UNIVERSITY OF DUNDEE

CENTRE FOR ENERGY PETROLEUM AND MINING

LAW AND POLICY (CEPMLP)
DO EXTERNAL SHOCKS HAVE AN IMPACT ON
ECONOMIC STABILITY? A STUDY ON NIGERIA

EGHOBAMIEN OSASU
150020882
JANUARY 2016

TABLE OF CONTENTS
LIST OF FIGURES AND TABLES

ABSTRACT

1.0

INTRODUCTION

2.0

LITERATURE REVIEW

3.0 METHODOLOGY
3.1 A Block Restriction Approach
3.2 Cholesky Decomposition
3.3 Sample selection

6
6
7
8

4.0 MODEL ESTIMATION RESULTS ANALYSIS

4.1 Impulse responses of External Shocks
4.2 Variance Decomposition (VD) of Domestic Variables

8
9
11

5.0

12

CONCLUSION

13

REFERENCES

LIST OF FIGURES AND TABLES

Figure 1 Impulse Response for CPI and GDP to crude price shocks
Figure 2 Impulse Response for CPI and GDP to Exchange rate shocks
Figure 3 Impulse Response for CPI and GDP to interest rate shocks

9
10
10

Table 1 Variance Decomposition of CPI

Table 2 Variance Decomposition of GDP

11
11

ABSTRACT
This research analyses the effect of external shocks on domestic
economic variables for Nigeria for the period of 1990Q1-2015Q4
using the Vector Autoregression with Block Restriction (VARBR)
model.

Impulse

Response

Functions

(IRFs)

and

Variance

Decomposition tools were used to measure percentage impact of

world oil prices, Exchange rates and Interest rates on Consumer
Price index (CPI) and Gross Domestic Product (GDP) for short and
medium term periods. Trace and Eigenvalue results support noncointegration between variables confirming suitability of the model.
Estimation results show that Inflation variation is affected by Oil
price shocks more than other shocks while GDP is affected by
Exchange rate shocks, followed closely by Oil Price Shocks. Interest

rate shocks have the least effect on the economic variables. The
results from this model suggest the presence of the Dutch disease in
the economy of Nigeria.

1.0

INTRODUCTION

Macroeconomic stability describes a national economy with minimised vulnerability

to economic shocks, increasing its possibility for sustained growth. Inflation is a
macroeconomic variable linked closely to economic stability. Moderate inflation
signifies economic development however; higher inflation levels may lead to
undesirable economic outcomes. This is because higher inflation levels lead to greater
uncertainty associated with anticipated business profits, which in turn discourages
business investment and damages purchasing power on the side of the consumer.
Real output of an economy is considered as closely as a macroeconomic variable to
economic stability as inflation.
For a crude exporting country, upward trend in crude prices increases domestic supply
cost invariably shifting supply curve downward and to the right, increasing the real
output of the economy. Higher world interest rates reduce consumption and
investment expenditures, causing harm to real output (Hsing 2012). Increase in
exchange rates leads a country to tend towards more exportation, thereby increasing
production which will increase real output of an economy. In this case, it is possible
for a weakening exchange rate to have positive effect on the wealth of a nation,
(Lavelle 2012).
Some factors such as crude oil price volatility, exchange rates and world interest rate
differences have been associated with economic instability in Nigeria and have
become evidenced in the lives of citizens through the persistence of irregular supply
of basic economic needs, corruption and poor infrastructure.
Hamilton (2009) gave a detailed analysis of world oil price shocks for the last four
decades, showing how world crude price has fluctuated in high and low waves from
$40 per barrel1, to hovering in intermittent small rises and drops between $36 and $63
in 2015(OPEC statistics 2015).

