Inflation and monetary policy effectiveness in the presence of external shocks: Evidence from the Nigerian economy

Résumé

Type of the article: Research ArticleAbstractThe inability of monetary policy to maintain price stability under the flexible exchange rate system, with the high volatility of the Naira/Dollar exchange rate in Nigeria, motivates this study. This study, therefore, investigates monetary policy effectiveness on price stability when an external shock threatens the system. With the standard deviation of the Naira/Dollar exchange rate as a proxy for external shock, results from the nonlinear autoregressive distributed lag (NARDL) using quarterly data from 1980Q1 to 2024Q1 reveal that monetary policy effectiveness is weakened by external shock. Specifically, monetary expansion is less inflationary in the short run than in the long run, whereas its contraction dampens productivity with no significant impact on inflation in a closed economy with no shocks. However, in the presence of external shocks, monetary contraction and expansion produced an overly ambiguous and inconsistent impact on inflation in both periods. This implies that besides the structural imperfections from external shocks, it weakens the policy response of monetary policy on price stability. With inflation persistence at 77.7%, while the adjustment speed to steady state equilibrium stood at 7.7% per quarter, it implies that the system will be divergently unstable in the long run. The study concludes that monetary policy effectiveness is weakened by external shocks; therefore, fiscal-monetary policies on price stability, a managed-float exchange rate system, and inflation targeting were recommended.

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