CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

Globalisation has increased the openness of global economies thereby necessitating an

increased focus on exchange rate pass-through with the aim of determining an appropriate

monetary policy response to exchange rate fluctuations. The incidence of large fluctuations in

exchange rates has informed the need for a better understanding of the determinants of

transmission of exchange rate variations into import and domestic prices (Aliyu, Sanni and

Duke, 2009). The concept of Exchange Rate Pass-Through (ERPT) has been well known to

Economists for a long time but significant interest in the concept grew since after the Plaza

Accord of 1985. This was an agreement between France, West Germany, Japan, USA and

UK to depreciate the US dollar in relation to the Japanese yen and German Deutsche Mark

and it was expected that the price of Japanese import in US dollar would be expensive.

However, it was later observed that the price of the Japanese imports in US dollar rose only

slightly or even remained unchanged and in some cases actually declined (Goldberg and

Knetter in Berga, 2012). This prompted Economists‟ increased interest in trying to estimate

the extent of speed and magnitude of Exchange Rate Pass-Through (ERPT).

Exchange Rate Pass-Through refers to the change in domestic prices that can be attributed to

a prior change in the nominal exchange rate (Aliyu et al., 2009). It is also generally

considered as the extent to which changes in exchange rate are reflected in the prices of

goods and services (Sanusi, 2010). When there is a proportionate change in domestic prices

arising from a change in exchange rate, the pass-through is said to be complete. It is

incomplete when the change is less than proportionate and zero pass-through occurs, when a

change in exchange rate does not affect domestic prices. ERPT affects consumer prices

directly through prices of imported consumer goods and indirectly through the prices of

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imported intermediate goods. When the currency of the domestic country appreciates, it will

lead to lower import prices of finished goods and inputs. Likewise, when the domestic

currency depreciates, it will result in higher import prices which are more likely to be passed

on to consumer prices. Currency depreciation also causes a rise in the prices of imported

inputs which may result in the increase in the marginal cost of producers. Thus, this results to

higher prices in domestically produced goods (Mohammed, 2013).

Initially ERPT was perceived to be theoretically one-to-one, i.e, hundred percent change in

foreign price is wholly passed unto domestic consumer prices. This is because the Purchasing

Power Parity (PPP) was based on the perfect competitive market model. However, later

empirical studies have found ERPT to be incomplete (Berga, 2012). This may not be

unconnected with the fact that most of the assumptions underlying the theory do not exist in

reality thus, leading to contradictory outcomes from empirical studies. Some of the

explanations to the incompleteness of pass-through include the exporters‟ Pricing-To-Market

(PTM). Krugman (1987) first popularised this idea that, when there is a depreciation in the

importers‟ currency, foreign exporters tend to reduce their export prices by reducing the

margin of their profits instead of increasing the import prices in order to maintain market

share. Similarly, exporters may invoice in the currency of the importer known as Local

Currency Pricing (LCP). In such situations, prices do not often fluctuate with the variation in

exchange rate (Goldberg and Knetter, 1997). Similarly, some studies on ERPT have found

that in some cases, there tend to be higher pass-through during appreciation than during

depreciation. In some situations also, there tend to be zero/low pass-through during small

changes in exchanges and higher pass-through during higher changes in exchange rate. This

brings about the concept Asymmetry in ERPT.

There has been a debate about the major sources of inflation in Nigeria. Exchange rate

depreciation is believed to be one of the sources of inflationary trend in Ni