Which is an equivalent of over $100 at current prices

While kryznar and kunovak (2010) analysed the impact of oil price shocks on
Inflation and GDP in Croatia, this paper intends to analyse the vulnerability of
Nigerias economy to oil price shocks and other external shocks such as real effective
exchange rates (Naira/USD) and global interest rates. The purpose of this is to provide
a more comprehensive study on the level of impact oil price shocks have on economic
stability.
Analysis is carried out using Vector Autoregression with Block Restriction (VARBR)
model. Given the number of variables, the use of this model is appropriate for this
analysis and will ensure possibility of analysing the impact of external shocks on
domestic economic variables. In contrast to recent literature, this paper analyses based
on two separate endogenous variables, Inflation and economic output. Based on
Impulse Response Function and Variance Decomposition of external shocks,
This paper quantifies their levels of impact on the domestic variables. The results
from the analysis estimated through the above stated methodology gives conclusion
on the level of importance oil price and other external shocks have on the stability of
Nigerias economy. Furthermore, this research is able to identify based on the results
which of the endogenous variables has more impact on the countrys economic
fluctuations.
The rest of this paper is arranged as follows: section 2 gives a review of literature
relevant to this study, section 3 describes the VARBR methodology, data and
modelling approach, section 4 outlines and explains estimated results and section 5
concludes the paper.

2.0LITERATURE REVIEW
In line with similar studies available in literature, a number of researchers have made
attempts to study the effect of external shocks on economic output (hereon known as
GDP) and inflation on developed economies. Few studies have been done on
developing small open economies.
Kryznar and Konovac (2010) analysed the impact of external shocks on inflation and
GDP of Croatia. Using a VAR model, estimated results suggests external shocks
having a significant spillover effect of Consumer Price Index (CPI) directly and
indirectly but barely explains domestic shock variation. However, European Union

(EU) GDP shocks seem to be a major factor on domestic GDP variation. Blanchard
and Gali (2010) identified the effects of oil price shocks on developing economies.
Their analyses imply the possibility of oil price shocks having a time coincidence
with variations of a different form. They also added that the effects of oil price shocks
changed over time with steadily smaller impact on GDP in more recent years. Vu and
Nakata (2014) studied the effects of oil price shocks on six ASEAN economies. They
concluded that oil importing ASEAN economies are more sensitive than their
exporting counterparts. The surge in global oil prices in 2008 was significant to high
inflation growth in 2008.
However, a few researchers have reached contrasting conclusions. Lorusso and
Pieroni (2015) and Allegret, et al (2012), applying structural VAR model and VAR
with block exogeneity respectively, assented to immediate decline in GDP growth
resulting from negative crude oil price shocks whereas, aggregate demand increased.
Their estimates imply that oil price shocks caused steady increase in inflation. Hsing
(2012) Investment-Savings-monetary-policy (IS MP) model approach noted a positive
relationship between international crude price and real GDP and a negative effect on
GDP by real exchange and world interest rate. In contrast to other Asian countries,
Indonesias GDP is not affected significantly by oil price shocks because most of the
crude demand is met locally. In an empirical analysis of inflation in Nigeria,
Odusanya and Atanda (2010) agree with Blanchard and Gali (2010) in attributing only
a moderate effect of oil price shock on inflation.
On a more historic account, Raddatz (2008) and Raddatz (2006) documented that oil
price did not have significant effect on economic stability before 1990. However, oil
price impact increased significantly with foreign trade. This reason agrees with that of
Hsing (2012).
A possible explanation for the different results from different analyses is the varying
economic and trade systems in different countries. Most Asian countries are crude
importers apart form Indonesia, reflecting in their contrast in outcomes of their
analysis. From Ghanas conclusion, other domestic factors have significant impact on
GDP and inflation variations over the years.
In contributing to research, most studies of this kind have considered the impact of
only world oil price, ignoring other important external factors such as real exchange

rate and real interest rates. Also, barely any research has been carried out with Nigeria
as a case study. Interesting results from Nigerias economy are anticipated because it
is the largest crude oil producing and exporting country in Africa, with daily
production of 2.5 million barrels per day at the end of 2014 (Africa Ranking, 2015).

