THEORETICAL LITERATURE REVIEW OF EXCHANGE RATE ON ECONOMIC GROWTH IN NIGERIA

Exchange rate is the price of the domestic currency in terms of another currency. The worth of a nation currency depends on a number of factors including the state of the economy, the competitiveness of her exports, the level of domestic production and the quantum of her foreign reserves. In a free market economy the exchange rate of a currency is determined by the interplay of supply and demand for that currency, the major objectives of exchange rate in Nigeria are to preserve the value of the domestic currency, maintain a favourable  externally reserve position and ensure price stability. However, the exchange rate policies applied in Nigeria

have traversed into two main mechanisms the fixed and the flexible regimes. A fixed exchange rate regime exists when the central bank issues an official price of its currency in terms of a reserve currency. The rate fixed is known as the currencies per value. Dwivedi (1980). In contrast, a flexible exchange rate regime depicts a situation in which there is no restriction on the foreign exchange transaction. Flexible exchange rates are permitted to fluctuate freely on the market or to respond to daily changes in demand and supply.

However, the choice of exchange rate regime is significantly influence by the degree of openness of an economy. According to World Bank (1997) the more diversified an economy is the more geographically concentrated the trade and the stronger the case for fixed exchange rate regime. On the other hand, the more diversified an economy is the greater the openness of the economy, the better for the country to adopt flexible exchange rate adjustment regime. Such regime reflects economic fundamentals and aims at achieving a stable exchange rate. Borrow et. al.,(1995) argued that the degree of openness of an economy influences the level and rate of economic growth. Thus, countries that are more open to international trade will tend to grow more rapidly because they have developed a greater ability to absorb technological advances and can take advantage of large markets. To this extent, the exchange rate regime influences the volume of international trade, which could bring about a positive effect on the growth of the economy. What this literature suggests is that the type of exchange rate regime which a country adopts influence her international trade. In the view of frankel and Rose (2002) trade should be higher under fixed regimes since exchange rate volatility and uncertainty will be lower, which will tend to reduce the cost of trade and hence increase its volume.

To Corden (2002) every country has wide array of exchange rate regimes to choose from depending on the desired degree of flexibility of the exchange rate regime and the nature of shocks faced by the economy. He said that the good of an exchange rate regime is optimization of output stabilization. Where the shocks are predominantly external such as terms of trade shocks, necessitating changes in relative prices, then flexibility in the exchange rate is most desirable because it’s the real exchange rate. However, where the shocks are mainly domestically induced through growth in monetary aggregate a flexible exchange rate would not be an ideal policy. Here, a proffered option would be a fixed exchange rate regime as money supply becomes an endogenous variable under a fixed exchange rate regime and triggers of an automatic adjustment mechanism that adjust to the shocks in money demand with minimal impact on growth (Celasun: 2003).

Aizenman (1994) has argued that exchange rate regime can influence economic growth through their effect on the rate of physical capital accumulation. This position finds supports in Edwards (1993) who argues that investment will tend to be higher under a fixed exchange rate variability. An exchange rate regime as a result of reduction in policy uncertainties, real interest rates and exchange rate regime could therefore influence growth through its effect on the level of development and financial market. According to an economic and financial review of the central bank of Nigeria presented by the external sector division of its. Research department in September 2003. Labour market efficiency ensures that the normal exchange rate will adequately address the real shocks to the economy. Where real wages are flexible and there is a low pass through of changes in the nominal exchange rate to domestic price levels, movement in the nominal exchange rate will translate into change rate. Where wages are rapid and there is high mobility of labour between sector across regions. The costs associated with exchange rate rigidity are quite high. Moreover, a well-diversified economy lowers the cost of exchange rate rigidity as the associated costs are more diversely distributed among the sectors of the economy and a shock to any one sector is insignificant to the balance of overall output of the economy.

The United Nations economic commission for Africa (UNECA) in its report little exchange rate management policies in Africa: Recent experience and prospects, (2002), opined that among the policy challenges facing many monetary authorities
in African countries are exchange rate managements. This report went further to reveal that many of these countries have moved liberalized their exchange systems and a number have adopted a “managed floating exchange rate regime” or an in dependently floating exchange rate by African countries has not been without its challenges and problems. Indeed, the need to change the institutional and regulatory framework and to develop well functioning foreign exchange markets of the countries.

Furthermore, the need to understand and appreciate the impact of exchange rate liberalization of external stability of currencies, on inflation, supply response and external competitiveness are also some of the challenges that African governments and policy matters have to deal with.

Ojo (1990) is of the view that one appropriate exchange rate will tend to maintain equilibrium in the inflow and outflow of foreign exchange in the economy while an inappropriate exchange rate policy, for instance under the over-valuation of the currency will tend to create instability in the foreign exchange market and make foreign exchange management more difficult. Obadan (1995) asserts that the desirability of exchange rate stability is not doubt in view of the implication of instability for micro and macroeconomic planning and projections and foreign investment flows.

In terms of volatility of rates, most countries have intervened in foreign exchange market in order to influence their exchange rates. This is simply because volatility in market fundamentals such as money supply income and interest affects exchange rate volatility because the exchange rate is a function of these fundamental. Large changes in money supply lead to change (wide swings) in the level of the exchange rate volatility (Bonser, 1996:44). Regardless of the origin of volatility, it could impede international investment flows by reducing investment in foreign financial assets and disrupting the efficient allocation of resources by creating disincentive for movement in investment capital. Therefore, countries that intervene in the foreign exchange rate volatility through the reduction of expected volatility of future market fundaments and policies, and reduction of the likelihood of speculative exchange rate movement.

However Nnanna (2003) is of the view that although the flexible exchange rates has a number of advantage including output stabilization that should ordinarily endure it over the fixed exchange rate regime, exchange rate pegs are rather common amongst small open economy because of the pass through effects of exchange rates movement into domestic prices, issues bordering on credibility, and the associated risks of unfledged foreign currency liabilities given incessant exchange rate volatility. The thinness of the foreign exchange markets in developing countries makes the likelihood of excessive volatility eminent, while the shallowness of the financial.

Obaseki (1998) explains that the equilibrium exchange rate is the desired level of the rate that ensures the simultaneous attainment of internal and external balance. Internal balance reflects a low inflationary variability and competitiveness on account of adequate accommodating capital flows to finance imbalances in the current accounts. Thus, the achievement of a high and sustainable rate of domestic economic growth in addition to price stability and external sector competitiveness amount to the attainment of internal and external balance. The exchange rate at which this is attained is the equilibrium exchange rate.