Exchange Rate Volatility and Its Effect on Domestic Price Stability in Nigeria

This study investigates the effect of exchange rate volatility on domestic price stability in Nigeria, focusing on the roles of nominal exchange rate, real exchange rate, exchange rate volatility, and parallel market exchange rate in determining inflation. Using annual time-series data spanning from 1986 to 2024, the study employs the Augmented Dickey-Fuller (ADF) unit root test to examine stationarity properties, the Johansen cointegration test to determine the existence of long-run relationships, and the Error Correction Model (ECM) to analyze both short-run and long-run dynamics. The ADF results indicate that all variables are integrated of order one, I (1), confirming the suitability of the VECM framework. Johansen cointegration results reveal a long-run equilibrium relationship between exchange rate variables and domestic inflation, suggesting that movements in exchange rates and their volatility have persistent effects on price stability in Nigeria. The ECM results show that nominal exchange rate, real exchange rate, exchange rate volatility, and parallel market exchange rate all positively influence inflation. Exchange rate volatility exhibits the strongest effect, with a coefficient of 1.236 and a high level of statistical significance, indicating that increases in currency fluctuations directly amplify domestic price instability. The nominal exchange rate also has a significant positive effect, implying that depreciation of the naira translates into higher inflation through increased import costs. The real exchange rate and parallel market exchange rate demonstrate positive but marginally significant effects, suggesting partial transmission mechanisms through domestic pricing channels. The error correction term is negative and statistically significant (-0.741), indicating that approximately 74% of deviations from the long-run equilibrium are corrected within one period, reflecting a rapid adjustment process toward long-run stability. Policy implications include the need for interventions to reduce exchange rate volatility, minimize discrepancies between official and parallel market rates, and maintain a stable nominal exchange rate.