The Main Determinants of Inflation in Nigeria

This paper analyzes the dominant factors influencing inflation in Nigeria. An error correction model of the inflation process is developed based on money market equilibrium conditions. The results of this analysis confirm the basic findings of earlier studies, namely, that monetary expansion, driven mainly by expansionary fiscal policies, explains to a large degreeThe Main Determinants of Inflation in NigeriavThe Main Determinants of Inflation in Nigeria the inflationary process in Nigeria. Other important factors are the devaluation of the naira and agroclimatic conditions. It was found that concurrent fiscal and monetary policies had a major influence on the impact of the depreciation of the naira on inflation.

Abstract

This paper analyzes the dominant factors influencing inflation in Nigeria. An error correction model of the inflation process is developed based on money market equilibrium conditions. The results of this analysis confirm the basic findings of earlier studies, namely, that monetary expansion, driven mainly by expansionary fiscal policies, explains to a large degreeThe Main Determinants of Inflation in NigeriavThe Main Determinants of Inflation in Nigeria the inflationary process in Nigeria. Other important factors are the devaluation of the naira and agroclimatic conditions. It was found that concurrent fiscal and monetary policies had a major influence on the impact of the depreciation of the naira on inflation.

THE RATE of inflation in Nigeria has increased steadily and markedly since independence in 1960. During theriod following independence (1965–75), Nigeria’s rate of inflation was about equal to that of its trading partners, averaging 10 percent annually (Figure 1). In the next decade (1975–85), the respective rates of inflation diverged dramatically, as Nigeria’s average annual rate nearly doubled, to 18 percent. while that of the trading partners narrowed significantly. to 4 percent. These trends continued between 1985 and 1990, as Nigeria’s annual average rose to 24 percent while its trading partners posted an average rate of 13 percent. More recently, since late 1990, Nigeria has experienced a period of stagflation. By the end of 1993, inflation had reached 60 percent and real per capita income growth had stalled.

Figure 1.
Figure 1.

Consumer Prices

(Annual percentage change)

Citation: IMF Staff Papers 1995, 002; 10.5089/9781451947205.024.A002

Sources: IMF, Internarianal Financial Statistics; and IMF staff estimates.Note: Rainfall defined as percentage deviation from average rainfall.

This paper reviews previous empirical studies of the determinants of inflation in Nigeria, analyzes the dominant factors influencing inflation, presents the empirical results of an error correction model, and discusses the policy implications of the empirical results.

Table 1.

Consumer Price Index Market Basketa

(Percent)

article image
Source: Nigerian Federal Office of Statistics.

Based on the 1985/86 National Consumer Survey.

Figures may not add due to rounding.

I. Composition and Structure of the Consumer Price Index

The official consumer price index (CPI) is based on a composite of urban and rural price data compiled monthly by the Federal Office of Statistics (FOS)1 and reflects household expenditure patterns in the 1985/86 National Consumer Survey.2

Composite food prices dominate the CPI. representing 69 percent of the total market basket (Table 1), with staple food commodities alone representing 42 percent. Consequently, factors affecting food prices dominate movements in the CPI (Figure 1). These factors include agroclimatic conditions, wages, domestic inputs, and import prices, with rainfall playing a key role. Subsistence agriculture, which is not included in marketed production, plays an important role in marginal supply and demand during periods of drought or abundant rainfall. Imports, while significant in the economy as a whole, have tended to be less significant in influencing the CPI since household consumption, which is predominantly food related, has a low import content.

II. Inflation During 1985–93

The rate of inflation dropped sharply in 1985 and 1986, as favorable weather conditions led to abundant crop production and tight fiscal and monetary policies substantially reduced excess liquidity in the economy (Figure 2). Anchored by a tight fiscal and monetary policy stance, and aided by favorable weather, the devaluation of the naira in 1986 (96 percent in domestic currency terms) had virtually no impact on that year’s rate of inflation. Inflation increased moderately in 1987, averaging 10 percent, with the onset of the 1987–88 drought and the lagged impact of the substantial devaluation in 1986. Table 2 presents data since the mid–1980s on some of the factors that have influenced inflation in Nigeria.

A severe drought in key growing regions of the country in 1987 and 1988, combined with fiscal and monetary expansion, led to a virtual doubling of food prices in 1988. Consequently, the rate of inflation jumped to 59 percent in 1988. While food prices actually fell during the second half of 1989 as rains and production improved, the average rate of inflation remained above 50 percent, primarily as a result of the cumulative impact of broad money growth and the sizable devaluation of the naira in 1989.

