THE IMPACT OF EXCHANGE RATE ON THE NIGERIA ECONOMIC GROWTH

 

 

 

ABSTRACT

 

 

Exchange rate is the price of one currency in terms of another currency. Exchange rates this exchange rate is also used to determine the level of output growth of the country. Over the years, Nigeria has adopted various exchange rate regime ranging research work is centered on the impact of  exchange rate on the Nigeria economic growth with special emphasis on the purchasing power of the average Nigeria and the  level  of  international  trade  transaction.  To do this, the classical linear regression model is applied and the ordinary least square econometric technique is also used to estimate the impact of exchange rate on economic growth. The variables  used  are  GDP  and  non-oil  export  as  the  dependent  variables,  real exchange rates interest rates, inflation rate and degree of trade openness as the independent variables.


 

 

TABLE OF CONTENTS

 

 

Title page-  -        -        -        -        -        -        -        -        -        i Approval page     -        -        -        -        -        -        -        -        ii Dedication  --       -        -        -        -        -        -        -        -        iii Acknowledgement         -        -        -        -        -        -        -        iv Abstract     -        -        -        -        -        -        -        -        -        v Table of content   -        -        -        -        -        -        -        -        vi

 

 

 

CHAPTER ONE

 

 

1.0 Introduction   -        -        -        -        -        -        -        -        1

 

 

1.1 Background of the Study -        -        -        -        -        -   -     1

 

 

1.2 Statement of the Problem -        -        -        -        -        -        4

 

 

1.3 Research question -      -        -        -        -        -        -        5

 

 

1.4 Objective of the study--        -        -        -        -        -        -        6

 

 

1.5 Research Hypothesis-        -        -        -        -        -        -        6

 

 

1.6 Scope of the Study-  -        -        -        -        -        -        -        6

 

 

1.7 Significance of the Study- -        -        -        -        -        -        7

 

 

1.8 Limitation of the Study-    -        -        -        -        -        -        8


 

 

 

 

 

 

 

 

CHAPTER TWO

 

 

2.0 Literature Review-  -        -        -        -        -        -        -        9

 

 

2.1 Determinants of the Nigerians Exchange Rate - - - - - - -  -  -      9

 

 

2.1.1 Foreign Exchange Rate, Export Performance

 

 

and Economic Growth--        -        -        -        -           -         -       11

 

 

2.1.2 The purchasing Power Parity Theory-        -        -        -        13

 

 

2.1.3 Theoretical Issues--        -        -        -        -        -        -        16

 

 

2.1.4 The Traditional Flow Model-  -        -        -        -        -        17

 

 

2.1.5 The Elasticity Approach-         -        -        -        -        -        18

 

 

2.1.6 The Monetary Approach-        -        -        -        -        -        20

 

 

2.1.7 The Portfolio Balance Model-  -        -        -        -        -        22

 

 

2.2     Empirical Literature-   -        -        -        -        -        -        26

 

 

2.3     Limitations of Previous Studies-      -        -        -        -        33

 

 

 

 

 

 

 

 

 

 

 

 


 

 

CHAPTER THREE

 

 

3.0 Research Methodology-    -        -        -        -        -        -        36

 

3.1 Model Specification-          -        -        -        -        -        -        36

 

 

3.2 Method of Data Analysis- -        -        -        -        -        -        38

 

 

3.3.1 Economic Criteria-         -        -        -        -        -        -        39

 

 

3.3.2 Statistical test (first order)-      -        -        -        -        -        40

 

 

3.3.3 Econometric (second order test)-       -        -        -        -        41

 

 

3.4     Nature and Source of Data-    -        -        -        -        -        43

 

 

 

 

 

CHAPTER FOUR

 

 

4.0 Presentation and Analysis of Result-   -        -        -        -        44

 

 

4.1 Presentation of Results-    -        -        -        -        -        -        44

 

 

4.2 Result Interpretation-       -        -        -        -        -        -        46

 

 

4.2.1. Analysis of Result based on Economic Criteria-  -        -        46

 

 

4.2.1.2 Analysis based on the A priori Criteria   -        -        -        48

 

 

4.2.2 Analysis based on statistical Criteria -        -        -        -        49

 

 

