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The word output gap is an indicator of the difference between the actual output of an economy and the maximum potential output of the economy, expressed as a percentage of gross domestic products (GDP). According to Okon (2013), a country’s output gap may be either positive or negative. A positive output gap is interpreted as indicating extremely high demand for goods and services in an economy, which might be considered as a plus for the economy.  However, the effect of the excessively high demand is that businesses and employees must work beyond their maximum efficiency level in order to try to meet the level of demand. A positive output gap commonly spurs inflation in an economy as both labour costs and the prices of goods rise in response to the increased demand. Alternatively, a negative output gap indicates a lack of demand for goods and services in an economy, and leads to companies and employees operating below their maximum efficiency level. A negative output gap is generally a sign of a sluggish economy, and forecasts a declining GDP growth rate and potential recession as wages and prices of goods typically fall when overall economic demand is low. Therefore, an output gap, whether positive or negative, is an unfavorable indicator for an economy, at least in regard to efficiency.
The important of output gap is derived from the fact that, output gap is an aggregate measure of resource strain in the economy. It has long been a device used at central banks to represent how “hot†or “cold†the economy is at any particular time and to forecast likely inflationary pressures. It can also be a useful indicator about the volatility of activity in the economy, whether resources are alternating quickly between periods of substantial resource strain to periods of substantial resource slack, or whether the economy is moving smoothly between moderate levels of resource strain and slack. Output gap is also, a useful device in assisting the understanding and forecasting of inflation developments and it provides a useful way of thinking about inflationary pressure in the economy. Output gap is the trend growth in the productive capacity of an economy. It is an estimate of maximum sustainable output, output that can be sustained in the long run without leading to macroeconomic instability.
Exchange rate is the price of one country’s currency expressed in terms of some other currency. It can also be defined as the price at which one unit of a country’s domestic currency exchanges for any other country’s currency in the world. An exchange rate has two components, the domestic currency and a foreign currency. In terms of domestic currency, the price of a unit of foreign currency is expressed while in foreign currency, the price of a unit of domestic currency is expressed.
A fluctuation in exchange rate is the change in the value of one currency against another currency and it is the rate at which the currency of a country is determined by the forces of demand and supply of foreign exchange which varies at intervals. Exchange rate fluctuation moves without intervention from the central bank or the government and a country with significant payment deficit would benefit from exchange rate fluctuation because fluctuations provide automatic adjustment. Exchange rate adjustments offer an automatic means of responding to adverse shocks without any overt policy action. The governments are free to choose their domestic policy because a fluctuating      exchange rate would allow for automatic correction of any balance of        payment disequilibrium, that might arise from the implementation of such policy and if a government has a policy of a fluctuating exchange rate, it does not need to hold large reserves of foreign currency with which to adjust the exchange rate by buying and selling its own currency.
The presence of fluctuations in exchange rate can have negative consequences for other objectives of government and also variations in exchange rate may cause uncertainty and discourage trade. Constant fluctuations in the external price of domestically produce goods mean that the demand for exports would be unstable. It has been recognized that depreciation of exchange rate tends to expand exports and reduce imports, while the appreciation of exchange rate would discourage exports and encourage imports. Thus, exchange rate depreciation leads to income transfer from importing countries to exporting countries through a shift in the terms of trade, and this affects the economic growth of both importing and exporting countries. If exchange rate fluctuation is eliminated, international arbitrage enhances efficiency, productivity and welfare. Mundell (1973) expressed that monetary and exchange rate policies are the chief source of uncertainty and volatility in small open economies and economic growth is enhanced when exchange rate fluctuations are smoothed.
The importance of exchange rate derives from the fact that it connects the price systems of two different countries making it possible for international trade to make direct comparison of traded goods, it also links domestic prices with international prices. Exchange rate is determined with reference to a basket of currencies, rather than the bilateral exchange rate between the domestic and any single currency.
The fluctuation of exchange rate has both advantages and disadvantage on the output of a country. The advantages of exchange rate fluctuation are: Lack of policy constraints: The government are free with a fluctuating exchange rate system to pursue the policies they feel are appropriate for the domestic economy without worrying about them conflicting with their external policy. Correction of balance of payments deficits: A fluctuating exchange rate can depreciate to compensate for a balance of payments deficit. This will help to restore the competitiveness of exports.
The disadvantages of exchange rate fluctuation are: Instability: fluctuating exchange rates can be prone to large fluctuations in value and this can cause uncertainty for firms. Investment and trade may be adversely affected. Speculation: The existence of speculation can lead to exchange rate changes that are unrelated to the underlying pattern of trade. This will also cause instability and uncertainty for firms and consumers.
Output gap is the difference between actual output produced in the economy over a given period and the “normal†or “trend†level of output produced in the economy (often called “potential†output). Output gap is unobservable, and the possibility that the linkage between the real economy and inflation is not well represented by models or frameworks that use the output gap concept. According to Claus and Scott (2000), Output gap can be difficult to measure and reflects only aggregate resource pressures, which could readily lead to policy errors if the output gap were mechanically used as the sole indicator of inflation pressure. However, there is no observable direct measure of trend output, nor do we know how trend output will develop in the future.
According to Robert Mundell and Marcus Fleming (1960’s), when the exchange rate changes, this affects the level of net exports, as exchange rate increases, the domestic currency depreciates and the net export rises. It has been recognized that changes in exchange rate may cause uncertainty and discourages trade and this leads to exchange rate depreciation, depreciation of exchange rate tends to expand exports and reduce imports. Thus, exchange rate depreciation leads to income transfer from importing countries to exporting countries through a shift in the terms of trade, and this affects the economic growth of both importing and exporting countries.
The change in exchange rate and its effect on net export, affects both the output and the Balance of Payment. As net export rises, the level of total expenditures increases, and the Current Account improves that is, the Current Account equals the level of net exports as net export rises and the current account rises becomes less negative. At this point, the economy does not need as high a level of capital inflows at each income level.
When there is a decrease in exchange rate, the domestic goods become relatively more expensive on international markets as net exports decrease. This leads to exchange rate appreciation, appreciation of exchange rate would discourage exports and encourage imports. As net export decreases, it has two effects that occur simultaneously: Total Expenditures fall and current account worsens. At this point, exchange rate will continue to appreciate until the capital inflow is halted at a point where domestic interest rate equals the foreign interest rate.
Against this backdrop, this study will evaluate how a change in exchange rate affects the net export and output in an economy.
H0:Â Â Â Â Â There is no significant relationship between exchange rate fluctuation and output gap in Nigeria
The study examines the influence of exchange rate fluctuation on output growth in Nigeria between 1981 – 2015