**Abstract**

The study investigated the influence of innovations in monetary policy on the rate of exchange volatility in Nigeria. The research adopted vector error correction model as well as impulse response function and forecast error variance decomposition function in the estimation using two models derived in the study. Monthly data between the periods 2009 and 2019 were adopted for the research. Our findings show that in the long run; all the monetary policy variables have a significant long run correlation with volatility in the exchange rate; but that money supply and the rate of exchange seem to have significant short run impact on volatility in the exchange rate, the other variables such as liquidity ratio or monetary policy rate did not show a significant short run relationship with the volatility in the exchange rate. Further findings on the volatility impulse response and the forecast error variance decomposition suggest a significant link between volatility in the exchange rate and money supply though the link was much more pronounced. The use of monthly data shows that the managed exchange rate regime by the CBN seems to have the desired effect in exchange rate volatility and thus having a critical impact on inflationary spikes.

**Keywords:** exchange rate volatility, monetary policy, central Bank of Nigeria, exchange rate regime, vector error correction model, impulse response function, forecast error variance decomposition

## **1. Introduction**

#### **1.1 Background of study**

Exchange rate and price instability seems to have a negative effect on producers economic well-being, on upcoming investors as well as the situation of current consumers alike as it results in unpredictability, which has a negative impact on commitments that are of longer run; that reduces the chances of attaining selfreliant growth in output, income, and employment. The foregoing has led both the monetary and fiscal authority to develop policies or moves that aim at the attainment of the exchange rate and price stability. One of the key goals of the monetary authority in Nigeria (Central Bank of Nigeria (CBN)) is the attainment of price and stability of the rate of exchange. The CBN's policy on the rate of exchange regime over the years can be placed in two categories, (1) The Pre-SAP (1960–1986) period, (2) Post SAP (1986–present). The pre SAP period was characterized by: direct foreign exchange control, in that the authorities simply maintained overvalued exchange rates. These policies led to the fall in the value of the naira as it made imports cheaper. It also led to a weak balance of payments position

subsequently. The Post SAP period was characterized by free float exchange rate, which also led to the steep depreciation of the naira.

Emefiele [1] observed that for the Nigeria economy, a depressed GDP growth, which having grown by nearly 7% in previous years culminated in the 2016 recession, rising inflation, did rise to the level of 18.7% by the end of January, 2017 from 9.6% a year earlier, depreciation of the foreign exchange from N155/1 US dollar as at June, 2014 to a peak of N525/1 US dollar in February, 2017. There seems to be a nexus linking shocks from monetary policy to exchange rate volatility for an economy such as Nigeria that is import-dependent [2]. Thus, maintaining an effective and stable exchange rate is a realistic proposition for the Nigerian economy. Exchange rate regimes differ from country to country, and the level of financial development is the basis for whatever policy position a country might adopt. The important attention given to price stability is said to be derived from "new developments in monetary theories and empirical evidence which show that sustainable growth can only be achieved when the price level is stable" [3].

Liberalization of the financial system in Nigeria is still ongoing; hence the anticipated impact of these monetary policy variables in dictating trends in the financial markets such as the foreign exchange market raises a query about their empirically verified effects on the various financial markets. The most pressing issue is the identification of: (a) monetary authority's policy tools and their actual effect on the naira rate of exchange to the US Dollar, (b) the aggregate impact of these tools on the Naira exchange rate, and (c) determining if financial liberalization undertaken in Nigeria has yielded the anticipated results. The main targeted goal this research sought to attain is to ascertain the extent of the volatility of the rate of exchange due to monetary policy shocks. Amato et al. [4] observed that based on "the implications of exchange rates for monetary policy, several questions are particularly relevant these are; what is the appropriate response of volatility in the exchange rate to broad money supply, treasury bills rate, statutory liquidity ratio, exchange rate and the external reserve changes"?

The theoretical postulations of Mundell-Fleming known as the impossible trilemma states that every country has three policy options, and these are: (i) unfettered mobility of capital, (ii) rate of exchange that is fixed, and (iii) ability to embark on monetary policy that can be considered independent. That any country's monetary authority can only apply two of the three policy options simultaneously at any point in time. What is revealed from the Nigerian experience is that in its adopted regime on the rate of exchange, the Central Bank of Nigeria has taken a middle ground approach as regards its regime on the rate of exchange by using a managed float exchange rate regime, thus making the exchange a monetary policy tool. The CBN has also allowed the operation of three different exchange rates in Nigeria. The foregoing was though not factored into the policy prescriptions of Mundell-Fleming.

The rest of the study is subdivided into: 2—review of relevant literature; 3 methodology, 4—data presentation, analysis, and discussion; 5—summary.

### **2. Review of relevant literature**

#### **2.1 Conceptual framework**

#### *2.1.1 Exchange rate volatility*

The rate of exchange refers to that rate at which the currency of one country is converted to another currency from a different country. There is volatility in the exchange rate when the rate of such exchange rate change happens rather randomly or in rapidity. Ozturk [5] defined exchange rate volatility as being associated with exchange rate movements that are unexpected. Exchange rate volatility has been a serious concern for those in the academia, policymakers, and participants in the financial markets for all economies across board in the world [6]. The volatility of the exchange rate has inflationary tendencies; hence the attempts by the central banks to watch exchange rate volatility.
