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The Bretton Woods monetary system of fixed exchange rates, which evolved immediately after the Second World War, worked fairly well for nearly thirty years until 1973 when it broke down. U.S. huge current account deficits occasioned by its involvement in the Vietnam War, posed significant challenges to the system. Upon the demise of the Bretton Woods system, a generalized system of floating exchange rates emerged, particularly for the developed countries. The developing countries have had varied experiences with exchange rate regimes, in choosing exchange rate regimes, developing countries need to be fully aware of the circumstances and conditions for their successful adoption. The important factors and criteria in such choices also need to be properly understood. Various forms of exchange rate regimes are open to individual countries. They range from clean floating or flexible exchange rate regime at one extreme to firmly fixed arrangements at the other extreme, with the remaining regimes falling in a continuum in between. These include managed float, pegs, target zones, currency boards, monetary union and dollarization Obadan (2009). In the last few years, a number of developing economies including Nigeria have moved from fixed to flexible exchange rates. This has in most cases led to instability in exchange rates thereby creating an atmosphere of uncertainty which help to aggravate the problem of inflation in the economy.


Monetary policy and exchange rate are key tools in economic management and in macroeconomic stabilization and adjustment process in developing countries like Nigeria, where non-inflationary growth and international competitiveness have become major policy targets. Real exchange rate is one broad measure of international competitiveness, while inflation emanates largely from monetary expansion, currency devaluation and other structural rigidities in the economy. The question of the exchange rate regime that a small open economy should choose has no definite answer, since such a choice depends on the objectives and focus of monetary authorities, as well as on assumptions about the structural characteristics of the economy. Structural characteristic of the economy in this sense implies openness of capital mobility, wage indexation and the level of economic growth and development (Busari et al, 2008).

Monetary policy formation and implementation thus influence macroeconomic variables, (hence macroeconomic stability) in any economy whether developed or underdeveloped. The critical distinction is the degree to which movement in the exchange rate pass-through to effects domestic macroeconomic variables, most especially consumer prices, output (as a measure of Gross Domestic Product GPD) and private consumption. The choice of an exchange rate regime is linked to some extent, to the achievement of specific targets set by the monetary authorities. Most of the times, these targets are related to internal and external imbalances. Therefore, a correlation between the choices of the exchange rate regime and real output, prices, balance of payments stabilization, and the sources of shocks hitting the economy is expected (Busari et al, 2008).


When the goal is balance of payments stabilization, it is preferable to adopt a flexible exchange rate system to overturn any current or capital account disequlibrium. Here consideration has to be taken on the Marshall-Lerner conditions, the degree of capital mobility and foreign reserve constraint. When the objective is to stabilize domestic price, the financial discipline issue becomes relevant. Many economists believe that the exchange rate can be used as an anchor for financial stability since it is one price of the economy. In this sense, a fixed exchange rate imposes a degree of financial discipline by discouraging recourse to inflationary finance. In contrast to this reasoning, proponents of exchange rate flexibility argue that the announcement of a fixed exchange rate would only cause financial crises followed by continuous devaluation. Finally when the objective is to stabilize real output, the role of exchange rate regime is mainly viewed as a shock absorber. That is, the choice of exchange rate regime is used to spread these effects. Therefore, this choice will depend on the nature of the shocks and the structural characteristics of the economy. Hence, it seems there is a clear trade-off between output/consumption volatility and inflation volatility. With a very high exchange rate pass-through, all monetary rules face a significant trade-off. The nature of the trade-off is also seen between “fixed and flexible” exchange rates (Busari et al, 2008).

While inflation rate is often used to track movement in domestic price level, exchange rate is used as policy tool in ensuring external stability and enhancing export performance (Caballero and Corbo, 1989). In addition, exchange rate policy impacts on the outcome of stabilization measures and debt management strategies (Busari and Olayiwola, 1999), especially in developing countries.


Generally, both fiscal and monetary policies seek to achieve relative macroeconomic stability. While the Keynesians argued that fiscal policy is more potent than monetary policy, the monetarists led by Milton Friedman on the other hand believed the other way round. (Azam, 2001), states that macroeconomic instability can be regarded as a situation of economic malaise, where the economy does not seem to have settled in a steady equilibrium position thereby making it difficult to make predictions and good planning.

Since the rate of interest is the cost of credit, monetary policy includes the control of money supply (through the control of high-powered reserves) and the rate of interest, (Iyoha, 2002). The success of monetary policy however, depends on the operating economic environment, the institutional framework adopted and the choice and mix of the instrument used (Nnanna, 2001) which was why the Central Bank of Nigeria (CBN) deemed it necessary to continuously reassess and evaluate its monetary policy implementation framework to enable it respond to the ever-changing economic and financial environment.

