Fiscal deficit, the parallel market for foreign exchange and money supply endogeneity in Nigeria

The main purpose of this dissertation is develop a model of inflation and monetary financing of fiscal deficits emphasizing the role of the parallel exchange rate, which is tested using data from Nigeria. The main point of departure from existing theoretical models, which emphasize an asset motive for holding parallel foreign currency, is the specification of a transaction demand for parallel currency arising from the demand for unofficial imports. The inclusion of a transaction motive in the model of the parallel market for foreign exchange results in the possibility of a stable steady state, in addition to the saddle path equilibrium that results in a model with only an asset motive. In addition, comparative static exercises show that the effects of devaluation policy, reserve policy, and fiscal policy on the parallel exchange rate premium depend on the relative strength of the asset and transaction motives in the demand for parallel currency. For exogenous changes in the price of exports, the effect on the parallel market premium is definitely negative regardless of the relative strength of the two motives for holding foreign currency. A structural econometric model uses two-stage least squares instrumental variables to estimate the equations for the parallel exchange rate and the inflation rate using annual data for Nigeria. Transaction motive variables are somewhat stronger and more significant than asset motive variables in the reduced form equation for the parallel market exchange rate. For the inflation rate the structuralist model provided stronger results than the monetarist model. The approximation of the money stock identity around the sample means shows that domestic credit to the government and the private sector were roughly equal components of the increase in the money supply. A Vector Autoregression model was estimated using quarterly data for the parallel market exchange rate, the stock of money and the price level series, all measured in differences of the natural logarithms for reasons of stationarity. The parallel market exchange rate and prices, and to a lesser extent, money and prices have two-way causal relationships. No causality is found between money and the parallel market exchange rate.