall in response to fall in money supply, and domestic interest rate also declines. This will invariably cause exchange rate to gradually deprecate to the long run purchasing power parity. 2.2.3 EQUILIBRIUM MODEL AND LIQUIDITY MODEL The equilibrium exchange rate model was the model developed by Alan Stockman and Robert Lucas in 1980 and 1982 respectively. The model analyses the general equilibrium of two 26 countries by maximizing the expected present value of a representative agent’s utility, subject to budget constraints. The equilibrium models are an extension of the generalization of the flexible price monetary model to give way for multiple-trade goods and real stocks across the countries. In this model, a rise n per capital output has two analytical effects, namely: The REALISTIC PRICE effect and the MONEY DEMAND EFFECT. The realistic price effect involves a reduction in price of domestic output while the money demand effect appreciates domestic currency as the demand for money (of transaction) increases. 2.2.4 PORFOLIO BALANCE MODEL The portfolio balance model is the exchange rate model that assumed that between domestic and foreign assets three exists an imperfect substitutability. In the model, a very basic model was set out which stipulated that net financial wealth of private 27 sectors can be split into three (3) namely: Money, Local Bonds And Foreign Bonds. The concluded that domestically-issued bonds could be viewed as government debts help by the local private sector as well as the level of net claims on foreigners held by the private sector. Under a free flat, a current account surplus on the balance of payment must be matched equally by a capital account deficit. 2.3 AN OVERVIEW OF EXCHANGE RATE REGIMES All over the world today, several exchange rate regimes are being operated to achieve a more realistic and sustainable economy. Broadly speaking, two (2) major exchange rate regimes were being operated before now. They include the PEGGED and FLOATING exchange rate regimes. 28 However, due to more attempts by the world economists to attain a perfect or near perfect situation around the globe, three new ones were developed. They include the crawling (adjustable) peg, the managed float and the exchange rate bonds. 2.3.1 THE GOLD STANDRD REGIME The regime preceded the establishment of the Britton wood (1988) that involved the government fixing the price of gold in terms of its domestic currency. The supply of domestic currency was linked to the supply of gold. Domestic currencies of most countries were maintained to be convertible into gold. Hence, the exchange rate in the gold standard was pegged (fixed) causing exchange to be stable. Moreover, the government abided by a rule that linked domestic money creation to the governments holding of gold. 29 The regime was in vogue until 1971 when the convertible of the Dollar into gold was suspended by the United States on account of Balance of Payment problems. The regime became obsolete and infective when the demand for foreign exchange reserves outgrew the supply of gold. Thus, it could no longer sustain the international demand for foreign exchange. 2.3.2 FLEXIBLE EXCHANGE RATE REGIME This exchange rate regimes, also known as floating exchange rate regime, involves the determination of the exchange rate through the forces of demand for and supply of foreign exchange between two countries. It evolved as a result of the global monetary crisis withnessed in 1971 arising fro the decision by some countries to float their currencies against the American Dollar and other currencies. 30 In this regime, equilibrium level is stained without government intervention. That is, exchange rate is allow to establish it equilibrium through the interplay of the market forces via the PURCHASNG POWER PARITY (PPP) approach which stated that “homogenous products should maintain equal prices in all countries Alternatively, in general, the price of a bundle of goods produced in two countries should be similar when expressed in a common currency. Furthermore, it predicts that exchange rate between two countries will adjust to reflect the price level difference between the two countries in the longrum. 2.3.3 THE CRAWLING PEG REGIME The crawling peg regime also called the adjustable peg or Dollar standard, involved the agreement reached by counties to peg their exchange rate against the Dollar and occasionally alter it 31 until a planned point is attained in a pre-determined future. This followed that exchange rate were fixed but countries could alter them up to the desired rate. This regime evolved after the second world war. It was quite different from the gold standard which had a 100% backing for the domestic currency to be printed by government at will. 2.3.4 THE MANAGED FLOAT REGIME This exchange rate regime is the regime that blends the features of freely floating exchange rate with Central Banks’ intervention to ensure that governments’ objectives are attained. It was embraced when more and more countries abandoned the fixed and floating regimes. It stipulated that the market forces were allowed to determined the exchange rate within defined bounds (minimum and maximum). The exchange rate regime became useful to several countries of the world as the government, through the 32 monetary authorities, employ it as an effective instrument to discourage demand on consumption of certain goods (eg imports). Hence, the central ban intervenes in the market to either cause stability or movement of the exchange rate in a predetermined direction. Currently in Nigeria, the managed float regime is the system operated to achieve government predetermined goals. 2.3.5 THE EUROPEAN MONETARY SYSTEM Following a resolution that the European currency unit (ECU) would be used as a unit of account for specialized transactions between governments of member states, the European monetary cooperation fund and receives ECU’s in exchange was established to create a link of monetary cooperation that was set out to bring monetary stability in Europe. 33 Some eight (8) European countries – Denmark, Belgium, Ireland, Netherelands, Spain, Germany, France and Italy pegged their currencies to each other and formed a system called the European monetary system (EMS) Apart from the pegging between Spanish and Italian currencies that allows a float of± 6%, no member country was allowed to move or float by more than± 2.25. 2.4 AN EVALUATION OF EXCHANGE RATE REGIMES IN NIGERIA The exchange rage regimes in Nigeria dates back to 1959, when the Nigerian currency maintained equal ranking with the British pound sterling, until the devaluation of the pound sterling by 10% in 1967. 