Transmission of Periodic Shocks from Exchange Rate to Inflation in Nigeria: Local Projection Impulse Response Function (LPIRF) Approach

The periodic shocks from exchange rate to inflation over the years have been a matter of great concern to policy makers in many import-dependent economies such as Nigeria. Hence, this study investigated the transmission of periodic shocks in exchange rate to inflation in Nigeria over the period 1981-2023. The study employed the innovative local projection impulse response function (LPIRF) to examine the response of inflation to shocks in exchange rate. Given several economic crises, policy and institutional changes in Nigeria, the model variables were subjected to multiple structural breaks. The LPIRF analysis reveals that the exchange rate pass-through (ERPT) to inflation in Nigeria is relatively low at 5.5% after two years, suggesting limited direct transmission of currency depreciation to consumer prices. This modest ERPT, although surprising, supports the hypothesis that foreign exporters to Nigeria engage in pricing-to-market strategies, absorbing exchange rate changes rather than fully adjusting export prices. It further indicates that while inflationary shocks from its own past values are short-lived, shocks from exchange rate variations have persistent effects, lasting up to a decade. Lastly, the counterfactual analysis confirms that exchange rate shocks, when conditioned on variations in the exchange rate, maintain a substantial pass-through to inflation. The study recommends that government authorities should consider improving foreign reserves management, implementing transparent foreign exchange allocation, and reducing parallel market pressures, as well as put in place structural reforms to promote local manufacturing and agricultural value chains that can mitigate the vulnerability of domestic prices to exchange rate fluctuations.