3.0

METHODOLOGY

For the purpose of this study, Nigeria is assumed to be a small open economy. VAR is
usually employed to examine and analyse the effects of external shocks in the share of
economic output and inflation variations by analysing oil price, real exchange rates
and interest rates. VAR is modelled with the assumption that all variables in the
system interact amongst themselves, treating all variables as exogenous and as a
function of all variables in lags. This assumption will not correctly apply in modelling
a small open economy in which its variable shocks are unlikely to affect larger
economies. Therefore, this paper adopts the VAR with block restrictions model
(VARBR)1.
VARBR attempts to nullify these restrictions by considering the interactions of
endogenous variables, allowing errors and structural forms to be accounted for 2.
VARBR models make use of long run restrictions to distinguish the structure of an
economy in its reduced form. The following section describes a VARBR model.
Average crude price, foreign exchange and interest rate constitute the exogenous
block while CPI and GDP constitute the domestic block.
3.1A Block Restriction Approach
In analysing the effect of external shocks on Nigeria, VARBR model is considered as
follows:
The

first

point

of

model

is

Q-dimension

reduced

form

VAR;

y t=r+ A 1 y t 1+ + A s y t s +U t

(1)

Where r is a (Q*1) constant term, Aj (j=1, s) are (Q*Q) VAR coefficients and U t is
the term for zero mean white error noise. In simplified form,
1 VARBR is a matrix modification of Standard VAR
2 In this situation, standard VAR analysis is not reliable due to variance decompositions
and impulse responses, which become complicated functions of the dynamic effect of the
structural disturbances.

At yt =v

(2)

t=0

Represents independent normally distributed random errors with distribution

MVN (0,1).
The vector y is divided into two blocks of variables. Vector

y 1 represents the external

factors constituting world crude price, real effective exchange rate (USD/Naira) and
interest rate while vector

y2

represents domestic factors constituting Nigerian GDP

and CPI. The vectors are broken down into structural coefficient matrix

Aj

linking

all variables from period 0 to period s.

A j=

j
j
A 11
A 12
j
A21j A 22

Aj

In the

,j=0s

structure,

A 12j = 0. This bears on the assumption that external shocks

effects on the variables of a small open economy but not the other way around.
The corresponding coefficient matrix,

Ao=

Ao11

o
A12

A o21

Ao22

A 0 is written as

,o=0s

The VARBR model is multiplied by the inverse of

A o , which is

A1
0

to arrive at

the reduced form of VAR model.

y= A j A1
o
The matrix of

j
B11
oj
B j= j
B 21 B22j

(3)
A j A1
for j = 0 s is stated as
o

,j=1s

The reduced form of VAR ready for estimation is stated as

s

y= Bt y vt + v

(4)

t =1

3.2

Cholesky Decomposition

To calculate Impulse response and variance decomposition, structural shocks

n= Ao v are identified using Cholesky decomposition of residual covariance

matrix from reduced form VAR model. An orthogonal matrix is chosen by fixing
restrictions in addition to

n(n+1)
2

from the covariance matrix.

Cholesky factor places restriction some shock effects to fix the remaining

n(n1)
2

. Cholesky decomposition enables accurate identification of shocks given a lower

triangular matrix. Kryznar and kunovak (2010)
3.3

Sample selection

VAR model estimate contains five variables: exchange rates for which real effective
exchange rate was chosen, Interest rates, CPI inflation and GDP which were obtained
from world bank IMF statistics bank. Oil prices taken as the average of WTI and
Brent crude prices have been drawn from EIA datasets. Quarterly data analysed in this
paper covers 1990Q1-2015Q4. Data on world crude price index is adjusted to 2010
USD. CPI and real effective exchange rates (Naira/ USD) are measured using 2010 as
base year1. The real effective interest rates have been included because they have a
significant influence on movement and price variation of domestic shocks. As a
component to identify external demand shock, lending interest rates have been used.

