External vulnerability and optimal monetary policy in Nigeria

Abstract

In this study, we assess the external vulnerability of the Nigerian economy by documenting three alternatives (zero, partial and full) oil price pass-through to inflation within a New Keynesian Dynamic Stochastic General Equilibrium (DSGE) framework. The results show that under a zero-oil price pass-through, the choice of inflation measure is immaterial, as macroeconomic responses to the shock are comparable under alternative Taylor rule specifications. The shock precipitates stagflation, transmitted via the income and exchange rate channels; and introduces an extra layer of vulnerability associated with higher external risk premium. Both core and oil inflation targeting monetary rules maximize welfare under a zero-oil price passthrough, while oil inflation targeting is shown to be welfare superior under partial or full oil price pass-through. Credibility consideration renders core inflation targeting the feasible optimal path for the central bank.