Inflation slowed considerably in 1990, to an average annual rate of 7.4 percent, largely reflecting the contractionary fiscal and monetary policies implemented during late 1989 and early 1990, and the improved harvests in 1989 and 1990 resulting from excellent rains. As a result, the increase in food prices was held to 3 percent in 1990. Toward the end of 1990, fiscal and monetary policies loosened considerably, which led to the upward movement in inflation in 1991, to 13 percent. The depreciation of the naira by 23 percent during 1991 also added to the upward pressure on prices.

The rate of inflation increased markedly in 1992, to 46 percent on an annual average basis, as a result of substantial excess liquidity in the economy brought about by the continued monetization of the growing fiscal deficit, which increased to 8 percent of GDP in 1992. The sharp devaluation of the naira (75 percent in local currency terms) during this expansionary period put further upward pressure on prices.

Inflation accelerated further in 1993, to an estimated 57 percent annually, reflecting the sharp increase in the fiscal deficit, to 18 percent of GDP. The devaluation of the official exchange rate (28 percent in local currency terms) also added upward pressure on the rate of inflation, but this pressure was tempered somewhat by the estimated 4 percent decline in the index of foreign prices.

Figure 2.
Figure 2.

Inflation, Money, and Exchange Rate Developments 1986–93

(Annual percentage change)

Citation: IMF Staff Papers 1995, 002; 10.5089/9781451947205.024.A002

Sources: IMF, International Financial Statistics; and staff estimates.
Table 2.

Factors Influencing Inflation

article image
Sources: IMF, International Financial Statistics; and IMF staff estimates.

End‐of‐period basis.

Broad money rose sharply during the second half of the year.

Table 3.

Selected Price, Money, and Exchange Rate Indicators

(Average annual change, unless otherwise specified)

article image
Sources: IMF, International Financial Statistics; and IMF staff estimates.

End‐of‐period basis.

Weighted average of trading partner prices (in dollar terms).

III. Quantitative Analysis of Inflation Developments in Nigeria

Factors Influencing Inflation

Recent studies on inflation in Nigeria broadly agree on the key factors influencing the rate of inflation: money growth, income growth, and exchange rate movements. These factors are presented for period averages in Table 3. It is noteworthy that, as the table indicates, the widening of the differential between domestic and foreign inflation has generally occurred during periods of rapid monetary expansion, while the impact of exchange rate movements on inflation is less clear. However, recent empirical studies do not concur on the relative importance of each of these factors as determinants of inflation. Most of them conclude that excess domestic demand, generated by expansionary fiscal and monetary policies, has been the principal factor underlying the rising inflation rate in Nigeria.3 Others suggest that cost‐push inflation resulting from excessive devaluations and wage increases has been the primary impetus for the upward inflationary spiral.4

Broad money growth has been found to be a fundamental determinant of inflation in many of the studies, while the impact of exchange rate movements on inflation has been less clear. This ambiguity is most likely the result of the time periods studied (Figure 3). During the 1960s and 1970s, when the official exchange rate was stable, there were numerous periods of high inflation. Subsequently, in the 1980s and early 1990s, the considerable devaluation of the naira occurred during a period of increasing price instability and rising inflationary pressures and most likely added to the upward movement in inflation. As the magnitude of the impact of exchange rate movements on inflation is unclear, it will be tested empirically below.

Figure 3.
Figure 3.

Inflation, Money, and Exchange Rare Developments

(Annual percentage change)

Citation: IMF Staff Papers 1995, 002; 10.5089/9781451947205.024.A002

Sources: IMF. International Financial Statistics, and IMF staff estimates.

Many of the studies also reported that real income growth played a significant deflationary role by increasing the demand for real money balances. In addition, some studies reported a significant and negative relationship between agricultural production and inflation. While this latter result is intuitive, the linear relationship between the income and production variables may have led to spurious results since agricultural production has accounted for such a large share of total production.

Derivation of the Inflation Equation

To measure the impact of relevant explanatory variables discussed above and predict the likely inflationary outcome of a specific mix of policy measures and exogenous factors, an equation for inflation is derived and analyzed below. The overall price level (P) is a weighted average of the price of tradable goods (PT) and nontradable goods (PN), and can be represented in log‐linear form as

logP=α(logPN)+(1α)(logPT),(1)

where α represents the share of nontradable goods in total expenditure. The price of tradable goods (PT) is determined exogenously in the world market and. in domestic currency terms, can be represented by foreign prices (Pf) and the exchange rate (e):

logPtT=loget+logptf.(2)

Both an increase in the exchange rate (in domestic currency terms) and an increase in foreign prices will lead to an increase in the overall price level.