4.0MODEL ESTIMATION RESULTS ANALYSIS

Figure 2.1 and table 1.1 show impulse response functions (IRFs) and variance
decomposition for domestic variables (log GDP and CPI) to shocks of external
exogenous functions of interest (log oil price, real effective exchange rate and interest
rates). Responses are expressed for sample period 1990:1 to 2014:4 for Nigeria. This
start date was chosen, as it was the beginning of the GDP rebase. Barungi (2014)
identified this period as the peak of economic decline and falling living standards.
Trace and eigenvalue tests at 0.05 levels were run on variables to confirm non cointegration between them. Non-cointegration makes VARBR a more adequate model
to run than Vector Error Correction Model (VECM).

1 After separately analysing coefficient of variation (CV) of Naira/UDS and world crude
prices, CV of price is 9.7% less than CV Naira/USD. This makes it possible for estimation
results to be significantly influenced by exchange rates.

The impulse response design makes it possible to measure the size of accumulated
influences of external shocks on variables of interest. It also allows for the estimation
of how significant a shock is on a particular variable and a time stretch in which a
shock is absorbed. One standard deviation confidence interval by Cholesky
decomposition appears above and below the point of estimate of each impulse
function. CPI and GDP responses are shown in one percentage point for all variables.
Variance Decomposition presents the extent to which these shocks are responsible for
the volatility of variables observed. Short and medium period terms are analysed since
it would not be desirable to analyse long run periods based on available data.
Making a general observation, Responses for all impulses are non-contemporaneous
to external shocks. Responses begin to manifest in short term periods (period 2 to 3)
and increase as period term increases. Comparing the magnitude of responses between
CPI and GDP, external shocks account for ten times higher magnitude of the
fluctuations in CPI than in GDP as displayed in figures 1,2 and 3.
4.1

Impulse responses of External Shocks

Impulse response of CPI and GDP fluctuations to world oil price shocks (figure1)
show that price effects on CPI and GDP are negatively significant 1 but more in CPI. In
CPI responses, the significant spill over effect is maintained from the short-term
period (period 2 to 5), as response gradually increases to 0.5% is seen. GDP response
to world oil price declines between the 5th and 7th periods (year 1991) and faced a
stable increase afterwards. Decline in response is explained by increase in response of
GDP to exchange rate and interest rate shocks during that same period. These
responses reflect the influence of price shocks on domestic variables through a number
of mediums similar to results gotten by Kryznar and Konovac (2010).

1Positive and negative responses are mirror effects of each other except there has been a
specified form of non-linearity.

Response to Cholesky One S.D. Innovations 2 S.E.

Response of CPI to OIL_PRICELOG
0.8
0.4
0.0
-0.4
-0.8
-1.2
-1.6
2

10

12

14

16

18

20

22

24

Response of GPD_LOG to OIL_PRICELOG

.02
.01
.00
-.01
-.02
-.03
2

10

12

14

16

18

20

22

24

Figure 1 Impulse Response for CPI and GDP to crude price shocks

In contrast to world oil prices, exchange rate shocks have an initial negative response
in the short term then rises sharply to a positive significant effect on CPI and GDP,
rising through medium term periods up to 0.4% in CPI and 0.02% in GDP. In
disagreement with the results gotten by Hsing (2012), the responses of CPI to interest
rates shocks averages around zero while for CPI and 0.01% for GDP. This could be
explained by the fact that foreign investor contributions are not considered as a
parameter in computing inflation in Nigeria.
These results show strong signs of Dutch disease in Nigerias economy similar to
Indonesia and in contrast to Malaysia as studied by Gosse and Guillamine (2012). The
relatively insignificant response of GDP to oil price shocks can be explained as the
effect of being a major crude exporting country. In contrast, exchange rates present a
more often than not significant positive response as a result of high rate of import of
finished products, with refined petroleum products topping the list1

1In Nigeria, crude oil accounts for 35% of GDP, 80% of government revenue and 90% of exports. Belinski (2015)

Response to Cholesky One S.D. Innovations 2 S.E.