34 2.4.1 THE PRE-SAP ERA This period spanned between 1962 to 1986, also referred to as the period of exchange control. The currency was allowed to move independent of the sterling to include the US dollar in the basket of currencies for determining the value of the naira after the country’s currency was changed to Naira in 1973. The pond sterling and the dollar had fixed exchange rates to the naira at 0.58 and 1.52 respectively. In 1978, a basket method of calculating the exchange rate was established in which the weights of both the pound sterling an the US Dollar were alternatively high. In 1985, the US Dollar was adopted as a currency intervention system where the naira linked to it as an intervention currency in order to reduce the perennial problem of high incidence of arbitrage in naira exchange rate. 35 Thus, the Nigeria exchange rate was quoted against the US dollar as a single intervention currency. 2.42 THE POST – SAP ERA In 1986, (September), the second- tier foreign exchange market (SFEM) decree was promulgated. It provided a flexible (floating) exchange rate system (a regime that involve two separate rates operate in the foreign exchange market). They are the FIRST – TIER and SECOND-TIER exchange rates. While the first-tier exchange rate was the OFFICIL rate, the SECOND-tier exchange rate was CENTRAL BANK-ORIENTED. Thus, it was operated by the Central Bank to achieve government’s goals. In 1987 (July), the first-tier and second-exchange rates were merged into a single exchange rate-the FOREIGN EXCHANGE MARKET (FEM) as a result of the lots of abuses and 36 multiplication of rates, which led to further depreciation of the naira, that the exchange rate system had created. In 1988, an autonomous rate was merged with the FEM to produce the inter-bank foreign exchange market (IFEM) as the exchange rate of the naira that experienced continuous fluctuations. In a bid to bring up the value of the naira, the 1994. in 1995, the dual exchange rate was re-introduced and this time called GUIDED DREGULATION. The, the Autonomous Foreign Exchange Market (AFEM) was establish through the Decree no 17 of 1995 on Foreign exchange for private source of foreign exchange. In this case, while the exchange rate at the AFEM was determined by the market, the CBN intervened occasionally to stabilize the naira exchange rate. Conclusively, in 1997 the official market maintained a fixed exchange rate for genuine government transaction. Thus, the dual 37 exchange rate was retained of which the official selling rate was pegged at N21.996 to the Dollar. This led to stability in the normal exchange rate in the year 1995-1997 at the AFEM and the value of the naira appreciated. However, in 1999 an inter-bank foreign exchange market (IFEM) was introduced to replace the AFEM in order to enhance transparency and allocative efficiency of the foreign exchange market. 2.5 EXCHANGE RATE DETERMINANTS Exchange rate determination varies from one country to another as well as from period to period. Past exchange rate policies in Nigeria have often been directed at efforts to resist the use of foreign exchange at officially determined exchange rate. The main objective of a nations exchange rate policy is to have a stable and realistic exchange rate that is in consonance with other 38 macroeconomic fundamentals. To attain this objective, a nation may be compelled to shift the exchange ate level in line with what the economy dictates. In most countries of the world, exchange rates are marketdetermined without government intervention whereas in some other economies, the exchange rate may be institutionally determined where rate is pegged by fiat to one or more convertible currencies. In between the two extreme cases of exchange rate determination lines lies the dual exchange rate determinations which is an admixture of both extreme systems of FLAT and MARKET DETERMINED rates. Thus, exchange rate regime determination is a function of the type of exchange rate regime adopted. Major factors that affect exchange rate determination and its shots are the policy stance of government and the activities of the operators of foreign exchange market. 39 In conclusion, from experience internationally, no country leaves it exchange rate determination completely to the market forces as some level of intervention is applied occasionally. Exchange rate stability will only be significant if it is measure in elation to estimated equilibrium rate of the currency-the purchasing power parity (PPP) Generally, the exchange rate of an economy’s currency could be determined by any of interest rate, transaction motive, volume of international transaction, political instability, policy action, etc. 2.5.1 INTEREST RATE Interest rate can be seen as the price paid for money borrowed. When interest rate rises in one country, people in and around the country will be interested to invest in the country. Hence, an increase in the exchange rate of the country. If there is a fall, on 40 the other hand, in interest rate the volume of investment will be lowered. Hence, a depreciation in the country’s currency. 2.5.2 TRANSACTION MOTIVE This handles motives for holding money for purchases. W hen there is a rise in the level of demand for a country’s currency for purchase of goods and services obtained in a country, the exchange rate for that country will rise. However, if there is a fall in the level of demand for a countries currency for transaction motive, the exchange rate of the country’s currency will fall. 2.5.3 VOLUME OF INTERNATIONAL TRANSACTIONS This refers to the movement of goods and services across the borders of a country in relation to other countries. If the volume of goods and services moving out of a country (export) is ,more than the volume of goods and services into the country (import), 41 there wil be an inflow of foreign exchange. Hence, a rise in exchange rate. However, if the volume of import of the country is higher that the volume of export, then will be an outflow of foreign exchange and consequently a fall in exchange rate. Hence, a depreciation in the country’s currency. 2.5.4 POLITICAL INSTABILITY This refers to the political situation of a country as it relates to governance and socioeconomic circumstances. If the political situation of a country is table and void of political disturbances, investors will be encouraged to invest in the economy. Hence, rise in the exchange rate due to capital inflow for investment. However, when the political situation of the country is unstable and full of disturbance, it results in the folding up of firms and transferring of funds out of the country causing a drain in the foreign reserves an discourage investors firm investing in the 42 country. Hence, a fall in the exchange rate of the country’s currency. 