Exchange Rate and Inflation: A Test of the Law of One Price in Nigeria

A simple model of inflation was built on the foundation of the Vector Autoregressive framework to analyse the response of domestic commodity prices to currency prices, global price trend and a number of macroeconomic variables. The study sought to determine the extent to which exchange rate values contribute to inflation and by extension, test the acceptability of the theoretical argument for complete exchange rate pass-through using Nigerian data. Series were confirmed to be integrated of order one when the Augmented Dickey Fuller test was applied to check the order of integration. Using the Johansen cointegration procedure, it was also established that there is long-run equilibrium relationship among the variables. The results of the Vector Error Correction Model confirmed the response of inflation to exchange rate in Nigeria. Inflation was also found to respond to the global trend of prices and those variables other than openness. Short run adjustment to long run equilibrium is completed within two years. Supply side measures were recommended as potent in correcting inflationary pressures in Nigeria.