Modeling the Asymmetric Effects of External Reserve Accumulation on Exchange Rate Stability in Nigeria

ABSTRACT : This paper investigates the asymmetric effects of external reserve accumulation on exchange rate stability in Nigeria between 1980 and 2019. A nonlinear autoregressive distributed lag (NARDL) method is applied to examine how partial sums of positive and negative changes in external reserves affect exchange rate stability. The empirical model is augmented to incorporate the asymmetric effects of trade and financial openness based on exchange rate stability based on theoretical predictions. The bounds cointegration test result shows evidence of asymmetric long run relationship among the variables. The estimated dynamic NARDL model reveals that exchange rate responds positively to positive changes in external reserves in both short and long run. This evidence suggests that increase in external reserve is important for achieving meaning stability in exchange rate in Nigeria. The results further reveal that exchange rate responds positively to positive changes in trade openness in the long run, but negatively to one period lag of negative changes in trade openness in the short run. The implication of this finding is that increase in cross-border trade transactions promotes foreign exchange earnings, which in turn support the goal of exchange rate stability. Additionally, the partial sums of positive and negative changes in financial openness have mixed effects on exchange rate. While exchange rate responds negatively to positive changes in financial openness in the short run, its response to negative changes in financial openness is significantly positive in both short and long run. Based on the findings, this paper recommends that the CBN should ensure prudent management of external reserves to optimize the associated benefits in terms of exchange rate stability while minimizing the associated costs.
KEYWORDS: Exchange rate, external reserve, trade openness, financial openness and Nigeria