The price of nontradable goods (PN) is assumed to be set in the money market, where demand for nontradable goods is assumed, for simplicity, to move in line with demand in the economy overall. As a result, the price of nontradable goods is determined by the money market equilibrium condition, real money supply (Ms/P) equals real money demand (md), which yields the following equation for nontradable goods prices:

logPN=β(logMslogmd),(3)

where Ms represents the nominal stock of money. md is the demand for real money balances, and p is a scale factor representing the relationship between economy‐wide demand and demand for nontradable goods. The demand for real money balances (md) is assumed to be a function of real income, inflationary expectations, and foreign interest rates:

mtd=f(yt+πtrt+1),(4)

where yt represents real income, πt represents expectations formed in period t – 1 of inflation in period t, and r,t+1 is the expected nominal foreign interest rate in period t + 1 adjusted by the expected change in the exchange rate in period t+1. 5 According to money demand theory, an increase in the stock variable (real income) will stimulate money demand, whereas an increase in the domestic opportunity cost variable (expected inflation) will lead to a decline. The expected rate of inflation in period t is assumed, based on adaptive expectations, to be equal to

πt=d1(ΔlogPt1)+(1d1)πt1,(5)

where ΔlogPt1 represents actual inflation in period t –1 and πt–1 is the expected rate of inflation in period t – 1. In this analysis, we assume that d1 = 1, leading to the following reduced‐form inflation equation:

πt=ΔlogPt1.(6)

Moreover, based on similar assumptions regarding the formulation of expectations, we assume that the expected foreign interest rate (rt+1), corrected for the expected change in the exchange rate, is equal to the observed rate in period t:

E(rt+1)=rt.(7)

An increase in expected future foreign interest rates (rt+1) is assumed to lead to a decrease in current real money demand as a result of substitution effects. Substituting equations (6) and (7) into equation (4) yields the following log‐linear money demand function:

logmtd=c2logytc3ΔlogPt1c4rt.(8)

Substituting equation (8) into equation (3) yields

logPtN=β(logMtc2logyt+c3ΔlogPt1+c4rt).(9)

Equations (2) and (9) can then be substituted into equation (1), where

logPt=αβ(logMtc2logyt+c3ΔlogPt1+c4rt)+(1α)(loget+logPtf).(10)

As discussed above, based on casual observation, the independent role of rainfall in influencing the predominantly food‐related consumer price index appears to be substantial. Accordingly, rainfall (Z) is investigated below as a potential additional explanatory variable.

Based on the underlying assumptions discussed above, the following a priori assumptions can be made regarding the signs of the explanatory variables:

Pt=f(Mt+,yt,et+rt+ΔPt1+,Pt+f,Zt),(11)

where an increase in nominal broad money, the naira/U.S. dollar exchange rate, expected nominal foreign interest rates adjusted for the expected change in the exchange rate, expected inflation, or foreign prices leads to an increase in prices in period t, while an increase in real income or rainfall leads to a fall in prices.

Econometric Methods and Results

This paper adopts a time series approach to the development of an econometric price model to address the criticism of potentially spurious results encountered in most recent studies of inflation in Nigeria, based on the nonstationarity of the data series, and to analyze the short‐run, dynamic structure of the relationship. Engle and Granger (1987) suggest a two‐step approach. First, the existence of a cointegrating relationship among the variables in equation (10) is determined based on standard cointegration techniques. If the variables are cointegrated, a stable long‐ run relationship can be estimated using standard ordinary least squares (OLS) techniques. Second, the information in the error term of the long‐run relationship is used to create a dynamic error correction model. According to Engle and Granger (1987), this error correction model produces consistent results even when the right‐hand‐side variables are not completely exogenous. The error correction model is then used to analyze the impulse response of inflation to a stimulus in the explanatory variables in a dynamic setting.

Testing for Cointegration

Testing for cointegration requires information on the order of integration of the variables. as vectors with multiple orders of integration require multiple‐stage testing.6 Accordingly, the stationarity of the vector of variables was analyzed based on appropriate unit root tests, and the order of integration of the P, M, y, e, and Z variables (all in log form) was determined based on standard Dickey‐Fuller (DF) and augmented Dickey‐Fuller (ADF) statistics.7 All the variables were found to be integrated of order 1, 1(1).

