Nigeria's Response to the Crude Oil Price Shock of 2014

The monetary and exchange rate policy, here on referred to as ‘monetary policy’, are significant tools for economic growth and development. Although monetary policy is not the only thing that counts towards a country’s economic prosperity, it plays an important role. In general, the aim of effective monetary policy is to provide the best set of conditions for economic growth, both in the present and, sustainably, into the future. To this end, monetary policy is typically focused on price stability, i.e. keeping inflation within a certain range.

Price stability and exchange rate stability are, however, inexorably linked. A rapid depreciation or appreciation of a currency implies that relative prices of imports and exports change rapidly, too. The implication, therefore, is that—as a key component of subsequent price stability—exchange rate stability is often considered a goal of monetary policy. However, it is important to note that exchange rate stability does not imply the maintenance of a fixed exchange rate. Instead, it implies the absence of rapid exchange rate movements.

Rapid exchange rate movements are unlikely in economies that operate flexible exchange rate policies. In these economies, the probability of an exchange rate movement above a certain threshold is unlikely, except during major events. These major events may occur occasionally. Sometimes, such events can even lead to a change in expectation of future policy or future economic activity. A change in expectation can lead to changes in capital flows, which would affect the currency. A recent example is the decision of voters in the United Kingdom voting to leave the European Union. The change in expectation of future policy and future economic activity led to turbulence in capital markets which saw the British pound weaken from US$1.46 to US$1.30 per British pound in the space of a week in June, 2016.

In many cases, however, exchange rate shocks occur as a result of significant changes in terms of trade. That is, significant changes in the value of exports or imports for any given country. In this context, the question for monetary policy is how to survive these terms of trade shocks or what the best set of polices to mitigate the negative consequences of these shocks are.