2.5.5 POLICY ACTIONS This refers to the monetary and fiscal policy adopted by a particular country. The monetary and fiscal policies adopted by a country results in capital flows between countries. If a country adopts a tight monetary policy, this will cause the interest rate to trise and cause investors to invest in the country. Hence, inflow of capital and a rise in the country’s exchange rate. However, if a country adopts a loose monetary policy, the interest rate will fall and cause investors to shy away to invest elsewhere. This will cause an outflow of capital and lead to a fall in exchange rate. 43 2.6 REVIEW OF EXPIRICAL LITERATRE Several empirical researches have exhibited strong proofs of the impact of exchange rate variations on other macro-economic aggregates. Mitechell (2006) observed that economic theory is vital in providing a model for comprehending the workings of the globe, however, evidence helps to determine which economic theory is correct. 2.6.1 EMPIRICAL LITERATURE ON THE STUDY USING FOREIGN DATA SET. Gyltasm and Schmid (1983) constructed a small macroeconomic model with intermediate goods having two conflicting effects generating an expansion through aggregate demand on one hand and having a devaluation result through its effect on the cost of imported inputs on the other hand. The parameter estimate of 44 countries were used to show that the demand effect dominates the cost effect in most cases (i.e in industrial and developing economies). Kombe Oswld M (2004) showed the movement of Zambia’s real effective exchange rate using the vector error correction model and quarterly time series data between 1973 and 1997 and concluded that exchange rate is different from models based on international monetary fund statistics. Branson (1980) constructed specific simulation model for Kenya which suggested that devaluation will have vital contraction effect in the Kenyan economy. Taylor and Rozensweig (1984) stimulated the effect of a number of policy measures including devaluation on economic growth for Thailand and suggested that exchange rate devaluation will have expansionary effect and generate an 45 increase in real GDP in the economy in a bid to provide solutions to the controversy whether exchange rate devaluation was concretionary or expansionary Edward (1986) brought out an empirical analysis which showed that devaluation has a negative shorten effect on output and expansionary effect in output growth in the medium term. Using the data in Latin America (1962-1982) he suggested that the observed decline in output growth in the period may not be a consequence of exchange rate changes but may rather reflect the effect of an imposition of restrictions and other policies that accompanied devaluation in that country. He concluded that it was the same case in the LDCs as it was pretty difficult to separate the effects of devaluation from macroeconomic policies after implemented pari-passu. Agenir (1991) showed that an anticipated depreciation of real exchange rate has a negative effect on economic activities 46 while an unanticipated depreciation has a positive impact on output, contrary to Edward’s result in 1986. According to Karl Marx [1992] . Devaluation tends to be contractionary in nature , the lower the Elasticity Of Substitution between imported inputs and domestic value added, the higher the degree of wage indexation coefficient, Morley [1992] conducted a cross sectional study on the impact of real devaluation on capacity utilization, during stabilization programme in the LDCs when significant nominal devaluation was above 15%. The outcome showed that while real devaluation tended to reduce output, it took at least two years to have their full effect. He also revealed that devaluation was not linked with significant rise in private savings as only investment declined. Hence, factors such as terms of trade and the capacity to import has a positive significant effect. 47 Moving from exchange rate impact on output level to the impact of exchange rate impact on inflation (domestic price level). Billson, Bon, Kenen and Pack (1980) postulated that exchange rate and foreign price level affect the domestic price level whereas the vicious cycle hypothesis maintained that exchange rate changes constitute an independent source of inflationary pressure where exchange rate and price level drive each other . Ndunga (1996) conducted a study to determine the degree of correlation between the exchange rate and inflation covering a period of twenty-three years (1970-1993) when accelerated money supply growth, fiscal difficulty, foreign exchange squeezes, etc were witnessed in Kenya. He found out that the rate of inflation and exchange rate changes drove each other while the foreign rate of inflation and the real 48 effective exchange rate drove the nominal effective exchange rate changes. When a study on the link between devaluation and inflation was done in Ghana by Younger (1992), the study showed that a 100% increase in exchange rate led to rise in prices by – 10%. Lonelon (1989) examined the role of money supply and exchange rate in the inflationary process in twenty three African countries and found out that during the period, money supply, expected inflation, real income and exchange rate devaluation were all vital determinants of inflation in the sampled countries. Carbo (1985) employed a macro model to explain the dynamics of the Chilean inflation during the periods 197-1982 it was unraveled that inflation rate was precipitated by exchange rate variations and wage indexation. 