Embedded in these objectives is a separate but highly related role, that is, a financial surveillance (stability) role. In order to ensure the realization of the goal of monetary and macroeconomic stabilization, the CBN deploys its monetary policy instruments in such a way as to ensure optimality in inflation, exchange rate and growth outcomes.


Since the mid- 1970s, the developing countries have moved to either pegging to a basket of major currencies, away from a single currency peg, or


adopting a more flexible exchange rate regime. In order to reduce the uncertainties arising from the medium – or long-term swings of major currencies which have produced various problems for them, developing countries have had the inclination to adopt intermediate exchange rate regimes rather than the polar regimes of firmly fixed exchange rate and floating exchange rates (Obadan, 2009).

Under the Structural Adjustment Programme, Nigeria’s economy was deregulated in 1986; a market based framework for the determination of exchange rate was adopted. This policy was made a tool for inducing the export promotion goal, coupled with other export targets such as the export incentives and miscellaneous provisions decreases of 1986. In spite of all the policy measures indicated above, the external sector performance has remained poor and uninteresting; the outcome of exchange rate policies remained unstable. Consequently, other sectoral policies failed woefully as the target of the other macroeconomic aggregates, which includes: interest rate, inflation rate, unemployment, money supply remained largely unrealized (Ifionu et al, 2007).

Since the early 1990s, two notable developments have conditioned the type of exchange rate regimes adopted by the developing countries; these are the intensification of globalization and emergence of financial crises. No doubt, the deep integration of a number of developing countries into the global economy has promoted trade in goods and services between the developed countries and the developing/emerging market economies. Thus, the choice of exchange rate regime by developing countries is of crucial importance to their self-protection from speculative attacks and currency crisis as well as


achievement of long-term growth. And the choice of exchange rate regime in the developing countries means which regime would be most appropriate not only for preventing massive capital inflows and currency crises but also for better facilitation of trade, FDI and economic growth (Obadan, 2009).

Thus, for the developing country, more access to the global capital market poses a policy dilemma for the choice of exchange rate regime. It seems, therefore, that the choice of an appropriate exchange rate by a developing country is not a straightforward task. Suggestions have been made that an appropriate exchange rate varies depending on the specific circumstances of the country in question and on the circumstances of the time period in question (Frankel, 1999).

Yet, in recent years, following the currency and financial crises of the 1990s, many developing countries have been advised to shift to the polar exchange rate regimes: flexible or fixed exchange rates with monetary union (or currency board). The feeling is that intermediate regimes between two polar regimes are no longer tenable, considering the trilemma entailed in the principle of the impossible trinity. This trilemma entails the difficulty in attempting to pursue exchange rate stability, capital mobility, and independent monetary policy. It is not possible to achieve all three objectives simultaneously; it is possible at most to achieve two of the objectives, making it necessary to sacrifice at least one (Obadan, 2009).

And as the argument further goes, as more countries try to have access to global financial markets, the choice of exchange rate regime is narrowed down to the degree of flexibility in terms of a perfect free floating or hard fixed exchange rates such as monetary union, currency board or even


dollarisation. This tends to be in line with the thinking of some analysts that some countries are better suited for a fixed exchange rate regime with monetary union or currency board while others are better off adopting a flexible regime.

Nevertheless, as at date, not much knowledge can be claimed about workable exchange rate regimes. As Velasco (2000) has observed, during the 1997 – 98 Asian crisis, arrangements that had performed relatively well for years came crashing down with almost no advance notice; other arrangements that once seemed invulnerable almost tumbled down as well. Mid-course corrections and policy changes proved equally troublesome; in every country that abandoned a peg and floated, the exchange rate overshot massively and a period of currency turmoil followed with attendant tremendous real costs. In choosing exchange rate regimes, therefore, developing countries need to be fully aware of the circumstances and conditions for their successful adoption. The important factors and criteria in such choices also need to be properly understood (Obadan, 2009).

Again, a number of empirical studies show that one of the factors that led to variations in inflation in Nigeria is changes in exchange rate (Folawewo and Osinubi, 2006). Ukwu et al (2003) in their paper, observe that there is a general agreement that a low long-term rate of inflation can be achieved by sufficiently limiting the rate of growth of broad monetary aggregate over a long time dimension. Inflation and exchange rate as at 2005 remained high and volatile. This does not mean well for the economy as it becomes difficult for investors to make good and stable business decisions in such situations. This no doubt represents a major constraint to stabilization opportunities in


monetary policy in Nigeria. Also it is observed that monetary policy stimulates growth better under a flexible rate regime but it is accompanied by severe depreciation, which could destabilize the economy.

Despite these observations, the effectiveness of monetary policy in macroeconomic stabilization under exchange rate regime has been less examined in Nigeria; thereby creating an information gap at the expense of economic expansion. It is against this background that this paper seeks to investigate the interaction between monetary, macroeconomic stabilization and exchange rate regime in Nigeria. The research questions that arise from above are as follows.

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