Fiscal Deficit, Inflation, and Currency Instability: Identifying Transmission Mechanism in Nigeria
Keywords:
Fiscal Deficit, Inflation, Currency Instability, Transmission Mechanism, Structural Vector AutoregressiveAbstract
This study investigates the transmission mechanisms linking fiscal deficit, inflation, and currency instability in Nigeria from 1981 to 2025. Anchored on the Fiscal Theory of the Price Level and the Monetary Approach to Exchange Rates, a Structural Vector Autoregression (SVAR) framework was employed to analyze these dynamics. Unit root tests confirmed variables are integrated of mixed order, validating the use of differenced data for robust inference. The SVAR estimation results reveal that fiscal deficits significantly drive exchange rate depreciation, with a coefficient of 0.452 (p<0.01). Inflation acts as a critical mediating variable; fiscal expansions fuel domestic price levels (coefficient 0.523, p<0.0I), which subsequently erode the Naira's purchasing power. While oil price volatility remains a significant external shock, variance decomposition indicates that over half of the forecast error variance in exchange rates is attributable to structural shocks from fiscal deficits and inflation. These findings confirm that fiscal indiscipline and deficit monetization are central to Nigeria's chronic exchange rate instability. The analysis established inflation as a critical mediating variable; fiscal expansions fuel domestic price levels, which subsequently erode the purchasing power of the Naira, leading to rapid depreciation. Consequently, this study recommends urgent fiscal consolidation to reduce the primary deficit-to-GDP ratio through enhanced non-oil revenue generation and reduced recurrent expenditure. Crucially, the Central Bank of Nigeria must curtail deficit monetization and maintain an independent, tight monetary policy focused on inflation targeting. By anchoring inflation expectations and accelerating economic diversification away from crude oil dependence, policymakers can mitigate pass-through effects and restore confidence in the Naira. Addressing these root causes is essential for achieving sustainable macroeconomic stability and breaking the cycle of currency depreciation.Downloads
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