49 Liviation (1980) in his contribution stated inflation as highly linked to exchange rate changes (prompted by balance of payment crisis). He opinioned that exchange rate depreciation increases the underlying rate of inflation either through measures in inflationary expectation which will be accommodated by the monetary authorities or the wage indexation mechanism. Chiber (1991), concluded a study on the causes of inflation in African countries. It was discovered that there exists a correlation between exchange rate regimes and inflation. He stipulated that the country with floating exchange rate regimes tend to experience higher inflation than those with pegged exchange rate. However, he stressed that the underlying cause of inflation was the high fiscal deficits financed primarily by money creation. Goldstein (1974) constructed a simple 2-equation wage price model to estimate the impact of exchange rate on the United 50 Kingdom’s wage and inflation level. He discovered that thee were some vital changes in wage behaviour. But, it was difficult to relate the changes directly to the devaluation as other factors and economy policies acted on wages and prices simultaneously. Thus, it was difficult to assign to any policy action arising from observed changes in wage-price behaviour after devaluation. Finally, considering exchange rate impact on import demand Grafot (1980) in his study examined various approaches to the balance of balance of payment adjustments, using Jamaica as a case study. After employing the ordinary least square for sample periods (1954-1973), he found out that relative prices and income are vital factors that influence the demand for imports when he estimated the import and export demand function. It was also discovered that disaggregates of imports led to better and more reliable estimates the import demand. Akakaiyi (1985) did an 51 investigation on the situation under which devaluation may really function in the short run as an adjustment instrument. He found out that if the elasticity is such that the relevant import structure does not hold, devaluation should be accompanied by a form of import re-structuring. Thus, before a country embarks on such a policy, it should obtain estimates of the price elasticity of demand for at least two categories of imports namely: competitive imports and non-competitive imports. Bhagwat and Orutsuka (1974) attempted to assess the importexport response upon devaluation with the help of selected quantitative indicators that are designed to be applicable to a varied cross-section of countries. They discovered that higher domestic prices of imports upon devaluation affect demand adversely and encouraged substitution of domestic goods for imported ones both in production and consumption. Thus, the 52 rise in demand for import sterming from the export-led level of domestic economic activity and from import- liberalization measures was stronger than the price effect of devaluation in the opposite direction. It was also discovered that the behaviour of imports after devaluation depends on the monetary-fiscal and wage policies of the period in consideration. 2.6.2 EMPIRICAL LITERATURE ON THE STUDY USING NIGERIAN DATA SET Olofin et al (1986) made a study in connection with the devaluation of the naira. It simulated different devaluation scenarios of the Nigerian economy within the framework of a macro model. Their discovery suggested that devaluation will neither improve external balance position nor would it succeed in effecting major internal adjustments at least in the short-run even 53 when combined with fiscal measures of expenditure. Also, the study showed that the cost of any amount of devaluation would far out-weigh any benefit that might be expected through internal and external adjustments. Egwaikhide (1993), built a macro- model of the Nigerian economy an evaluated the historical impact of devaluation on the indicators of growth like LGD, investment, inflation, etc. He discovered, after employing a simulation procedure of a 50% devaluation of exchange rate that while GDP fell, the balance of payment improved marginally. He added that the situation will lead to an increase in money supply which propels inflation. Hence, it stipulates that devaluation may necessarily be inflationary. He concluded that in order to maintain both internal and external balance, devaluation must necessarily be completed with the appropriate money and fiscal measures. 54 Fakiyesi (1996), employed OLS technique on data covering 19601994 and discovered that exchange rate depreciation, monetary expansion, inadequate output, inflation expectation etc are the major determination of inflation in Nigeria. He concluded that effective fiscal and money tools will stimulate productivity in the real sector and proper management of exchange rate might limit the growth of inflation. Moser (1995), carried out a research on the factors that real exchange rate and money supply are major determinants of inflationary pressure in Nigeria. Dprbusch and Fischer (1993) after studying, presented the study on moderate inflation occurences because of external shocks in commodity prices, increased production costs, fiscal deficits and exchange rate. 55 Their study also confirmed that inflation can be reduced to low levels through a combination of light fiscal policy, income policy and some exchange rate commitments. Ukpolo (1987) examined what the effect of a combination of devaluation policy with trade liberalization he discovered that BOP situation of the LDCs will improve with enormous trade imbalance using Nigerian data as a case study to assess the impact of devaluation on the net foreign exchange earnings and on the economy. The devaluation of the naira was unique with implications for being a one sector dominant economy. Thus, the elasticity of the value of imports was relatively inelastic. The proportionate drop in the quantity of imports was out weighed by the proportionate rise in the domestic price of imports in the country. In effect, Nigeria could not take advantage of the competitive edge that was gained through devaluation due to the 56 lack of short term responsiveness to import-substitution production. Ayodele (1985) demonstrated that exchange rate changes have significant impact on Nigeria external account. In his stuy, the concept of effective exchange rate data was employed so as to capture the effective changes in the cost of imports that are occasional by changes in the exchange rate along Nigeria major trading partners. The study adopted the flow of funds approach for modeling the foreign sector of the Nigerian economy. He discovered that an increase by a naira in the effective price of foreign exchange would result in increases of N403.73, N71.88 and N475.61 million in the net capital inflow, current account balances and the foreign reserve positions respectively after two years. According to him, this favourable effect wee not well captured by previous studies because the researchers often failed 57 to employ the correct measures of exchange rate between Nigeria and the rest of the word. Also, he added that he allowed enough time for the discounting of the currency by 2% on the parallel (non-official)market. A standby arrangement was adopted as a solution to the gap that existed between the official and parallel markets exchange rates. Inflation which had fallen to 0% in April 2000 reached 14.5% by the end of that ear and 18.7% in August, 2001. In 2000, higher world oil