Macroeconomic Analysis using VAR Model: The Impact of Money Supply on Inflation in Nigeria

Abstract

Inflation remains a persistent macroeconomic challenge in developing economies like Nigeria, where controlling the money supply is a central policy tool for stabilization. This study empirically examines the dynamic relationship between money supply growth and inflation in Nigeria from 1961 to 2023 using a bivariate Vector Autoregression (VAR) model. Drawing on the Quantity Theory of Money, I account for real-world complexities such as structural rigidities and external shocks that can weaken the theoretical one-to-one link between money and prices. Annual time-series data on Consumer Price Index (CPI) inflation and broad money (M2) growth are employed. Pre-estimation tests confirm that both series are non-stationary in levels but stationary after first-differencing, justifying a VAR in growth rates. A lag length of one year is selected based on information criteria. Key findings include a unidirectional Granger causality from money supply to inflation (F=13.099, p<0.001), meaning past changes in money supply significantly predict inflation, whereas the reverse is not true. Impulse response analysis reveals that a positive money supply shock triggers a gradual rise in inflation, peaking after about one year before tapering off, reflecting monetary transmission lags. Variance decomposition shows that money supply shocks account for roughly 30% of the variation in short-run inflation (first 1–3 years), while the bulk of inflation variability is due to other factors by the long run. These results affirm a monetary influence on inflation in Nigeria but also underscore the role of non-monetary factors and policy lags. Based on these findings, the policy implications emphasize the importance of prudent money supply management for price stability, while coordinating with fiscal policy and structural reforms to address supply-side constraints. The study concludes with recommendations for policymakers at the Central Bank of Nigeria (CBN) and the Ministry of Finance on controlling inflation through better monetary-fiscal coordination and discusses the need for future research to expand the model beyond the current bivariate setup to capture additional drivers of inflation.