A Dynamic Stochastic General Equilibrium (Dsge) Model Of Oil Price Shocks And Exchange Rate Pass-Through To Domestic Inflation In Nigeria

Developing economies, like Nigeria, have historically been reluctant to admitting more than a moderate degree of exchange rate flexibility due to the fear that such variations might feed into domestic prices. The potential vulnerability of small and open economies to exchange rate pass-through into domestic prices is high and arises from the high share of tradable goods, high import content of domestic production and exports, as well as generally high degree of integration with the global trading system. Policy makers are concerned about the extent and speed of exchange rate pass-through into domestic prices. If pass-through is low, a variation in the exchange rate to improve the trade balance may prove impotent. The implication is that policy makers may not necessarily need to be worried about potential inflationary consequences of exchange rate fluctuations. However, in recent times, there seems to be a growing degree of disconnect between oil price shocks, exchange rate changes and domestic consumer prices. While there is a large volume of literature on DSGE analyzing different areas of economic issues in developed and emerging economies few of these studies are based on the African economies and, in particular, Nigeria (Alege, 2009). In Nigeria, with the pioneering work of Olekah and Oyaromade (2007) in this area, other attempts were made by Olayeni (2009), Alege (2009), Garcia (2009) and Adebiyi and Mordi (2010). From available information, there are no DSGE models that have investigated the extent and speed of oil price shocks and exchange rate pass-through to domestic prices using a DSGE technique. This paper, therefore, aims at filling this gap by adopting Bayesian techniques to estimate the extent and the speed of oil price shocks and exchange rate pass-through to domestic prices in Nigeria using a dynamic stochastic general equilibrium (DSGE) methodology. Most DSGE models available in the literature have a basic structure that incorporates elements of the new-Keynesian paradigm and the real business cycle approach. The benchmark DSGE model is an opened or a closed economy fully micro-founded model with real and nominal rigidities (see for instance Christiano, et al, 2005; and Smets and Wouters, 2003). Considering the peculiarities of Nigeria as an oil-dependent economy, the dynamic evolution of the endogenous variables of interest will include, among others, aggregate demand equation (IS curve), aggregate supply (the Phillips curve), uncovered interest rate parity (UIP) and monetary policy reaction function (a forward-looking Taylor rule). Bayesian estimation technique will be employed. Technically speaking, Bayesian estimation is a mix between calibration and maximum likelihood, which are connected by Bayes’ rule. The calibration part is the specification of priors and the maximum likelihood approach enters through standard econometrics based on adjusting the model with data. The expected results are whether or not pass-through of oil price and exchange rate to domestic prices in Nigeria is low or high. This will serve as a guide to the Monetary Policy Committee of the Central Bank of Nigeria in arriving at her policy rate (Monetary Policy Rate), which serves as an anchor to other market (interest) rates