Exchange Rate Pass-Through: A Case Study of a Small Open Economy

Abstract

The exchange rate pass-through for Nigeria imports is estimated by applying an econometric procedure to sectoral data which avoids the pit-falls in previous studies. We use the mark-up approach, which implies setting export prices as a mark-up on production costs. So, the price facing importers is the exchange rate adjusted production costs where mark-up depends on the competitive pressures in the import's market and the nominal exchange rate. Our results indicate incomplete pass-through at varying degrees across sectors, which implies that the foreign exporters passed on only part of the increase in their costs of production to import prices. Also, it reveals that the effort of the Nigerian government in encouraging companies to use local inputs where possible instead of relying on imported intermediate inputs is gradually yielding positive results. Important policy implications that follow from our results of incomplete pass-through to domestic prices could influence CBN forecasts of future path of inflation, a key element in the conduct of monetary policy. Indeed, the successful implementation of monetary policy presupposes that CBN has not only a good understanding of inflation dynamics but is also relatively successful at predicting the future path of inflation. Also, our results imply that the exchange rate policy may be a blunt instrument when used to restore external balance since relative price adjustments will be limited. Furthermore, the incomplete pass-through suggests that exchange rate changes are likely to lead to smaller real effects on the economy through lower changes in both the terms of trade and import volumes and finally, the extent of inflation (deflation) effects of exchange rate depreciation (appreciation) operating through changes in the prices of imported goods will be moderated.