Response of CPI to EXCHANGE_RATES
3

-1
2

10

12

14

16

18

20

22

24

Response of GPD_LOG to EXCHANGE_RATES

.05
.04
.03
.02
.01
.00
-.01
-.02
2

10

12

14

16

18

20

22

24

Figure 2 Impulse Response for CPI and GDP to Exchange rate shocks
Response to Cholesky One S.D. Innovations 2 S.E.
Response of CPI to INTEREST_RATE
1.0
0.5
0.0
-0.5
-1.0
-1.5
-2.0
2

10

12

14

16

18

20

22

24

Response of GPD_LOG to INTEREST_RATE

.01

.00

-.01

-.02

-.03
2

10

12

14

16

18

20

22

24

Figure 3 Impulse Response for CPI and GDP to interest rate shocks

4.2Variance Decomposition (VD) of Domestic Variables

VD values for CPI and GDP are displayed in Table 1 and Table 2 respectively. In short
run period, shocks to crude price account for 1.46% of CPI fluctuations and in medium
term periods (21-24), it accounts for over 11% of fluctuation, increasing further to
23%. Exchange rates also account for quite a significant value, accounting for 2.04%
in the short run. Its impact declines to 1.39% and increases into the medium term
period accounting for 19.37% of inflation fluctuations. Interest rate shocks have no

significant effect on inflation fluctuations. There is further decline down along the
medium term to almost zero.

Period
1
2
3
5
10
15
20
24

(OIL_PRICEL (EXCHANGE (INTEREST

OG)
RATES) RATE)
0.000000
0.004907
0.790497
1.461870
6.035742
8.099123
11.80359
11.10576

0.000000
0.132231
0.338396
2.046896
1.393363
12.57639
16.63362
19.37396

0.000000
0.413055
1.243954
1.233818
1.260852
1.045222
0.316423
0.016068

Table 1 Variance Decomposition of CPI

The response of GDP fluctuations to Oil price shocks account for 27.31% in medium
term and shows signs of further increase downwards. In the short term, it accounts for
1.33%. Response to exchange rate shocks increases dramatically as periods get longer.
In the short term, it accounts for 1.25% but increases over a short period to 31.34% in
the medium term. Interest rate shock has a little more effect on CPI than GDP
fluctuations. There is slight increase in the medium term periods to 1.75% and
continuous decline towards zero further down the medium term periods. Variance
decomposition results confirm the presence of Dutch disease in Nigeria's economy.

Period
1
2
3
5
10
15
20
24

(OIL_PRICEL (EXCHANGE (INTEREST

OG)
RATES)
RATE)
0.168158
0.698279
1.334163
3.640657
10.63203
15.63176
25.63095
27.31853

0.075315
1.118652
1.254929
1.196454
11.24529
15.22633
25.22805
31.34757

0.175944
0.185624
0.318396
0.344793
1.392862
1.400475
1.759934
0.392112

Table 2 Variance Decomposition of GDP

From the IRFs and VDs, it is expected that persistence in crude price reduction
will result in a decline in economic output. However, this may be somewhat offset by
the relatively cheaper importation costs of refined crude. A continuous increase in
Naira/USD rates will negatively affect the economic output unless there is a downturn
in importing refined petroleum products in the next few years that will cause a steeper

inflation. Interest rate shocks however, will impact more on foreign investors 1 than on
domestic variables.

5.0CONCLUSION
This paper has investigated to quantify effects of external shocks on domestic
economic fluctuations in Nigeria. From the analysis, evidence has been put in place
on mediums by which external shocks effect on Nigerias economic stability. The
initiative to analyse the impact of exchange rates and interest rates in addition to
world crude oil prices has paid off in realising that cumulatively, world crude oil price
shocks account for the largest proportion of domestic parameter variation. However,
exchange rate shocks also play a significant role in economic fluctuations especially
in the economic output of Nigeria but leaving interest rates shocks with no significant
effects. The results of this model suggest that more consideration should be given to
study the effects of the Dutch disease on Nigerian economy and how it is affected by
external factors.

