Journal of Economics and Sustainable Development www.iiste.org ISSN 2222-1700 (Paper) ISSN 2222-2855 (Online) Vol.5, No.4, 2014 157 Testing for Gibson’s Paradox: Evidence from Nigeria BigBen Chukwuma Ogbonna Department of Economics, Ebonyi State University, Abakaliki. Nigeria bigbenogbonna@yahoo.com Abstract This paper is set to investigate the existence of a significant long-run relationship between nominal interest rates and price levels and examine the possible causal link between the variables of interest using quarterly data on Nigeria for the periods of 1970 – 2012. Maximum likelihood method of co-integration, suggested by Johansen (1988, 1991) and Granger causality in an ADL model with p and q lags suggested by Koop (2005) are implemented to determine the number of co-integrating vectors and verify the nature and direction of causality between nominal interest rates and the price levels in Nigeria respectively. The co-integration results show that the null hypothesis of no significant long-run stable relationship between nominal interest rates and the price levels is rejected for Nigeria with the identification of one co-integrating vector. This result fines support for Gibson Paradox in Nigeria which supports the view that nominal interest rates and the price levels trend together over a long period of time and on the positive note too. When the ADL models were estimated to gauge the extent of both long and short run causality between the variables of interest, the results suggest the existence of a very strong causal link from nominal interest rates to price levels, in the long run while no causality was identified in the short run. This portrays nominal interest rate as a veritable tool for the moderation of general price level in Nigeria. This by implication puts forward the fact that supply rather than demand side dominates in determining the level of consumer price index in Nigeria. Therefore policy efforts to drop inflation while keeping the nominal interest rate high may prove ineffective in Nigeria as the two share strong positive correlation. Keywords: Nominal interest rates, price level, Gibson paradox, cointegration, Nigeria 1. Introduction An economic observation made by J. M. Keynes during the period of the gold standard, indicates a correlation between interest rates and the general price level. Keynes discussed this finding in his work "A Treatise on Money" (1930). The designation of this result as a paradox stem from the fact it expressed a contrary view to that generally held by economists at the time, which was that interest rates were correlated to the rate of inflation. The result of Keynes' study showed that interest rates were highly correlated to wholesale prices but had little correlation to the rate of inflation. In effect, this paradox hypothesizes that interest rate movements are significantly linked to the level of prices rather than the rate of change in prices. It is on the strength of the above observation that this study intends to investigate the possible long-run relationship between nominal interest rates and the price levels. Furthermore, we test for direction of short term and long-run causal relationship between nominal interest rates and the price level dynamics over the period of 1970 – 2012 using quarterly data on Nigeria,. In effect, this study hypothesizes that the rate of interest is the cause of inflation in Nigeria. The study employs money deposit banks lending interest rates and inflation rates for the period under review in investigation of the hypothesis.The remaining part of this paper is structured as follows: In section 2, brief review of related literature is presented; section 3 presents Data and Econometric methodology; section 4, empirical results and section 5, the concluding remarks. 2. Empirical Review Irving Fisher writing by1896 expressed a view that interest rate is a function of the rate of price changes rather than the price level. He further characterized real interest rate as the observed nominal market rate of interest as adjusted for the anticipated rate of change of prices. But writing in 1930, J. M. Keynes expressed a divergent view from the fisher’s effect. Keynes was rather of the believe that price levels and interest rates tend to rise together and to fall together, a phenomenon he described as "Gibson Paradox" and one of the most completely established empirical facts within the whole field of quantitative economics. Fisher in an attempt to reconcile the empirical generalization with his theory interpreted the Gibson phenomenon as the manifestation the slow adjustment of anticipations of inflation to actual changes in prices. This account was not acceptable to Keynes who in 1930 offered a very different explanation. He was of the opinion that the Gibson phenomenon reflected the delayed reaction of commercial banks to changes in the real rate of interest. This equally did not command general acceptability and satisfaction among economists. To this effect, “Gibson paradox” appears to be an empirical phenomenon without a theoretical explanation (see King & Watson, 1997). There is plethora of empirical investigations on the Gibson phenomenon as summarized below.