*4.1.7 Forecast error variance decomposition functions*

The graphs of the forecast error variance decomposition functions are presented in **Figure 4**.

As shown in **Figure 4**, it can be observed from the variance decomposition of exchange rate volatility that own shocks contributed most [100%] to its variations in the first month of forecast but declined drastically in the other months. The proportions of variations in exchange rate volatility, due to shocks in treasury bill

**Figure 4.** *Forecast error decomposition functions. Source: Results extract from E-views 11.0.*

rate and liquidity ratio, are minimal throughout the 5 months of forecast. As revealed in the top panel of **Figure 4**, the variance decomposition function for exchange rate volatility due to own shock (top left corner) is the transpose of that due to exchange rate shock (top right corner). Thus, the percent exchange rate volatility variance due to a shock in exchange rate is minimum [0%] in the first month of forecast. However, in all other months of forecast, it rose drastically to an average of 90% ranging between 86% and 91%. To this end, the variance decomposition of exchange rate volatility shows that own shocks predominantly determined variations in the first month of forecast while exchange rate mainly accounted for volatility in exchange rate in the other periods. Treasury bill rate and liquidity ratio accounted for less than an average of 3% all through the five months of forecast.

#### **5. Summary**

The first model shows that the monetary policy rate did not have a significant relationship with volatility in the exchange rate not even with a two-month lagged period, but the money supply had a negative and significant short run nexus with the volatility in the exchange rate. Though, the monetary policy rate was not significant; yet the impulse response functions exchange rate volatility responded negatively to innovation in the MPR from what is revealed by **Figure 1**. The forecast error decomposition reveals that own shocks account for 100% of variation in the first month falling to only 91% in the fifth month; there were minimal variations for monetary policy rate and money supply for five months. The two variations account for less than 6% in the entire forecast period. Though, MS was marginally higher than MPR.

In the second model, the Treasury bill rate's two lagged values were not significant in the short run. The liquidity ratio's two lagged values of the liquidity ratio nexus with the volatility of the exchange rate were not significant in the short run. Exchange rate volatility responded negatively to innovations in Treasury bill rate throughout the 5 months of forecast. But a shock to liquidity ratio and exchange rate volatility responded positively all through the five months of forecasting exchange rate volatility and responded positively to shocks in exchange rate within the months of the forecast as shown in **Figure 3**. Shocks predominately determine variations in its variations, in the first month of forecast, while exchange rate and liquidity ratio accounted for less than average of 3% all through the five months of forecast as in **Figure 4**.

#### **6. Conclusion**

In the long run, monetary policy instruments tend to have significant long run nexus with the volatility in the exchange rate; yet looking at the critical short-run dynamics, we find that only the exchange rate and money supply that have significant short-run impact on volatility in the exchange rate. The nexus for money supply is negative as in a priori expectation; yet exchange rate had a negative but significant impact on the volatility in the exchange rate.

The study seems to justify the CBN's managed float exchange rate regime a well as reliance on monetary targeting as this tends to stabilize the volatility in the exchange rate, due to its inflationary impact (volatility in the exchange rate). The Mundell-Fleming trilemma never envisaged the existence of managed float exchange rate regime, and this has produced and unexpected reality as it exists in Nigeria. The impact on deposit money banks as a result of an unmitigated fall in the *Exchange Rate Volatility and Monetary Policy Shocks DOI: http://dx.doi.org/10.5772/intechopen.99606*

rate of exchange and the attendant inflationary spiral is something that should be of serious concern to the CBN and other regulatory institution. Inflation and exchange depreciation will impact negatively on the assets of DMBs and the ability of stable and useful global players; hence the ability of the CBN's managed float exchange rate regime to mitigate such volatility happens to be a great relief.
