External shocks and macroeconomic volatility in Nigeria: does financial development moderate the effect?

Abstract

Purpose – Motivated by the negative effect of external shocks on the domestic economy, this study explores the role of financial sector development in absorbing the effect of external shocks on macroeconomic volatility in Nigeria. Design/methodology/approach – Autoregressive distributed lag and fully modify ordinary least square are used to examine the moderating effect of financial development in the link between external shocks and macroeconomic volatilities in Nigeria between 1986Q1 and 2019Q4. External shock is proxy using oil price shock, and financial development is proxy by domestic credit to the private sector and market capitalisation. At the same time, macroeconomic volatility is proxy by output and inflation volatilities. Macroeconomic volatilities are generated using generalised autoregressive conditional heteroskedasticity (GARCH 1,1). Findings – The results indicate that domestic credit to the private sector significantly reduces output and inflation volatilities in Nigeria in the short and long run. However, market capitalisation promotes macroeconomic volatility. More specifically, financial development indicators play different roles in curtaining macroeconomic volatilities. The results also reveal that external shocks stimulate macroeconomic volatility in Nigeria in the short and long run. Nevertheless, the effects of external shocks on macroeconomic volatilities are reduced when the role of financial development is incorporated. Practical implications – This study, therefore, concludes that strong financial sector development serves as a significant shock absorber in reducing the adverse effect of external shock on the domestic economy. Originality/value – This study contributes to the extant studies by introducing a country-specific analysis into the empirical examination of how financial development can moderate the influence of external shock on macroeconomic volatilities.

Keywords

• External shocks
• Macroeconomic volatility
• Financial development
• Nigeria