Journal of Economics and Behavioral Studies (ISSN: 2220-6140) Vol. 9, No. 6, pp. 47-56, December 2017 47 Re-Examining the Nexus between Exchange and Interest Rates in Nigeria David Mautin Oke 1 , Koye Gerry Bokana 1 , Olatunji Abdul Shobande 2 1 College of Law and Management Studies, University of KwaZulu-Natal, South Africa 2 Faculty of Social Sciences, University of Lagos, Nigeria okdam76@yahoo.com, OkeD@ukzn.ac.za Abstract: Nigeria has experienced somersault of foreign exchange policies by the Central Bank. One policy concern in recent times is to have an appropriate target of the exchange and interest rates. Therefore, this paper seeks to provide a foundation for the targeting of an appropriate exchange and interest rates for the country. Using the Johansen Cointegration and Vector Error Correction Mechanism approaches, it specifically examines the relationships among Nigeria’s weak exchange rate, its local rate of interest and world interest rate. Contrary to many studies, a control measure involving inclusion of inflation, money supply and national output in the model is done. The analysis showed an equilibrium association between exchange rate and interest rate-cum-other variables and steady rectification of deviance from long-run stability over a sequence of incomplete short-run modifications. Increase in domestic and world interest rate, inflation, money supply and GDPat equilibrium would strengthen the exchange rate. Besides, further findings showed some bi- directional causal associations among the variables. By long-run implication, the targeting of an appropriate exchange rate in Nigeria requires a tightened monetary policy that is not inflation and growth biased. However, increase in world interest rate, money supply and inflation rate must be moderate in order not to worsen the exchange rate as suggested by the short-run result. Keywords: Interest rate, Exchange rate, Money supply, Inflation, GDP, Nigeria 1. Introduction In the midst of another recession in Nigeria which began in 2016 after 25 years is a worsen exchange rate and a low return on investment, that is, interest rate, given the high level of inflation. Historically, Nigeria’s exchange rate began to crash in1986 when the Structural Adjustment Program (SAP) was introduced. Thirty one years after, the exchange rate did not improve. It has rather gone bad with a US dollar exchanged at about NGN500 in the parallel market as at fourth quarter of 2016 and NGN380 in the second quarter of 2017. There are indications that if the governments of the country are not serious in handling the economic matters of the country, the recession may persist for more than three years and exchange rate might to continue to depreciate with low interest rate. Although there are also forecasts that the country would grow by 2.2 percent in 2017 since the oil market has gradually recovered and there is relative peace in the Niger Delta. The recession was largely due to the crash in the international oil market in 2015 and heavy drop in oil production in the country. The unfortunate scenario is that Nigerian economy remains fragile with its growth being largely financed by oil revenue (see Babatunde, 2015, Olagbaju & Akinbobola, 2016).There remains theoretical concerns as well as constraints in the choice of exchange rate regime in both developed and developing countries. This is because the choice of exchange rate regime as well as theoretical model of exchange rate ought to consider the link with financial discipline, inflation and economic development. It implies that commitment to an exchange rate policy should be compatible with the main macroeconomic equilibrate; otherwise it will not be sustainable (see Dordunoo & Njinkeu, 1996; Bohl, Michaelis & Siklos, 2016). Exchange rate policy has a long history in Nigeria. Between 1959 and 1967, Nigeria implemented fixed parity exclusively using the British pound and this was abrogated in 1972. The aftereffects of the devaluation of pound in 1967 and the onset of a powerful US dollar led to the insertion of US dollar in the exchange rate parity. In 1973, the US dollar was devaluated and Nigeria returned to fixed parity with the pound. As a way of reducing the counter bounce effect of devaluation of the individual currency parity, both British pound and US dollar were considered. In 1978, the central bank reverted to import weighted basket of currency method which was considered due to the tie of seven currencies: US dollar, British pounds, Japanese Yen, French Franc, German Mark, Swiss franc and Dutch guilder. In sum, between 1980 and 2016, the fixed and flexible exchange rate systems were used interchangeably. This paper seeks to investigate the nexus between exchange rate and interest rate in Nigeria. Specifically, it tests the long run relationship among exchange rate,