Monetary Policy, Interest Rates, Inflation and the Exchange Rate

When the central bank changes the rate at which banks borrow from it, the effects reach every business within weeks: the interest on the overdraft changes, customers delay or bring forward purchases, and the value of the naira against the dollar moves, which changes what imports cost and what exports earn.

Monetary policy is the second instrument of economic policy, alongside the fiscal policy covered in the last topic, and the finance manager must be able to read it.

This topic explains what monetary policy is, how interest rates are used to control inflation and how the change travels through the economy (the transmission effect), how interest rates and the exchange rate are linked, why a central bank cannot use one instrument for two jobs, and how monetary policy affects business, with Nigerian facts as at the date of this page. The next topic covers money markets, banks and money market instruments.

Monetary policy is also part of the answer to the government activities question in November Diet, 2025, Question 6 (10 marks). Read macroeconomic policy targets, gross domestic product and fiscal policy first.

Monetary policy and inflation

Monetary policy relates to monetary issues in the economy, in particular the rate of inflation, interest rates and the exchange rate of the domestic currency against foreign currencies. There is a link between growth and inflation: excessive inflation goes with an “overheating” economy, a slowdown in growth and possibly recession.

A major target of monetary policy is therefore likely to be control over inflation, which is the main objective in, for example, the United States, the eurozone and the United Kingdom, where interest rate policy is the main instrument. In Nigeria the Central Bank of Nigeria uses the Monetary Policy Rate, the interest rate it charges when it lends to banks, as a major instrument for controlling inflation.

How the interest rate controls inflation

1. To reduce inflation in the long term, expectations about future inflation must be reduced, because inflation increases when expectations are high.
2. To reduce those expectations, the authorities must be seen to act whenever inflationary pressure shows. The central bank can act by raising the rate at which it lends to other banks.
3. There is a transmission effect: if banks must pay more to borrow from the central bank, they raise the rates they charge borrowers. In time, higher borrowing costs reduce the demand of companies and individuals for credit, and this reduces consumption spending.

So, if spending is rising too quickly and there is a risk of inflation, rates should be raised; higher rates eventually discourage borrowing and restrict the growth of spending. If the economy could grow faster without the threat of inflation, rates may be lowered to stimulate spending and investment.

Nigerian position as at 5 November 2026

The Central Bank of Nigeria raised the Monetary Policy Rate sharply in 2024, to 27.5% in November 2024. The Monetary Policy Committee held at 27% in November 2025, cut by 50 basis points to 26.5% in February 2026, held in May and July 2026 and, on 22 September 2026, reset the rate to 23%, a cut of 350 basis points, the largest in the bank’s history.

The Governor described it as an operational realignment to strengthen the transmission of policy and not a switch to an accommodative stance. Headline inflation had eased to 15.43% in July 2026. The rate at which a company can actually borrow is higher than the policy rate, so a floating-rate loan quoted at the policy rate plus 4 percentage points would have cost 30.5% before the reset and 27% after it.

On ₦200m that is ₦61.0m a year before and ₦54.0m after, a saving of ₦7.0m. With inflation at 15.43%, a nominal rate of 23% is a real rate of 1.23 ÷ 1.1543 − 1 = about 6.6%.

Monetary policy and the exchange rate

Monetary policy can also affect the value of a country’s currency. In general, higher interest rates are likely to attract more investors into buying investments in the currency, and lower rates are likely to persuade investors to sell. Changes in interest rates, by affecting the supply of and demand for the currency, can therefore change its exchange rate.

The government or central bank could make the exchange rate a key target, perhaps to stabilise the currency and encourage international trade. But if interest rates are used to manage the exchange rate, interest rate policy cannot at the same time be used to control inflation.

In Nigeria a large part of foreign exchange receipts comes from oil, so the exchange rate depends largely on the international price of oil: a rise in oil price and oil income leads to naira appreciation, and a fall to depreciation in the long run. In the short run the Central Bank of Nigeria may intervene, using foreign reserves, to defend the naira.

Monetary policy and business

• Inflation control helps in the long term. Businesses benefit when inflation and price rises are restricted, because real economic growth is likely to be greater.
• The cost of borrowing. Changes in interest rates change borrowing costs and so profits. High rates on long-term finance may deter new investment and reduce capital spending.
• Customer spending. Higher rates may reduce consumer spending and make it harder for companies to sell their products, especially goods bought on credit.
• The exchange rate. A change in the naira affects the naira cost of imported inputs and the naira value of export earnings. For example, an importer owes $200,000. At ₦1,328.67 to the dollar (the Central Bank rate on 24 September 2026) the cost is ₦265.73m. If the naira falls to ₦1,450, the cost is ₦290.0m, which is ₦24.27m more. An exporter with $200,000 of receipts gains by the same amount.

The ideas in more depth

Why expectations matter

If everyone expects prices to rise by 20%, wage claims and price lists are set accordingly and the inflation happens. A central bank that is believed to be serious can bring expectations down with smaller rate changes. This is why its decisions are accompanied by explanations and why the market watches every meeting.

Why the real rate matters more than the nominal rate

A borrower’s true cost of money is the interest rate less the inflation it will suffer. With nominal rates at 23% and inflation at 15.4% the real rate is positive and fairly high, so borrowing for investment remains costly; when inflation is higher than the nominal rate, the real rate is negative and borrowers gain at the lender’s expense.

Sources and references

• Central Bank of Nigeria Monetary Policy Committee decisions, including the 307th meeting of 21 and 22 September 2026; the National Bureau of Statistics for inflation.

These points are stated as at 5 November 2026.

Worked examples

1. Before.
   30.5% × ₦200m = ₦61.0m.
2. After.
   27% × ₦200m = ₦54.0m, a saving of ₦7.0m.

1. Real rate.
   1.23 ÷ 1.1543 − 1 = 6.6%.

1. Before.
   $200,000 × 1,328.67 = ₦265.73m.
2. After.
   $200,000 × 1,450 = ₦290.0m: an extra ₦24.27m.

How to answer in the exam

• State the instrument and the chain of effects (policy rate, lending rates, spending, inflation).
• Give the effect on the company and an illustration, for example the cost of a floating-rate loan.
• Say that the rate and the exchange rate cannot both be targeted with one instrument.
• Use current facts when the question is set in Nigeria, such as the oil link of the naira.

Common mistakes in the exam

• Mixing up monetary and fiscal policy.
• Saying that a rate rise reduces the cost of borrowing.
• Forgetting the transmission effect through the banks.
• Ignoring the exchange rate effect on importers and exporters.
• Using the policy rate as the company’s own borrowing rate.
• Confusing nominal and real interest rates.

Quick revision

• Monetary policy: inflation, interest rates, exchange rate.
• Higher policy rate: higher lending rates, lower spending, lower inflation.
• Higher rates attract inflows and may strengthen the currency.
• One rate cannot control both inflation and the exchange rate.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

Spotted a mistake? Tell us and we will check it.