4.2.2.1 The Coefficient of multiple Determination        -        -        49

 

 

4.2.2.2 The t-test Statistics-     -        -        -        -        -        -        49

 

 

4.2.2.3 The f-statistics Test-    -        -        -        -        -        -        51

 

 

4.2.3 Analysis based on Econometric Criteria-   -        -        -        53


 

 

4.2.3.1 Test of Autocorrelation-        -        -        -        -        -        53

 

 

4.2.3.2 Normality Test- -        -        -        -        -        -        -        54

 

 

4.2.3.3 Heteroscedasticity Test-        -        -        -        -        -        55

 

 

4.2.3.4 Multicollinearity Test- -        -        -        -        -        -        56

 

 

4.3 Evaluation of Research Hypothesis-    -        -        -        -        58

 

 

 

 

 

CHAPTER FIVE

 

 

5.0 Summary of Findings, Conclusion and Policy Recommendation 59

 

 

5.1 Summary of Findings-      -        -        -        -        -        -        -   59

 

 

5.2 Conclusion-    -        -        -        -        -        -        -        -        -   60

 

 

5.3 Policy Recommendation-  -        -        -        -        -        -        -   61

 

 

Bibliography-       -        -        -        -        -        -        -        -        -   63

 

 

Journals-    -        -        -        -        -        -        -        -        -        -   64


 

 

CHAPTER ONE

 

 

1.0 INTRODUCTION

 

 

1.1 BACKGROUND TO THE STUDY

 

 

A country foreign exchange policy is derived from the perceives overall economic objectives to achieve and the expected direction of growth (CBN, 2003). Consequently, non conflicting sectoral policies are conceived within the ambit of the overall policy framework such that each sectoral policy reinforces each other.

          A simplest definition has it that exchange rate is the price of one currency in terms of another. Thus, it measures the worth of a domestic economy in terms of another economics (Obeski, 1998).

          Exchange rates regularly quoted between all major currencies mostly that of the trading partners, but frequently one important currency (that is the dollar) is used as a standard in which to express and compare all rates.

          It is one of the key tools in economic management and in the stabilization and adjusts policies in developing countries. Exchange rates policies play a vital role in determine the position of a country in terms of international competition.

          In autonomous markets, the exchange rate was seen to be volatile, and depreciated at will. This exerted pressure on the official foreign exchange market, and made the monetary policy target of the period to continually unrealistic due to the inflationary financing of government deficit with the deregulation of the economy; a market-based framework for the determination of exchange rate was adopted. It was envisaged that the realization of macroeconomic stability would lead to the elimination of distortions in the external sector and this enhance growths, stimulate non oil exports, increase foreign exchange inflows, moderate demand pressure in the foreign exchange market and generally improve foreign exchange to eliminate the parallel market premium capital flight and also enhance the inflow of foreign investigation (CBN: 2003).

          From the forgoing it becomes clear that the concept of exchange rate policies has the impact so as to show in the one of the macroeconomic variables, it contribute to economic growth of Nigeria. It is therefore necessary that a research work be carried out to this effect so as to provide suggestion that will served as a guide towards the actualization of macroeconomic objectives that will bring about the level of targeted economic growth in Nigeria.

 

 

1.2 STATEMENT OF THE PROBLEM

1.     Should the range be decided in advance?

 

 

1.3 RESEARCH QUESTION

1.  What is the impact of exchange rate on Nigeria’s economic growth?

1.4 OBJECTIVES OF THE STUDY

The objectives of the study are to determine the impact of exchange rate on the growth of the country.

1. To estimate the impact o exchange rate on Nigeria’s economic growth

1.5 RESEARCH HYPOTHESIS

 

 

Based on the objectives of the study, the following hypothesis were formulated.

1.  HO: exchange rate has no significant impact on Nigerias economic growth

 

 

 

 

 

 

1.6 SCOPE OF THE STUDY

 

 

This research work is designed to cover the period 1980-2010, a period of thirty one years. The general overview of the profile of Nigerians exchange rate over the years shall be discussed.  The scope consist of the regulatory and

deregulatory exchange rate period that is the fixed exchange rate and the floating exchange rate period. The study is based on core macro-economic performance of Nigeria between 1980-2015.