REFERENCES
SECONDARY SOURCES
Adom, P. K., et al. (2015). "Analysing Inflation Dynamics in Ghana." African
Development Review 27(1): 1-13.
Allegret, J.-P., et al. (2012). "The impact of external shocks in East Asia: Lessons from a
structural VAR model with block exogeneity." International Economics 132: 35-89.
Blanchard, O. J. and J. Gali (2007). The Macroeconomic Effects of Oil Shocks: Why are
the 2000s so different from the 1970s?, National Bureau of Economic Research.
Bresser-Pereira, L. C. (2008). "The Dutch disease and its neutralization: a Ricardian
approach." Revista de economia poltica 28(1): 47-71.
Goss, J. B. and C. Guillaumin (2013). "Can external shocks explain the Asian side of
global imbalances? Lessons from a structural VAR model with block exogeneity." Review
of International Economics 21(1): 85-102.
Hamilton, J. D. (2009). Causes and Consequences of the Oil Shock of 2007-08, National
Bureau of Economic Research.
Hsing, Y. (2012). "Impacts of the Trilemma Policies on Inflation, Growth and Volatility in
Greece." International Journal of Economics and Financial Issues 2(3): 373-378.

1This also counts as external shocks

Krznar, I. and D. Kunovac (2010). "Impact of external shocks on domestic inflation and
GDP." CNB Occasional Publications-Working Papers (26).
Lutz K. (2011). "Structural Vector Autoregressions." CEPR (Discussion Paper No.
DP8515).
Lorusso, M. and L. Pieroni (2015). Causes and Consequences of Oil Price Shocks on the
UK Economy, Centre for Energy Economics Research and Policy, Heriot-Watt
University.
Odusanya, I. A. and A. A. Atanda (2010). "Analysis of Inflation and its Determinants in
Nigeria."
Raddatz, C. (2007). "Are external shocks responsible for the instability of output in lowincome countries?" Journal of Development Economics 84(1): 155-187.
Raddatz, C. and S. L. Schmukler (2012). "On the international transmission of shocks:
Micro-evidence from mutual fund portfolios." Journal of International Economics 88(2):
357-374.
Rajan, R. G. and A. Subramanian (2011). "Aid, Dutch disease, and manufacturing
growth." Journal of Development Economics 94(1): 106-118.
Vu, T. K. and H. Nakata (2014). The macroeconomic effects of oil price fluctuations in
ASEAN countries: Analysis using a VAR with block exogeneity.
OTHER SOURCES
B, B. (2014). African Economic Outlook- Nigeria. Nigeria.
http://www.africaneconomicoutlook.org/fileadmin/uploads/aeo/2014/PDF/CN_Long_EN/
Nigeria_EN.pdf
Lavelle. K (2012). How does foreign exchange rate affect GDP? Thursday, 8 th November
2012. [http://www.purefx.co.uk/help-centre/daily-market-commentary/view/how-doesforeign-exchange-rate-affect-gdp] accessed 22 January 2016
Top ten oil-producing countries in Africa 2015 [http://www.africaranking.com/top-10-oilproducing-countries-africa/5/] Assessed Monday January 4th, 2016.
OPEC basket crude oil price development from October 2014 to October 2015 (in U.S.
dollars per barrel) [http://www.statista.com/statistics/277914/monthly-average-prices-ofthe-opec-crude-oil-basket/]
[http://apps.eui.eu/Personal/Canova/Articles/ch4.pdf-] Wold representation
[http://pareto.uab.es/lgambetti/Lecture4.pdf] Structural VAR Theory
Scott Belinski (2015), Will Falling Oil Prices Resolve Nigerias Dutch Disease?

By on January 23, 2015 [http://www.economonitor.com/blog/2015/01/will-falling-oilprices-resolve-nigerias-dutch-disease/]