Introduction
Generally, in economics, inflation, interest rates (IR), and foreign exchange rates (FXT) are fundamental aspects of macroeconomics. The three aspects can potentially influence the overall development pattern of any country. Both inflation and IR are significant factors that impact the FXT. Over the past few years, Nigeria has been experiencing an increase in the inflation rate, which is a significant problem. Currently, the Nigerian currency (NGN) has recorded high instability compared to some significant currencies worldwide (Babalola, 2021).
A theoretical foundation, such as the interest rate parity (IRP), is essential in solving the effects associated with IR, inflation, and the FXT. Apart from the theoretical point of view, statistical models such as regression analysis can be vital in examining the nature of the relationship between the IR and inflation FXT using the available historical data. In order to solve the economic problem, it is important to understand the possible effects of inflation and IR on the FXT. IR and inflation rates impact the value of a country’s currency against the purchasing power of different currencies.
Understanding the Concepts
Inflation
The term inflation is the consistent increase in the general prices of goods and services in a country over a specific period. During this time, the currency’s purchasing power is considered low. In other words, the quantity of products in demand is less than the amount of money in supply, thus making the currency lose its value (Ahmed et al., 2021).
In Nigeria, inflation has remained a significant economic threat over the years. Despite the government’s efforts to stabilize the negative impacts, the cost of living in the country has been rising steadily. The common indicators of inflation include the consumer price index (CPI). The CPI enables the measurement of the inflation rate based on the consumers’ perspective.
Interest Rates
IR is the fixed amount of charge incurred by a borrower for the utilization of funds that mainly belong to financial institutions, such as commercial banks. In most cases, IR can be grouped as short-term or long-term. The former is influenced by inflation, while the latter is the responsibility of a country’s central bank.
The Nigerian government mainly uses IR as a tool to control the effect of inflation on its economy. Generally, an increase in IR translates to high FXT (Akbar et al., 2019). On the contrary, low IR does not appeal to investors, making the FXT decline.
Foreign Exchange Rates
FXT is the rate at which one currency is converted to another. In other words, it depicts the value of foreign money to that of domestic. Research by Dornbusch (2019) posits that FXT can either be flexible or fixed. The former implies that FXT is set and controlled by the government, while the latter relies on the nature of the market. When the FXT is declining, the purchasing power of the money reduces. The aspect impacts the trade flows between the home country and foreign nations.
The Effects of Inflation and IR on FXT in Nigeria
Generally, the connection between the IR, inflation, and FXT is complex. Both IR and inflation rates interplay significantly, and their results always positively or negatively influence the FXT in Nigeria. In the country, inflation has a direct impact on the FXT.
For instance, in the recent past, the NGR has depreciated following the rising inflation rate in Nigeria. The currency value has dropped significantly compared to the dollar (Babalola, 2021). Based on this perspective, it can be stated that high inflation rates have negatively affected the FXT in Nigeria. When the value of money is low, the country is forced to spend more, especially on undertaking trade flows, that is, imports and exports.
In addition, following the high inflation rate in Nigeria, most of the products are more expensive. This aspect has made exports from the country less competitive in the international markets. Usually, nations tend to import goods and services offered cheaply in the market. However, being that Nigeria’s commodities are costly, they are not demanded, causing the need for the NGN to decline (Wang et al., 2019).
The facet is negatively impacting the FXT. Similarly, according to research by Babalola (2021), Nigeria has a positive direct correlation between IR and FXT. Generally, high IR is more attractive to foreign investors. The financiers are lured by the fact that investing in the economy will give them a significant reward from their respective investments.
As foreign investors flow into the country, the demand for the NGN increases, making the currency gain value over some of the coinage. The aspect will, in turn, impact the FXT in the country. Based on the IRP model, rising IR leads to improvement in the FXT, which is vital for the growth and stability of the domestic market. The Nigerian government has maintained a high interest rate over the past years to influence the value of NGN in the economy.