 

 

 

 

1.7 SIGNIFICANCE OF THE STUDY

 

 

The significance of this study lies on the recommendations made at the end of the following:

1.     Importer who make payment in foreign currencies.

2.     Policy makers of the central bank of Nigeria who issues the guideline government international trade practice.

3.     Bank-especially the commercial banks and merchant banks.

4.     The general public who has a right contribute and be informed of the activities our banking institutions.

5.     It is hoped that findings and recommendations of this study will adequately benefit the various interest groups named above.


 

 

 

 

1.8 LIMITATIONS OF THE STUDY

 

 

During the course of this research the researcher experience a number limitation constrains.

          The researcher was faced with already known problem of gathering material from the Nigeria organization. Almost every information is classified and therefore most of the companies and banks approached were weary of releasing financial information related to the topic.

          Gathering of information from public organization such as federal ministry of finance, federal of statistics and central bank of Nigeria was also difficult.


 

 

CHAPTER TWO

 

 

2.0      LITERATURE REVIEW

 

 

2.1    DETERMINANTS OF NIGERIA’S EXCHANGE RATE

 

 

In terms of finance, exchange rate (also known as a foreign exchange rate, forex rate, ER, Fx rate or Agio) between two currencies is that rate at which on currency will be exchanged for another. It is also regarded as the value of one country's currency in relation to another. In a commonest definition, exchange rate 'ER' is the price of a nation’s currency in terms of another currency.

An exchange rate can be quoted in two ways, direct and indirect.

i.                    Direct; the price of the foreign currency in terms of dollars.

ii.                  Indirect: the price of dollars in terms of foreign currency.

SOME OF THE MAJOR TYPES OF EXCHANGE RATE ARE AS FOLLOWS:

i.                    Fixed exchange rate system.

ii.                  Flexible exchange rate system.

iii.               Floating exchange rate system.

i.                    Fixed exchange rate system: This refers to a system in which exchange rate for a currency is fixed by the government.

The basic purpose of adopting this system is; to ensure stability in foreign trade and capital movements.

To achieve stability, government undertakes to buy foreign currency when the exchange rate becomes weaker and sell foreign currency when the rate of exchange gets stronger.

ii.                  Flexible exchange rate system: This refers to a system in which exchange rate is determined by forces of demand and supply of different currencies in the foreign exchange market.

In this exchange rate system, the value of currency is allowed to fluctuate freely according to changes in demand and supply of foreign. There is no official (government) intervention in the foreign exchange market. Flexible exchange rate is also known a 'floating exchange rate.

Exchange rate movements is an important determinant of international transactions. Furthering, Ogunleye (2010) noted that the exchange rate in Nigeria has been principally influenced by external shocks resulting from the vagaries of world price of agricultural commodities and oil prices, both major sources of Nigeria export and foreign exchange earnings;   contending that when the economy depended on agricultural exports, exchange rate volatility was less pronounced given the fact that these products were subjects to less volatility and that there were more trading partners involved in the calculation of the countrys exchange rate. This is minimally affected by the real exchange rate fluctuating by only 0.14% between 1970 and 1977. The increased dependence of the country on oil, resulted in several trade shocks from global oil price shock fluctuating the naira exchange rate by 10% between 1970 1985 (Ogunleye 2010). To Iyoha and Oriakhi (2002), movements in real exchange rate during this period were nominal shocks resulting from fiscal expenditure in ambitious development projects; and when the windfall ended, the government resorted to financing its expenditures through money creation. Thus expansionary monetary fiscal policy according to him, exerted upwards pressure on inflation, aggravating sharp movements in real exchange rate. From 1986, the adoption of the structural adjustment  programme  (SAP)  became  a  contributory  factor  in  shaping  the dynamics of real exchange rate in Nigeria. One of the cardinal points of this policy was floating nominal exchange rate policy. As the naira was allowed to float the nominal exchange rate movement became more pronounced.

 

 

 

 

 

 


 

 

 

2.1.1  FOREIGN   EXCHANGE   RATE,  EXPORT PERFORMANCE AND ECONOMIC GROWTH

Fluctuations, positive or negative, are not desirable to producers of export products as it has been found to increase risk and uncertainty, international transactions. Findings by the International Monetary Fund (IMF) (1984) revealed that these fluctuations include undesirable macro-economic phenomena inflations though observed positive effect of exchange rate fluctuations on export trade in European Union countries (Caballew and Carba, 1979).