prices resulted in government revenue of over 16 billion dollars (about double the 1999 level). Looking into the import-export relation, in 2004, importation of goods was to the tune of 26 billion US dollars. The leading sources included China (9.4%) the United States (8.4%), the United Kingdom (7.8%), the Netherlands (5.9%), France (5.4%), Germany (4.8%), and Italy (4.0%). The imported goods constituted: manufactured goods machinery , transport 58 equipment, chemicals, foods, and live animals. Exports of foods, on the other hand, was to the tune of 52 billion US dollars. The leading destination of exports were the United States (47.4%), Brazil (10.7%) and Spain (7.1%). In the 2004 also, oil accounted for about 95% of merchandise export while cocoa and rubber accounted for 60% of the remainder. In 2005, Nigeria posted a 26 billion US dollar trade surplus corresponding to almost 20% of GDP, achieving a posted current account balance of 9.6 billion US dollars. Moreover, a major breakthrough was achieved by Nigeria in the same year. An agreement was reached with the Paris Club to eliminate the country’s bilateral debt through a combination of write down and buy-backs. In mid-June of 2006, the exchange rate was pegged at 128.4 naira to the US dollar. Data shows that External debt with the London Club is 12 billon US dollars with external reserves of 59 49 billion dollars (December 2oo6). The exchange rate trend between 2000 and 2006 follows thus: 2005 – 128 naira to the Us dollar 2004 – 132.89 naira to the US dollar 2003 – 129.22 naira to the US dollar 2002 – 120.58 naira to the US dollar 2001 – 111. 23 naira to the Us dollar 60 CHAPTER THREE METHODOLOGY 3.1 An Overview of the Model The study shall follow a linear specification via the partial adjustment approach. At the broadest level of generalization, theories and empirical studies have established strong evidence of a correlation between exchange rate variation and aggregate demand as proxy by gross domestic product. Informal activities such as variations in broad money supply instruments, government expenditure, inflation rate, foreign reserve, interest rate and real exchange rate, are generally highly dynamic and their influence transmits into other macroeconomic variables. The relationship between variations in exchange rate is therefore likely to be dynamic in nature and therefore has influence on the aggregate demand in an economy. 61 Apart from the impact analysis component of this study, the degree of responsiveness of macroeconomic instability to changes in these instruments shall be measured. A point to note here is that the variables would be in their log forms in order for scaling purposes. Also, the Error Correction Model, if co-integration exists, will help to correct the deviation from the long term equilibrium (Gujarati, 2004; Greene, 2000). 3.2 Model Specification Following from our research objectives 1, and 2, we develop a compact functional form of our variables follows: ADt = f (GEt, INFt, M2t FRt, INTt,) …………………………………. ( Where AD = Aggregate Demand GE Government Expenditure = 62 M2 = Broad Money Supply FR = Foreign Reserves INTR= Real Interest Rate INF = Inflation Rate For empirical computation, equation (1) transforms to: AD = 0 + 1 + GE + 2 + M2 + 3 + FR + 4 INTR + 5 INF + µ1…..(2) = parameters to be estimated µ = error term For the purpose of scaling the variation in model (2), we shall present the model in a log form, hence: LOFAD = 0+ 1+LOGGE+ 2+ 3LODFR+ 4 LOGINTR + 5LOGINF+µ1………………………………………………………… ….(3) 63 Usually in econometric modeling, the response of the dependent variable to the explanatory variables is rarely instantaneous. Very often the dependent variable responds to the explanatory variables with a lapse of time (See Gujarati, 2004). 3.3 Unit Root Test The assumption so far is that variables are well behaved that is to say they do not possess any of the time series problems. However, literature has shown that most macroeconomic data are confined to time so that their mean is time-dependent making them non-stationary and co integrated (Granger and Newbold, 1974; Dickey and Fuller, 1981; Enders, 1995; Sims, 1990; Pindyck and Rubinfeld, 1998). We shall therefore subject the entire variables to a unit roots stationarity test using Augmented Dickey-Fuller (ADF) test. 64 3.4 Co Integration and Error Correction In order to bring the short run dynamic specification relationship to their long run specification, the co integration test becomes necessary. In the event that GDP has an identical order of integration with any of the explanatory variable(s), we therefore suspect co-integration. Hence, we estimate their linear combination without the constant and subject the residual to unit root test using the following equations respectively: µt = (r-Zt-1)…………………………… (7) Where z = vector of the co integrated factor(s) and y is the vector of al the dependent variables. If the residual is stationary there is co-integration. Under this scenario, the long-run multiplier of the explained variable will be highly dependent on the impulse of the explanatory variables in question. Hence the appropriate model for 65 estimation will be the Error Correction Model, (Engle and Granger, 1987). 3.5.1 Economic Criteria: The economic a prior expectations will evaluate the parameters whether they meet standard economic theory expectations both in signs and sizes. 3.5.2 Statistical Criteria: Statistical tests of significance will be based on the t-tests. The Fstatistic will be used to assess the significance of the overall regression. 3.5.3 Econometrics Criteria Econometric criterion involves conducting several tests to evaluate the true position of the model. They are secondary tests which will be perform in order to further attest to the reliability of 66 the expected result. conducted include Specific econometric tests that will be autocorrelation, model mis-specification muticollinearity and the residual normality. Autocorrelation Test This test will be performed to see whether the errors terms corresponding to different observations of the series are correlated. Since the classical OLS assumption assumes that the disturbance term relating to any observation is not influenced by the disturbance term relating to any other observation. (Gujarati 204). The popular Durbin Watson d statistics shall be used for this test. Model Mis-Specification Test To find out if the model is well specified, the Ramsey reset test is used. This follows the F-test such that if F-critical exceeds F- 67 observed, then the model is well specified and the variables truly fit the equation. Residual Normality Test This tests whether the residuals are normally distributed. The Jacque-Bera statistic will be used for the test. Multi-co linearity test When multicollinearity exists, it becomes difficult to separate the individual influences of the explanatory variables. If any of the partial R2 exceeds the overall R2, then there is serious multi-co linearity (Petterson, 2000). This test will therefore be conducted so as to measure the level of correlation between any two of the variables holding all other variables constant. Sources of the Data 68 The data to be employed for this analysis are secondary in nature. They shall be obtained from the Central Bank Nigeria Statistical Bulletin Vol. 17, December 2006 publication. Econometric Software We shall load the data initially into Microsoft Excel Worksheet and the imported into the PC-GIVE software for the analysis. 