Analysing the Relationship Between Financial Sector Development and Inflation Dynamics in Nigeria

Financial sector development can influence inflation dynamics through credit expansion, monetary transmission, and liquidity creation effects, and the empirical nature of this relationship in Nigeria's banking system requires rigorous investigation. This study empirically analyses the relationship between financial sector development and inflation dynamics in Nigeria for the period 1990 to 2022. Financial sector development was proxied by the domestic credit-to-private-sector ratio, the financial system deposits-to-GDP ratio, and the banking sector net interest margin. Inflation was measured by the headline Consumer Price Index inflation rate. The autoregressive distributed lag bounds testing approach and Granger causality analysis were employed with cointegration tests. Results confirmed a long-run cointegrating relationship between domestic credit expansion and inflation, with a significant positive long-run coefficient (0.42, p < 0.05), consistent with the monetary quantity theory. However, financial system deposits growth had a negative long-run relationship with inflation (-0.29, p < 0.05), suggesting that deposit mobilisation supports inflation-dampening monetary policy effects. Granger causality tests confirmed bidirectional causality between credit expansion and inflation, complicating the identification of purely causal effects. The study fills an important gap in the Nigerian finance-inflation empirical literature and concludes that credit expansion without commensurate deposit mobilisation is inflationary, recommending coordinated monetary and macroprudential policy to manage credit-driven inflation risks in the financial system. Keywords: financial sector development, inflation, domestic credit, monetary policy, cointegration