Walsh and Yu (2010) viewed the effect of these fluctuations from first its impact  on  foreign direct  investment  where they noted  that  low exchange rate favour the importation of production, machinery and production export in periods of high foreign exchange rate. Furthering, ford and stein (1991) found a strong evidence of a weak host country increase inward model as depreciation (down change in exchange rate) make a host country less expensive.

Blongein (1997) argued that exchange rate depression in host countries tend to increase foreign direct investment inflows adding that a strong real exchange rate strengthens the incentives of foreign companies to produce at home for export instead of investing in a host country for export.  Different open economies


 

 

experience different episodes of exchange rate appreciation. Exchange rate induces a contraction of the exporting manufacturing sector. Maintenance of export performance to them require the depreciation of the real exchange rate of a countrys currency, the achievable through monetary injections noting that a policy of exchange rate depreciation can successfully prevent a contraction of export output, having an allocative effect in the economy (Lama and medina, 2010).

Adubi and Okunmadewa (1999) posited that Nigeria as a developing nation is expected to gain from export conversion price increases as a result of currency devaluation findings by Obadan (1994) and Osuntogun et al (1993) on the effect of stable exchange rate on export performance showed that exchange rate affect a countrys export rate with its attendant risk affect export earnings, performance and growth positive to exporters when devaluated poor result from the floating exchange rate regimes of the 1970s necessitated a change in foreign exchange rate management. The structural adjustment programme was introduced in 1986, with the cardinal objective of restructuring the production base of the economy with a positive bias for agricultural export production. This reform facilitated the continued devaluation of the Nigerian naira with the expected increase in domestic prices of agricultural export boasting domestic production.


 

 

To Srour (2006), diversification of countries export base is one reason given by developing nations for changing foreign exchange rates and regimes which in turn according to the world trade Organization (2010) increases local production, employment, income and economic growth concluding foreign exchange rate is a determinant of export trade and economic growth in Nigeria. Churwu (2007) and Adubi and Okunmadewa (1999).

 

 

 

2.1.2  THE PURCHASING POWER PARITY THEORY

 

 

The purchasing power parity (PPP) is one of the earliest and perhaps most popular theory of exchange rate. This posits that the exchange rate between two currencies would be equal to the relevant national price levels. It assumes the absence of trade barriers and transactions cost and existence of the purchasing power parity (PPP) (Obioma, 2000). In this version, the purchasing power parity (PPP) doctrine equates the equilibrium exchange rate of the ratio of domestic to foreign price level (Lyon, 1992).

E-Pd

 

 

PE


 

 

Where; E is the nominal exchange rate defined in terms of domestic currency per unties of foreign currency. Pd is the foreign price, PE level with perfect efficiency and absence of trade barriers transaction cost and the purchasing power parity (PPP) doctrine would be tantamount to the applications of the law of one price it all the countries produced explicitly the same tradable goods. It is important to know that the PPP is a major component of the monetary approach the PPO between the two currencies are provided by (Gustaar Cassel 1998) is the amount of the determination of equilibrium exchange rate. It is often applied as a proxy for the monetary model in exchange rate analysis (CBN, 1998).

The relevant version of PPP doctrine relates the equilibrium exchange rate to the product of the exchange rate in a base period and the ratio of the countries price indices (Argh, 1994). By definition, we have the relative purchasing power parity (PPP) as

E Pd Ro

 

 

PE Where

Ro is the actual exchange rate at the base period (the number of units of domestic currency per unit of foreign currency). The purchasing power parity theory defines


 

 

two equilibrium exchange rate system. The first is the short run equilibrium exchange rate which is defined, in this context as the rate that would exist under a purely freely floating exchange rate system. Second is the long-run equilibrium that would yield balance of payment equilibrium over a time period in corporating and cyclical fluctuations in the balance of payment (including those that relate to business cycle at home and abroad). Deviation of prevailing exchange rate from the relative purchasing power in a currency are generally attributed to problem of arbitrage and expectations in the goods market. Some of the assumptions of PPP theory  however  are  quite  unrealistic.  Efficiency  level  for  example  vary  from country to country and as such, there are deferring cost functions.