A cointegrating relationship was confirmed for the P. M, y, e, and Z variables. The DF and ADF test statistics rejected the hypothesis of the existence of a unit root in the error term of the regression of the variables, with P as the dependent variable, confirming that the error term was stationary.

Estimation of the long‐run relationship yielded (with the t–statistic in parentheses):

Pt=3.028+0.689Mt0.516yt+0.254et+0.0191Zt+ut(12)(1.967)(30.132)9.241(7.644)1.153

Sample: 1960–1993 R2= 0.996 SE = 0.095 CRDW = 1.24

The model performed well in terms of explaining the price level as a function of money, income, and the exchange rate. All the coefficients had the appropriate signs with the exception of the rainfall variable. The rainfall variable, though, was found to be insignificant in the long run, consistent with one’s intuition.

Dynamic Model

The dynamic version of the long-run relationship estimated in equation (12) can be specified as an error correction model:

ΔPt=β0+Σi=0η(β1iΔMti+β2iΔyti+β3iΔeti+β4iZti)+Σi=1η(β5iΔPti)+β6ECt1+νt,(13)

where Δ represents the first difference operator, ECt the error correction term, and vt a disturbance term.

The error correction model utilizes information in the error term of the long‐run model to approximate deviations from the equilibrium and represent the short‐run response necessary to move the system back toward its equilibrium. The error correction term is calculated as

ECt=PtPt,(14)

where Pt is the actual value of P in period t and Pt is the fitted value of Ptestimated in equation (12).

Figure 4.
Figure 4.

Actual and Fitted Inflation, 1961–93

(First difference log (CPI))

Citation: IMF Staff Papers 1995, 002; 10.5089/9781451947205.024.A002

Sources: IMF. International Financial Statistics; and IMF staff estimates.

Equation (13) was used to estimate the short‐run model, with the most parsimonious formulation of the model presented below (with the standard errors in parentheses), based on a simplification search with η = 2:

ΔPt=0.019+0.356ΔMt0.294Δyt+0.191Δet10.230ΔZt2+0.333ΔPt10.508ECt1(15)(0.025)(0.082)(0.102)(0.064)(0.107)(0.118)(0.153)

The model was estimated using standard OLS estimation techniques on annual data for the period 1963–93. It performed well in terms of the expected signs on the coefficients of the explanatory variables and in terms of its explanatory power, with an adjusted coefficient of determination (R2) value of 0.69.8 When the error correction model was fitted against historical inflation data, it performed well in terms of tracking the cyclical nature of price movements in Nigeria (Figure 4).

The presence of serial correlation, or more general forms of autocorrelation, was rejected based on the Breusch–Godfrey and Box‐Pierce Q statistic. The Jarque‐Bera test statistic confirmed normality, and the ARCH test rejected up to fourth‐order heteroscedasticity in the disturbance term. The presence of a general specification error was rejected based on the results of the Ramsey RESET(1) test.

The estimated error correction model was found to be stable over the period studied based on the Chow breakpoint test. Four years were selected for the Chow F‐test as possible breakpoints (1977, 1979, 1982, and 1985), consistent with previous empirical studies, representing years of pronounced structural reform or exogenous shocks. The CUMSUM recursive residuals test also confirmed the structural stability of the model. Figure 5 plots the CUMSUM cumulative recursive residuals, with deviations outside the 5 percent critical line implying structural instability.

Impulse Responses and Policy Implications

The impact of changes in the exogenous variables on the inflation path can be studied using the dynamic structure of the error correction model above. More specifically, the impulse response of inflation to each of the explanatory variables can be calculated based on the dynamic multipliers. Figure 6 shows the impulse response of inflation (ΔPt) over time to a permanent 1 percent increase in each of the right‐hand‐side variables in equation (15).

Figure 5.
Figure 5.

Structural Stability of Price Equation

Citation: IMF Staff Papers 1995, 002; 10.5089/9781451947205.024.A002

Based on the multipliers, a permanent 1 percent increase in the rate of money growth would yield a 0.36 percent increase in inflation in the initial year, increasing to 0.53 percent by the fourth year, moving toward a long‐run increase in inflation of 0.69 percent. At the same time, a permanent 1 percent increase in the exchange rate (devaluation) would lead to an increase of only 0.19 percent in inflation by the second year, with no impact in the initial year, and an increase of 0.25 percent in the long run.