Moreover, the interest rates in Nigeria have made the cost of borrowing money in the country high, causing the domestic economy to be less attractive to foreign investors. This facet has significantly deterred potential investors from investing in the country (Babalola, 2021). The majority of foreign business individuals are afraid of the charges they will incur in the country following the hike inIR by commercial banks. When there is a limited number of people from other countries operating businesses in the country, the overall demand for the NGN decreases, making the FXT drop significantly. Therefore, through high IR, the Nigerian FXT is impacted negatively.
Economic Theory
Various economic theories explain the relationship between IR, inflation, and the FXT. The IRP model connects the difference that exists between foreign and domestic IR. The home IR is generally the exchange rate determinant. An increase in the domestic market’s inflation rate leads to the home currency’s depreciation. This aspect implies that there is a negative correlation between FXT and inflation. The model suggests that two countries that are involved in trade should have the same FXT (Liao, 2020). The model is useful because it applies the method to predict the association between IR and FXT between Nigeria and other foreign countries.
Based on the arguments of the IRP theoretical model, the effects of IR and inflation rates in the FXT can be curbed effectively. According to the theory, irrespective of the currency an individual invests in, the hedged return should be the same even if the IR is different (Li et al., 2021). In other words, the philosophy assumes that investors are barred from locking in the available FXT in a currency for a reduced price and then opting to buy another country’s money, as it is offered at a higher IR.
Statistical Model
A mathematical approach involving the use of a regression model can be utilized using historical data to solve the effects of IR and inflation on the FXT in Nigeria.
The following model;
FTX = ú + X1CPI + X2IR + X3GDP + X4MS + X5FDI + e
From the above formula, FXT value of NGN to US dollar is the measure of exchange rates; CPI determines inflation; IR, lending rates; Gross Domestic Product (GDP), a determinant of economic growth; MS, money supply; FDI, Foreign Direct Exchange; X1-X5, regression coefficients; ú, constant; e, error.
Using the model, an F-test statistic can be applied to justify the significance of the regression equation above. The analysis depends on the available historical data covering all the mentioned variables. During the study, the coefficients are used to determine the variation between the independent variables. When all the aspects are taken into consideration, the model should provide a measure that can be used to identify the link between the IR, inflation, and FXT.
Conclusion
Inflation and IR have a significant impact on a country’s FXT. High interest rates in Nigeria have potentially increased the value of the NGN, making the currency valuable. On the other hand, the IR imposed has scared most foreign investors from the local Nigerian market, thus lowering demand for local money. These aspects have made FXT in Nigeria rise and decline.
In the case of inflation, Nigeria has been facing an increase in the prices of goods and services over the past years. The facet has made the NGN depreciate and lose its value compared to other currencies. In order to rectify the Nigerian economy and create a well-balanced system, the government can use theoretical models such as IRP and statistical methods to address the effects of IR and inflation on the FXT.
References
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Akbar, M., Iqbal, F., & Noor, F. (2019). Bayesian analysis of dynamic linkages among gold price, stock prices, exchange rate and interest rate in Pakistan. Resources Policy, 62, 154-164. Web.
Babalola, A. (2021). Impact of interest rates on exchange rate in Nigeria: An analytical investigation. Timisoara Journal of Economics and Business, 14(2), 107-124. Web.
Dornbusch, R. (2019). The theory of flexible exchange rate regimes and macroeconomic policy. In J. Herin et al. (Eds.), Flexible Exchange Rates and Stabilization Policy (pp. 123-143). Routledge. Web.
Li, J., Lu, X., Jiang, W., & Petrova, V. S. (2021). Multifractal Cross-correlations between foreign exchange rates and interest rate spreads. Physica A: Statistical Mechanics and its Applications, 574, 125983. Web.
Liao, G. Y. (2020). Credit migration and covered interest rate parity. Journal of Financial Economics, 138(2), 504-525. Web.
Wang, Y., Wang, K., & Chang, C. P. (2019). The impacts of economic sanctions on exchange rate volatility. Economic Modelling, 82, 58-65. Web.