A small open economy model for Nigeria: a
BVAR-DSGE(λ) approach
O. láye.ni O. láolú Richard
Department of Economics, Obafemi Awolowo University, Ile-Ife, Nigeria
Tel:234(0)8059856698; email:rolayeni@oauife.edu.ng
July 8, 2009
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Abstract
Motivated by the way a small open economy should react to business cycles,
we have estimated a small open economy (SOE) model for Nigeria. This is with a
view to understanding how the Nigerian economy should be managed in the face of
a cycle such as the current global meltdown. Our SOE model is used to generate
dummy observation priors for the VAR in line with the BVAR-DSGE(λ) technique.
We consider four monetary policy rules and estimate each of the resulting models
using DYNARE 4.0.2. We find that the Central Bank of Nigeria (CBN) places
little weight on the exchange rate behaviour in reacting to the cycles, resulting
in overshooting and persistence in the exchange rate but strongly reacts to the
behaviour of inflation and, to a lesser degree, of output, output gap or its growth
following the shocks.
We conclude that it will be important for the CBN to pursue a guided exchange
rate policy by actively responding to the exchange rate movement to avoid over-
shooting and persistence, that the terms of trade must be endogenize and that
there is scope for the CBN to learn from past policy outcome by building a much
stronger feedback.
Keywords: BVAR-DSGE(λ), SOE, Nigeria
JEL classification numbers: C11,C13,C69
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Introduction
The way a small open economy should react to business cycles is a current issue in the
macroeconomic literature. The importance of this issue has been brought to the fore
consequent upon the current global meltdown. For a developing economy like Nigeria,
this suggests a serious concern for the policymakers. Following the slides in the price of
crude oil and the concomitant depreciation of the naira, the way the Nigerian economy
should react to cycles has dominated the discussions in the political and academic circles.
From October 2008 until March 2009, the immedi