Inflation Targeting as A Monetary Policy in Nigeria: An Application of Vector Autoregressive (VAR) Model

Abstract

This work seeks to explore the applicability of inflation targeting in the Nigerian economy based on time series data from 1990Q1 to 2014Q4. Although the conditions for its successful take off has been identified in the literature; this work empirically examined the predictable relationship between monetary policy instrument and inflation. Unit root test, Co-integration test, unrestricted VAR methodology as well as impulse response analysis with five variables in a 2 lag specifications were employed. The impulse response functions from the VAR model show that the response of Consumer Price Index (cpi) to its own shocks is contemporaneously very strong and remain so throughout the short and medium term horizons, but, less persistent afterwards. The response of cpi to innovations in money supply (liquidity channel) and interest rate (interest rate channel) were found to be less significant. This was reinforced by results from variance decomposition of the cpi where the latter two accounted for less than 15 percent of the variance of the former in both the short and medium term. This goes to show that while expansionary monetary policy, which works through the liquidity channel, positively affects prices in the economy, inflationary pressure is usually followed by contractionary monetary measures in the economy. The response of cpi to positive innovation in output is counterintuitive implying that an in increase in productivity rather leads to decline in prices generates more inflationary pressures in the economy while the response of output to shocks in cpi is more consistent and gives a dynamic link. The research also found out that the exchange rate is face with the problem of exchange rate pass-through in Nigeria, because of the level import tendencies in economy. This implies that inflation in other countries are imported to the country through high demand import of goods and service by many Nigerians. Therefore, the paper recommends that government should use exchange rate as inflation targeting instrument in Nigeria to reduce the level of imported inflation for economic growth in Nigeria.