To align international comparisons on the assumption of some technological efficiency in all countries could be deceptive. Again the choice of the base year for the relative purchasing power parity (PPP) is often arbitrary. Finally, PPP is often presented as if causality runs from price level to exchange rate. Actual experiences are often more complicated when monetary/fiscal policies move, both causality could be quite exogenous or bi-directional (Argy and Frenkele, 1998).


 

 

2.1.3  THEORETICAL ISSUES

 

 

There is consensus in the literature on the impact of exchange rate stability neither on economic growth nor on the mechanism through which oil price fluctuations affect growth from the macro-economic perspective, theoretically, flexible  exchange  rate  allow  an  easier  adjustment  in  response  to  asymmetric country specific real shocks. (Schnabel, 2007). The macro-economic effect if low exchange rate volatility under the fixed exchange rate system are associated with low transactions costs for international trade and capital flow thereby contributing to higher growth. Indirectly, fixed exchange rate enhances international price transparency as consumers can compare prices indifferent countries more easily. If exchange rate volatility is eliminated international arbitrage enhances efficiency, productivity and welfare. Earlier, Mundell (1973a, 1993b) opined that monetary and exchange rate policies are the chief source of uncertainty and volatility in small open   economics   and   economic   growth   is   enhanced   when   exchange   rate fluctuations are smoothed.

The transmissions mechanism according to Scbnabel (2008) through which oil prices affects real economic activity include both supply and demand channels. The supply  side  effects  are  related  to  the  fact  that  crude  oil  is  a  basic  input  to


 

 

production, and an increase in oil price leads to rise in production cost that induces firms to lower output, the demand side effect is derived from the fact that oil prices changes affect both consumption and investment decisions. Consumption is adversely affected because increase in oil price affects disposable income and the domestic price of tradable good. Investment is adversely affected because such increase in oil price also affects firms input prices and thereby increasing their costs.

 

 

 

2.1.4 THE TRADITIONAL FLOW MODEL

 

 

The  traditional  flow  model,  views  exchange  rate  as  the  product  of  the interaction between the demand for and supply of foreign exchange (Augutus,

2003). In this model, the exchange rate (sin equilibrium when supply equals demands demand for foreign exchange, (Olisadebe, 1991). The exchange rate adjusts to balance the demand by the domestic resident for foreign exchange. The demand for foreign exchange depends on domestic residents demand for domestic goods and assets. On the assumption that the foreign demand for domestic goods is determined essentially by domestic income, the relative income plays a major roe in determined exchange rate under the flow model. Since assets demand can be


 

 

said  to  demand  on  difference  between  domestic  and  foreign,  interest  rate differentials is other major determinants of the exchange rate in this frame work.

Under the traditional flow model that is the balance of payments model, the exchange rate is assumed to equilibrate the flow supply of and the flow demand f or foreign currency. The balance of payment deficits (surplus) in current amount is offset by surplus in (deficits) in the capacity account. The major limitations of the traditional model or the portfolio balance model include the overshooting of the exchange rate target sand the fact that substitutability between money and financial asset may not be automation, this lead or led to the development of the monetary approach.

 

 

2.1.5 THE ELASTICITY APPROACH

 

 

This approach merely restricts to trade invisible goods. According to this approach, the success of devaluation in improving the balance of trade and through it, the balance of payment depends upon the demand elasticity of imports and exports developing country (Dewett, 1982). In other words an improvement in the balance of trade will depend upon whether the demand for import and export is elastic devaluation makes which makes import of the devaluating country costlier


 

 

than before and in case her demand for import is elastic, ad higher amount will be spent by the foreigners thereby affecting adversely the balance of payment of the devaluing country. However, if her demand for exports as a result of devaluation in her balance of payments, will purchase more, likewise, if her demand for imports is elastic, then the imports of the country will be significantly reduced by developing country.

However, some rules are needed to related the required degree of elastics for the success of devaluation in improving balance of trade. In this context, we have what is called marshal learner conditions”. According to these conditions, devaluation will improve the balance of trade of a country of the sum of the elasticity of demand for assuming both elasticity are infinite.