69 CHAPTER FOUR PRESENTATON AND ANALYSIS OF RESULT 4.0 INTRODUCTON This sector first of all, will evaluate the fundamental properties of OLS. Thus each of the variables would be examined for unit root and co-integration. Consequently, the Augmented Dickey – Fuller (ADF), defines the equations for these tests. 4.1 ADF Test for Stationary Employing the Augmented Dickey-Fuller test, unit roots test was run on the variables up to their 2nd differences with the following result: 70 Table 4.1 Variable Unit Root Test (ADF-test) DDLAD DDLM2 DDLFR DDLRINT DLINF DDLEXR DLGE (d) 2 2 2 2 1 2 2 Lag 2,1,0 2,1,0 2,1,0 2,1,0 2,1,0 2,1,0 2,1,0 -5.2289** -2.8153** -5.8783** -5.8783** -43590** -4.2305** -5.2319** -7.2001** -3.7223** -7.0095** -8.5220** -5.5715** -5.7156** -6.7060** -10.525** -7.8906** -8.3571** -10.717** -5.1802** -7.7639** -11.394 Critical Values -1.955 -1.955 -1.955 -1.955 -1.955 -1.955 -1.955 5% & 1% -2.66 -2.66 -2.66 -2.66 -2.66 -2.66 -ADF -2.66 NB** Indicate significance at the 5% & 1% levels. In the table above, the level of integration or the significance (5% & 1%). Of each of the variables is shown by the **. This result revealed that some variables (explanatory variables) were of the same order with the dependent variable. That is, they were made stationary after second difference. integrated of order 1 (2). Thus we can say they are Therefore, the evidence of co- 71 integration was shown from the order of integration presented above, which proves that the dependent variable has the same order with some explanatory variables, and for this reasons, we conduct co-integration test as shown below. 4.2 Co Integration test Given the unit root properties of the variables, we proceeded to implement the Engle-Granger co-integration procedure. Since the dependent variable have the same order of integration with some of the explanatory variables. In doing this, we first of all estimate their combination at level form without the intercept and obtain their residual which is then subjected to cointegration test as show in the table below. 72 Table 4.2: Co-Integration Test t-adf Lag 5% Critical Val 1% Critical Val Residual -1.3661 2 -1.954 -2.652 Residual -1.0778 1 -1954 -2.652 Residual -1.0129 0 -1.954 -2.652 The result presented in table 4.2 shows that there is actually no presence of co-integration among the variables. This is so because the residual obtained from the linear combination of the nonstationary variables in question were not statistically significant at both 55% and 1% critical value. However, this led us to adopting out formal model as specified in chapter three above. 73 4.3 Results from Modeling Log of GDP by OLS The result of our OLS model is presented in Table 4.3 Table 4.3 Result Summary Variable Coefficient Std Error t-value t-prob Part R2 Constant -3.0599 3.0749 0.995 .03300 0.0413 LGEX -0.33315 0.48298 -4.690 0.0002 0.5203 LINF 0.21855 0.13839 3.579 0.0079 0.3178 LM2 1.2726 0.42427 2.999 0.0064 0.2812 LFR 0.26111 0.16654 2.568 0.0025 0.2566 LINT 0.74797 0.53928 3.387 0.0017 0.2972 LEXR -0.35983 0.31599 -2.139 0.0065 0.1934 R2 = 0.960745 F(6,23) = 93.818, DW = 1.75 74 4.4 Economic Interpretation Government Expenditure (GEX) The variation shown by the coefficient of government expenditure in the model has a negative value of -033315. This finding implies that the value of government expenditure indicate a negative trend to the aggregate demand in the economy. That is a unit increase in government expenditure variation will lead to a decrease in the aggregate demand by -0.33315 units. In other words as variation in government expenditure is increasing, aggregate demand in the economy is declining. Also, using the 2-t Rule of thumb, variation in government expenditure is statistically significant judging from the t-value of -4.690 which is greater than 2 in absolute value at 5% level of significance. This result suggests that the variation in government expenditure as a growth instrument appeared to have a meaningful impact on the aggregate demand in the Nigerian economy. 75 Rate of Inflation (RI) The value of the coefficient of inflation rate is 0.21855 and it did not conform to the “a priori” expectation. It implies that a unit increase in inflation rate will cause aggregate demand to increase by 0.21855 units. However, the value of inflation is statistically significant, and the result renders inflation control as major instrument for maintaining the growth of aggregate demand, though inflation rate contributes negatively to aggregate demand growth in Nigeria and as well to the aggregate growth of the economy (GDP). Again, using the 2-t rule of thumb, variation in rate of inflation is statistically significant judging from the t-value of 3.579 which is greater than 2 in absolute value at 5% level of significance. This result suggests that the variation in rate 76 inflation appears to have a meaningful impact on the growth of aggregate demand in the Nigerian economy. Broad Money Supply (M2) The coefficient of broad money supply is 1.2726. This implies a positive relationship between broad money supply and aggregate demand growth. This positive sign conform to our economic “a priori” expectation because increase in the rate of broad money supply is expected to boost the level of economic activities and as well increase the aggregate demand. In other words a unit increase n broad money supply will cause economic output and aggregate demand to increase by 1.2726 units, thereby increase the aggregate growth of the economy. Also, using the 2-t rule of thumb, variation in the rate of broad money supply is statistically significant judging from the t- 77 value of -2.999 which is greater than 2 in absolute value at 5% level of significance. This result suggests that the variation in broad money supply appears to have a meaningful impact on the growth of aggregate demand in the Nigerian economy. Foreign Reserves (FR) The coefficient of foreign reserves is 0.26111. This implies a positive relationship between foreign reserves and the growth in aggregate demand in Nigeria. This positive sign conform to our economic “a priori” expectation because increase in the rate of foreign reserves is expected to boost the level of aggregate demand in the economy. In other words, a unit increase in foreign reserves will cause aggregate demand to increase by 0.26111 units, thereby increase the aggregate growth of the economy. 