An Empirical Assessment of the Real Exchange Rate and Poverty in Nigeria: Empirical LiteratureEquations 4 and 5 can be used to illustrate the conditions for internal and external balance, which requires excess demands for non-tradables and tradables to equal zero. In this regard, (E, G) which represents internal equilibrium, is represented by a curve with negative slope, (MM). This highlights the idea that a RER appreciation is key in restoring equilibrium in the non-tradable market when public spending goes up. In other words, a rise in absorption, which is the same as an increase in public expenditure, triggers an excess in the demand of non-tradables. The relative price of nontradable has to go up for the imbalance to be eradicated, implying that the RER has to appreciate. The external equilibrium is represented by an increasing curve (CC), implying that if public expenditure increases (so does the absorption), relative price of tradable must rise in order to eliminate the external imbalance. The simultaneous internal and external equilibriums are represented in point at E in Figure 1.
The point D represents a condition where there is an external imbalance, such as a trade deficit. D can also be described as a situation where the RER is below the equilibrium level, or overvalued. This is indicative of the conditions that prevailed in many African countries after the second oil shock (Oumar, 2007). One way of clearing this external imbalance, moving from D to E, consists in both reducing the absorption and depreciating the relative price of tradables to non-tradables. Economic policies are therefore designed to achieve these two objectives and such policies are usually qualified as good economic policies. These policies include prudent fiscal, monetary and exchange rate policies with the focus of avoiding the overvaluation and excessive absorption. Obviously, economic policies in the dependant economy model’s framework tend to primarily impact on the RER and absorption. As a result, analyzing the impact of sound economic policies on poverty, amounts to assessing the impact of RER and absorption on poverty.
In the empirical literature investigating the relationship between RER and poverty are linked with the level of output. In this regard Modey analyzed the effect of RER on output for 28 devaluing countries using a regression framework. After the introduction of controls, he found that depreciation of RER induce changes in output. Rodriguez and Diaz estimated a six variable VAR-output, growth, real wage growth, exchange rate depreciation, inflation, money supply and the Solow residuals in an attempt to decompose the movements of Peruvian output. They observed that output growth could mainly be explained by “own” shocks but was negatively affected by increases in exchange rate depreciation as well. Rogers and Wang obtained similar results for Mexico. Using a 5-variable VAR model-output, government spending, inflation, RER and money growth-they found that most variations in the Mexican output resulted from “own” shocks. They however added that exchange rate depreciation led to a decline in output.
Kamin and Khan used error correction mechanism in assessing the link between output and the RER for a group of 27 countries. Their result showed that devaluation is not contractionary in the long term. After controlling for spurious correlation, reverse causality appeared to alternate the measured contractionary effect of devaluation in the short term, although the effect persisted even after the introduction of controls. read more

Figure-1

Figure 1: Dynamics in a dependen: economy model