Let  Exd,  Emd    =  price  elasticity  of  demand  for  exports,  and  imports

 

respectively. Exs, Ems = price elasticity of supply for exports and imports respectively. Then according to learners condition, devaluation will increase a countrys  balance  of trade,  Exd,  EmdD1,  given  infinite  Exs, Ems.  I  should  be emphasized that the marshal learners condition related only to demand for commodity exports and imports. The response of capital should be taken into consideration before it can be determined whether devaluation will improve the


 

 

balance of payment or not. This is because, if sufficient amounts of autonomous capital flows into the devaluing country, it would  be possible to have the sum of elasticity of demand less than one and yet devaluation may lead to improvement in the balance of payment of the devaluing country. This is reduced as a result of devaluation, the with the sum of elasticity greater than one, would aggravate the deficit. This would occur if capital was discouraged by devaluation and investors fear further devaluation. Moreover, if the trading partners retaliate, devaluation will not make any impact on the import and export of the devaluing county, even though her demand for imports and exports may be elastic.

 

 

 

2.1.6  THE MONETARY APPROACH

 

 

The monetary approach is predicted on the importance of money. It identifies exchange  rate  as  a  function  of  relative  shift  in  money  shift  in  money  stock, inflation rate as a proxy and domestic output between an economy and a trading partner economy. It is important to know that the purchasing power parity (PP) is a major component of the monetary approach. The monetary approach is a recent development in the theory of exchange rate determination. It view as the exchange rate  as  being  the  relative  price  of  two  assets  (natural  monies)  is  determined


 

 

primarily by the relative supplies of demand and for those movies, the equilibrium exchange rate is attained when the existing stocks of the two monies are willingly held (Gbosi, 2003).

It is therefore argued that a theory of exchange rate deterioration should be stated contently in terms of the supplies and demand for those monies. In this model, exchange rate adjusts to allocate the total stocks of foreign exchange in question in the asset  market. This new  theory of exchange rate determination according to (Guarter and Hottman, 1985), can be presented in one or two terms the   monetary   approach   or   the   asset   market   approach   of   exchange   rate determination. These approaches emphasizes on the roles of money and assets in determining the exchange rate, when it is flexible. The asset market approach or monetary approach, attributes variation in exchange rare essentially to income and expected rates of return as well as the other factors that influence the supplies of demand for the various nation monies over the relative supplies of money and the fact that the demand for money is viewed to depend on the level of real income and the interest.  The  monetary  approach  postulated  that  the  exchange  rate  is determined primarily by two key factors, namely, relation several versions of the monetary  approach  to  exchange  rate  determination.  The early  flexible  price


 

 

monetary model  which is based  on  the assumptions  of continuous purchasing power parity (PPP) and the existence of stable money demand functions for the domestic and foreign economics. The strictly price monetary model is an extension of the flexible price model except that, it allows for accommodation of short term deviation from the PPP. In other words, the strictly price monetary theory takes the fact that there may be deviations from PPP in the short-run and in the long-run, the deviation will tend to disappear.

The strictly-price monetary theory takes interest rate differentials as capture by exchange rate deviation. Price exchange is an automatic and in response to changes, inflation, therefore depresses the exchange rate unlike the balance of payment model were the effect of Y on exchange rate is payment model where the effect of Y on exchange rate is positive. It is negative in the strictly price monetary theory.

2.1.7 THE PORTFOLIO BALANCE MODEL

 

 

The portfolio balance model views exchange rate as the result of the substitution between money-and financial assets (Gbosi 2003). In the monetary approach, there is no room for current movement to play a role in the determined exchange rate. Thus, the monetary approach cannot explain the observed tendency


 

 

of the currency of a country, with a current account supplies (deficit) to depreciate. This apparent shortcomings of the monetary approach was said to be related to its narrow view of an exchange rates as the relevant prices of movies in addressing this shortcomings, the portfolio balance approach posits that an exchange rate is determined at least in short-run by the supply and demand in the markets for a wide range of financial assets.