78 Using the 2-t rule of thumb, variation in the rate of foreign reserves is statistically significant judgng from the t-value of 2.568 which is greater than 2 in absolute value at 5% level of significance. This result suggests that the variation in foreign reserve appears to have a meaningful impact on the growth of aggregate demand in the Nigerian economy. Real Interest Rate (INT) The variation in the rate of interest possesses robust coefficient of 0.74797. This implies that a unit increase in the rate of interest causes aggregate demand in the economy to increase by 0.74797 units, all things being equal. The robust responds of this results is further confirmed by its t-value of 3.387 which is greater than 2 in absolute value at 5% level of significance following 2-t Rule of Thumb. Though the finding here imply that 79 positive variation exist between rate of interest and the aggregate demand in Nigeria, it can be observes not to be in conformity with some theories and no conformity to others. As high interest rate reduces the incentive to borrow as well as investment which transmits to low demand in an economy. Real Exchange Rate (RER) Real exchange rate displays a negative coefficient of -0.35983. This result suggests that a unit increase in real exchange rate cause aggregate demand growth to decline by 0.35983 units. Notwithstanding, Real exchange rate is statistically significance inn showing positive fiscal instrument of maintaining aggregate demand growth in Nigerian economy. The negative signs and strong size of the variable show how frequent changes in real exchange rate precipitate in macroeconomic growth. 80 4.5 Statistical Criteria (First – Order Test) These tests are determined by statistical theory and aims at evaluating the statistical reliability of the estimates and parameters of the model (Koutsoyiannis, 1977). From the sample observation, the first order test is carried out based on the following R2, t – probability (t-prob) and F-test. Coefficient of Determination (R2) In our model, R2 = 0.960745, which implies that approximately 96% of the variation in the dependent variable (AD) is explained by the variations in the explanatory variables. Judging by the size of the coefficient of determination (R2), 96% shows a good fit for the model. Meaning that 96% variations is explained in the model leaving around 4% variations in the model unexplained. 81 4.5.2 t value Following a 2-t Rule of Thumb, a variable is statistically significant if its t-value is greater than 2 in absolute value at any % level of significance. In other hand, it statistically insignificant if its t-value is less than 2 in absolute value at any % level of significance; (Gujarati, 2004). Consequently, from the t-values generated in the regression as shown in Table 4.3, all of them were statistically significant since at 5% level of significance their various t-values were greater than 2 in absolute value. 4.5.3 F-test Following Gujarati (2004), to find out whether the model is adequate and well specified, we use the F-test such that if the Fcalculated are F(6,23) = 93.818, which exceeds F-tabulated of 2.53, at 5% level of significance implying that the model is well specified and adequate for forecasting and policy analysis. 82 4.6 Evaluation based on Econometric Criteria (Second Order Test) These tests are based on econometric theory and are aimed at finding out whether the underlying assumptions of OLS regarding the estimation of time series data is satisfied. Test for Auto Correction The DW rule value of 1.75 suggested no presence of positive serial autocorrelation. This was derived from the Rule the Thumb which decision was made in guide from the table presented below. D-W Statistic Positive Autocorrelation Between 1.5 and 2.5 No positive serial autocorrelation Below 1.5 Positive serial autocorrelation Above 2.5 Negative serial autocorrelation 83 The above table shows that our DW statistical value of 1.75 falls between 1.5 and 2.5 and for this; we conclude that there is no positive serial autocorrelation in the error terms. 4.6.2 Test for Hetroscedasticity We shall employ the White’s hetroscedasticity test see Gujarati (2004) third Edition. Hypothesis Ho: (There is no hetoscedasticity; i.e. homoscedasticity) H1: (There is hetroscedasticity) Decision Rule: Reject Ho if the calculated hetroscedasticity valye which follows the Chi Square distribution with 12 degree of freedom, otherwise accept Ho. following the above formula, 84 calculated value of 7.3859 is less that tabulated value of 21.0 we accept Ho of homoscedasticity or equal variance of the error terms. 4.6.3 Test for Multicollinearity Multicollinearity test shall be used to ascertain the violation of the tenth assumption of classical linear regression model. In carrying out the test, we shall investigate the R2 and t-test. A classical symptom of multicollinearity is that a model with R2 which is high, say in excess of 0.8, and most of the t-value are not statistically significant, we say that the model has multicolliearity problem. We conclude based on empirical findings as guided by the above decision rule, that the model is free of multicollinearity problem having all the variables except one statistically significant. 85 4.6.4 Normality Test The normality test adopted is the Jarque Bera (JB) Test of Normality. The JB test of normality is an asymptotic, or largesample, and it is based on the OLS residuals. This test computes the skewness and Kurtosis measures of the OLS residuals and it follows the Chi-square distribution (Gujarati, 2004:148). Hypothesis H0 1 = 0 (the error term follows a normal distribution) H0 1 = 0 (the error term does not follows a normal distribution) At = 5% with 2 degree of freedom. Decision Rule: Reject Ho if X2cal > X2(0.05) (2 df), and accept Ho and tab reject if otherwise. 