Background to the Study
Trade involves the transfer of goods and/or services from one person or entity to another, often in exchange for money. The concept of trade has gained wide recognition due to the existence of specialization and division of labour, in which most people concentrate on a small aspect of production, but use that output in trades for other products (Oyejide, 2006).International trade has flourished over the years due to the many benefits it has offered to different countries all over the world. The advent of globalization has led to increasing demand for international trade. According to Oyejide (2006) international trade is the exchange of services, goods, and capital among various countries and regions, without much hindrance. The international trade accounts for a good part of a country’s gross domestic product. In international trade, the importation and exportation of goods are limited by exchange rate, import quotas and mandates from the customs authorityof various countries participating in global trade (Bah and Amusa, 2013). The importing and exporting jurisdictions of various countries may impose a tariff on the goods and services traded in global market. In addition, the importation and exportation of goods are subject to trade agreements between the importing and exporting jurisdictions of participating countries.
According to Chowdhury (2013), fluctuations are upward or downward movement in the prices of products in an economy. Fluctuations in prices are a common phenomenon in the economic world, particularly among producers of agricultural products.More so, fluctuations in the level of the national income of a country representing growth or contraction. A market economy is not static. It’s dynamic. A rise in national income means an economy is growing, while a decline in national income means that an economy is contracting. The current economic model describing economic fluctuations in a market economy is the business cycle.
Exchange rate is defined as the rate at which one currency is exchanged for another, usually between countries. From this definition above, exchange rate is regarded as a price of one’s country currency in terms of another country’s currency. Thus, the exchange rate between the naira and the dollar refers to the amount of naira required to purchase a dollar. According to Obaseki (2013) the exchange rate of a particular currency measures the worth of a domestic economy in terms of another. He went further to identify other importance of exchange rate as; it measures the external value of a currency,it provides a direct relationship between the domestic and foreign prices of goods and services, etc. Supporting the above, Iyoha (2008) opines that foreign currency is required for making payments to other countries for goods, services, interest payments on loans for investment. Thus, Nigeria’s demand for US dollars, British Pound Sterling, French francs and Japanese Yen is largely derived from Nigeria’s demand for American, British, French and Japanese goods respectively. Nigeria’s supply of these currencies is earned by its exports to those countries. Therefore, understanding the behaviour of the exchange rate fluctuation and its impact on trade is very significant.
Edwards (2004) is of the opinion that under the flexible exchange system, the exchange rate is determined by the interplay of the forces of demand and supply, increase in imports leading to increase in demand for the foreign currency of the exporting country while an increase in exports leads to increase in the supply of that foreign currency. A rise in the general level of internal prices will stimulate demand for imports which now become relatively cheaper. This will increase demand of foreign currency without there being an increase in its supply and so there will be a tendency for the home currency to depreciate (Oyejide, 2008). If prices in all countries are rising, the effects on the exchange rates will cancel out. The extent to which a country must pay attention to the value of its currency in terms of others will determine the extent of its freedom of action with regard to its internal monetary policy. A country with a large volume of internal trade or transactions will probably be more interested in the internal value of its currency than one which is more nearly self-supporting (Iyoha, 2008). Therefore, the extent to which exchange rate fluctuation determines the trade of a country depends largely on the extent to which the country depends on imported goods and services for survival.
From a macroeconomic point of view, exchange rate variation exerts strong effects on theeconomy, as they may affect the structure of output and investment, lead to inefficient allocation of domestic resources and external trade, influence labour market and prices, and alter external accounts (Aron, Elbadawi and Cornel, 2009). Hence, shifts in exchange rate affect international trade directly and indirect. Theindirect effects are hard to isolate from macroeconomic point of view, complex to describe, and empirically hard to test, as they have second, third or fourth round effects. This is why exchange rates are often treated in models as external (exogenous) variables.The availability of financial hedging through forward exchange markets helps reduce the uncertainty generated by fluctuations of nominal exchange rates.
Developing economies are consistently facing an important issue with respect to fluctuation of exchange rates and their subsequent effect on trade (Ihimodu, 2013). Exchange rate is a vital instrument for economic management and therefore it is an important macroeconomic indicator used in assessing the overall performance of the economy (Iyoha, 2008). Since movements in the exchange rate has been discovered to have rippling effects on other economic variables such as trade, interest rate, rate of inflation, etc, it is therefore important for every country as long as it opens its doors to international trade to establish a method or procedure by which its exchange rate (i.e. the price of its currency) would be determined (Iyoha, 2008).
According to Frankel (2001), the relationship between exchange rate fluctuation and trade (i.e imports and exports) are; volatility in exchange rates leads to the uncertainty in trade, thus, making it difficult to take decision on international trade and investment; fluctuating exchange rate leads to speculation which will in turn lead to undesirable trend in the economy, even if perfect, it is not in all cases that those buying are the best user nor can all the intended users be in the economy’s best interest. More so, fluctuation in exchange rate provides instability in the value of foreign assets.
In Nigeria, past exchange rate policies have been largely directed towards efforts to restrict the use of foreign exchange at officially or administratively determined rated. However, recent policy shifts have reflected a move towards market determined exchange rates, as is the case in most economics of the world. The unidirectional movements of exchange of rate along the path of depreciation since 1986 when foreign exchange auction sessions were introduced suggest very strongly that something is basically wrong in the exchange rate management system (Obadan, 2011).
According to Chowdhury (2013), a lot of factors have been suggested as causing the naira exchange rate to fluctuate. Among these are: excess demand from foreign exchange amidst inadequate funding of the foreign exchange market; poor performance of autonomous source of foreign exchange inflow; fluctuations/instability of the crude oil market, speculative and sharp practice of authorized dealers; expansionary monetary and fiscal policies, which fuel demand pressure in the market; eexchange rate fluctuation can affect trade directly through uncertainty and adjustments costs, and indirectly through its effect on the structure of output, investments as well as on governmentpolicies. The flexible exchange rate regime produced a significant volatility and uncertainty in the exchange rate of the naira. Thus, the study is geared toward ascertaining the extent volatility in exchange rate affect trade.