The model assumes that individuals allocate their wealth (w) which is fixed at a point in time, among alternative assets. Domestic money (m) domestically, issued bonds (b) and foreign bonds denominated in foreign currency (f) in a simple one country model. Theories of economic growth provide the empirical frame work  for  this  study.  The classical theory of economic growth assumed  the existence of a perfectly competitive economy where invisible hands allocate resources efficiently. Though Adam Smith, recognized the start of the development process when argued that division of labour increases productivity which raised relatively output, the classicist regard capital accumulation as a key of economic development. The Harrods defect in that on the other hand, it constitutes a demand for output and on the other hand, it increases the total productivity capital of the economy.  The mechanism through which  economic  development  is


 

 

accomplished is net investment. Both Harrods as well as Domar assumes fixed capital output that is, a rigid relationship between capital stock and output (Domar

1957).

 

 

The neoclassical growth theory on the other hand stresses efficiency in the allocation of resources and largely ignores social and political factors in economic growth. In spite of growth in national output, relative deprivation, poverty and imbalance among sector continued to increase. The structural change theories of which Aurthr Lewis, two sector surplus labour theory is a well known representative, addressed these  structural  distortions.  The  expected  growth  of output and employment in the modern sector may not be realized. This is so when capital stock embodying labour savings, technical progress is sued in the modern sector in such a situation that the expected transfer of the assumed surplus labour from the traditional to the modern sector has often failed to nationalize structural change theory, therefore, emphasize the degradation of the economy to facilitate greater understanding of the development process. Capital formation has been emphasized as it rates to the production of capital goods, like machines, plants and equipment. To measure economic growth, economist use data on gross Domestic Product (GDP) which measures the total income of everyone in the economy. The


 

 

real GDP per person also observe large differences in the standard of living among countries (Mankiw and Gregory, 1994).

The  Solow  growth  model  shows  how  growth  in  the  labour  force  and advances  in  technology interact  and  how  they affect  output.  The first step in building the model, we examine how the supply and demand for goods determine the accumulation of capital. To dot thus, we hold the labour force and technology fixed,  later,  we  relax  these  assumptions  fixed  by  introducing  changes  in technology. The Solow growth model enables us to describe the production distribution and allocation of the economys output data print in time. Moreso, the Solow growth model shows how savings, population growth and technological process affect the growth of output over the time. The simply of goods in the Solow growth model is based on the low familiar production function Y = f (k,L). Output depends on the capital stock and the labour force. The Solow growth model, assumes that production function has constant returns to scale.

However, the new endogenous growth model propounded that technological changes is endogenous to growth because it is responsible for the signal as price and profits in the economic system. The endogenous growth theorist introduced the concept of human capital  as  a factor for growth. These new growth  theorists


 

 

include Mankiw, Romar and Weil, Arrow, Villanueve Rebelos A. K. model. The increasing returns theorist opposed the one classical growth theory that are subject to decreasing returns and said that the investment in some new area product, power source or production technology proceeds through time that each new increment of investment is more productive than the previous increment. The source of these increasing returns can be seen through cost and idea. Investment in the early stages of development may create new skills and attitudes in the work force whose cost may be lower than the previous investment at the initial stage. Also each investor may find investment because of the infrastructure that has been created by those who came before.

Finally, the new growth do not predict convergence and hence, countries with abundant physical and human capital will grow permanently faster that countries with small capital in contrast to the Solow model, the new growth model predicts divergence as implied in (Romer, 1996) and (A.O. Jenur, 2008).

 

 

2.2 EMPIRICAL LITERATURE

 

 

Empirical evidences have shown strong effect of short-run and long-run adverse effect of exchange rate swings on economic growth performance through


 

 

the trade channel. The nature of the effect however, runs in either position or negative direction. According to IMF (1994), and European commission (1990), empirical evidence in favor of a systematic positive (or negative) effect of exchange rate stability on trade (and thereby growth) in small open economics has remained mixed. Gravity models have been used as framework to quantify the impact of exchange rate stability on trade and growth. Schnabel (2003) found evidence that exchange rates ability is associated with more growth in the EMU periphery. The evidence, according to him, is strong for emerging Europe which has moved from an environment of high macro-economic instability to macro- economic stability during the observation period. Other empirical studies examine the role of capital market in ensuring exchange stability and economic growth.

The study undertook an investigation, aimed at finding any relationship before regional trade agreement (RTA) and growth. He focused on whether openness size of the population and the gross domestic product (GDP) affected growth of countries that have entered i