86 From the result obtained from Jarque-Bera (JB) test of normality, JB = 1.084 (See appendix), which is less than chi-square of X2(0.05) (2 df), and accept H0 and reject if otherwise. tab From the result obtained from Jarque-Bera (JB) test of normality, JB = 1.084 (See appendix), which is less than chi-square 2 table of Xtab = 5.99147. therefore, we accept H0 and conclude that the error term follows a normal distribution. 4.4.5 Test for Adequacy of the Model This test was conducted to test whether the model was well specified. In this test, the Reset Test was adopted. The test follows t – distribution, at 5% level of significance. 87 Statement of Hypothesis H0: Normal specification of the model H1: Wrong specification of the model Reset F* = 0.83331 Decision rule: Reject H0 if F* > F – tab, and accept if otherwise where F0.05, (1,22) = 4.30. Conclusion; Since F* = 0.8331 < F –tab = 4.30 we accept the null hypothesis and conclude that the model used is well specified. 4.7 Evaluation of the hypothesis The hypotheses have earlier been stated as: H0: Exchange rate instability has no significant impact on aggregate dement in Nigeria. 88 H1: There is not causal relationship between exchange rate and aggregate demand in Nigeria. Going strictly by the result of the tables presented above, all the variables conformed to the “a priori” expectation, and also, all the variables were statistically significant. Furthermore, the f – test shows that the regression is significant and the adjusted R2 is completely a good fit. The result is also shown to be robust to possible sources of specification test, the hetroscedasticity, which shows that the error term have equal variance. From the observation above, we noted that exchange rate instability has an appreciable impact on the aggregate demand of the Nigerian Economy. 89 CHAPTER FIVE SUMMARY, POLICY IMPLICATIONS AND CONCLUSION 5.1 Summary This study examines the impact of exchange rate variation on the aggregate demand in the Nigerian economy over the period of 1979-2008. The study explores simple regression models with the adoption of Ordinary Least Square (OLS) method of estimation in examining these variables. This work, amongst other things, found out that all the variables included in the models contributes in explaining the role of exchange rate on aggregate demand in Nigeria. These massive contributions of these variables may strongly depend on the circumstances in the Nigerian economic environment. Major empirical studies have investigated the relationship between exchange rate and economic growth and the role played by the exchange rate volatility is confronted in the 90 domestic economy. This study further believed that for the actual developmental impact of aggregate demand to be felt in Nigeria there should be large local markets, natural resource endowments, good infrastructure, low inflation, an efficient legal system and a good investment frame work promotion. In contrast, corruption and political instability have the opposite effect. These finding are consistent with the reports of multinational companies that operate in Nigeria. 5.2 Conclusion The paper empirically investigates the role of exchange rate variability on aggregate demand in Nigeria. The empirical investigation presented in the work strongly suggests that Nigeria needs to sufficiently develop it’s financial system in order to let a well formulated exchange rate policy contribute positively to 91 aggregate demand growth. The outcomes of the empirical investigation suggest that Nigeria should first reform their domestic financial system before liberalizing the capital account to allow for a favorable exchange and as a result enlarged FDI inflows. However, be that as it may, we draw the final conclusion by calling on the Nigerian government to note that exchange rate variation is expected to have positive impact on aggregate demand growth. However, due to insufficient data, we can not confirm this expectation in this work. We suggest that further empirical analysis should be performed with more detail information on the determinant of exchange rate variation and it’s impact on aggregate demand to verify their theory backings. However, the interrelationship between exchange rate in promoting economic growth appears to be quite complex and for 92 this, further investigation is needed so that an appropriate explanation for this phenomenon can be given. 5.3 Policy Implication The starting point in reclaiming and re-inventing projects in Nigeria is to squarely admit that oil and the manner we have designed to utilize it have constituted a stumbling block to Nigeria’s progress. For the vision 20:2020 not to end up as an empty sloganeering in Nigeria, the economy has to be growing annually at the rate of 15 per cent or more. To achieve this, we must therefore begin by breaking down the institutional arrangements around oil and reconstruction Nigeria’s with each of the federating units being fiscally viable regions. The emphasis is to orchestrate a new politics that is aimed at cake-baking ather than cake sharing, one 93 which aims to mobilize the creative energies of Nigerians and their endowed resources to unleash one of the economic miracles of the 21st Century. For sustainable democracy to emerge, fundamental changes are required in the constitution, the electoral system, the fiscal federalism and operations, as well as a gamut of legalinstitutional reforms that are developmental and capable of promoting private enterprise and competition” (Soludo, 2005:11). There is need to devise effective mechanisms for coordination and cooperation between federal government and federating subnationals in such a way as to make it possible to agree on economy-wide macroeconomic objectives and targets, and ways of achieving same. This could entail legally enforceable fiscal rules that ensure that individual governments pursue goals and targets that are consistent with overall national objectives. 94 The policy options for Nigeria’s growth and stability go far beyond a few macroeconomic reforms, into the transformation of the very basis of production and exchange in the Nigerian economy. Accordingly, there is need to pay specific and systematic attention to the context of action and the production relations in the various sector of the economy (Ukwu, et al 2003). It must be understood that Nigeria cannot develop on a sustainable basis without restoring the umbilical cord between government and business (private sector) thus bringing back competition among the regions/states to create wealth. When government revenue depends on whether or not private businesses thrive, it will become the primary business of government to ensure that businesses survive and boom. 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