Figure 6.
Figure 6.

Dynamic Response of Inflation

Citation: IMF Staff Papers 1995, 002; 10.5089/9781451947205.024.A002

Sources: IMF, International Financial Statistics; and staff estimates.

A permanent 1 percent increase in real GDP would be expected to reduce inflation by 0.29 percent in the first year, with a decrease of 0.44 percent after four years. moving toward a long‐run decrease of 0.56 percent. Improved rainfall also reduces inflation. A 1 percent increase in rainfall would be expected to decrease inflation by 0.23 percent after two years, decreasing to 0.34 percent by the sixth year.

In addition to confirming that inflation is directly linked to growth in the money supply, the model also suggests that the Nigerian authorities could use appropriately tight financial policies to reduce the inflationary impact of a devaluation. Conversely, the model predicts that a devaluation during a period of excessively expansionary fiscal and monetary policies will have substantial inflationary consequences, as the impact of the monetary growth further adds to the inflationary pressures. Moreover, the inflationary impact of a devaluation during a period of loose financial policies would be especially strong if the country were in the midst of, or just pulling out of, a long period of drought.

IV. Conclusions

Nigeria’s rate of inflation has increased markedly over the past two and a half decades. The results of this analysis confirm the basic findings of earlier studies, namely, that monetary expansion, driven mainly by expansionary fiscal policies, explains to a large degree the inflationary process in Nigeria. Other important factors were the devaluation of the naira and agroclimatic conditions.

It was found that concurrent fiscal and monetary policies had a major influence on the impact of the depreciation of the naira on inflation. The devaluation increases prices, but the impact can be counteracted by implementing appropriate financial policies. As shown in 1986 and 1990, a tight fiscal and monetary policy stance during and shortly after a devaluation substantially reduces the impact of the devaluation on domestic prices, while a devaluation during a period of excessive expansionary financial policies magnifies the impact on inflation, as was seen in 1992.

Agroclimatic conditions were also found to be a factor influencing the rate of inflation. Given the considerable role of food commodities in the CPI, agroclimatic conditions (rainfall) have a significant influence on overall movements in prices, as was shown in 1988/89 and 1990/91.

APPENDIX Data Sources

The estimates were based on annual data from International Financial Statistics (IFS) for the period 1960-93. The IFS data were supplemented as necessary with IMF staff estimates for 1992 and 1993. Real income is derived by deflating nominal GDP by the consumer price index.

Broad money is defined as the sum of narrow money plus quasi-money, and the official naira/U.S. dollar exchange rate index is used for the exchange rate variable. The IMF’s estimate of the exchange-weighted inflation rate of partner countries is used as the proxy for the foreign inflation variable and the U.S. three-month treasury bill rate is used to proxy foreign interest rates.

The rainfall variable was based on annual rainfall data (in millimeters). The source of the data for the period 1970-92 was The Central Bank of Nigeria Statistical Bulletin (June 1993), while the data for the period 1960-69 were compiled from the World Weather Database

Table Al.

Data Base, 1960–93

(In millions of naira, unless otherwise specified)

article image
Sources: IMF, International Financial Statistics; and IMF staff estimates.

In millimeters per year.

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*

Gary G. Moser is an Economist in the African Department. He received his Ph.D. from George Washington University. He thanks Peter Isard, Malcolm Knight. Donald Mathieson, Reinold van TO, and several other colleagues in the African Department for many useful comments and suggestions.

1

Price data are collected for 256 items in 83 urban towns and 312 rural centers on a weekly or monthly basis. The FOS compiles the data monthly to prepare a CPI for each of the 21 states and an aggregate rural and urban CPI as well as the national composite CPI.

2

The FOS completed a new National Consumer Survey during the period April 1992 to March 1993. A preliminary analysis suggests that expenditure on food items is broadly in line with the data from the 1985/86 national survey.

4

See, for example, Adamson (1989) and Aighokhan (1991).

5

As a result of fixed interest rates over most of the period, domestic interest rates were not included as they do not add significant additional information. See Engle and Granger (1991).

7

The inflation, foreign interest rate, and foreign prices variables were dropped from the analysis as they were found in earlier versions of this paper to be insignificant.

8

All the coefficients were significant at the 1 percent level with the exception of the constant term, which was insignificant at the 10 percent level

IMF Staff papers: Volume 42 No. 2
Author: International Monetary Fund. Research Dept.