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Abstract
This study is an economic assessment of the effectiveness and the potential side effects of the monetary policy toolkit developed over the past decades using data obtained from Central Bank of Nigeria from 1995 to 2020(Q1). Interest rate, exchange rate, inflation rate and ratio of broad money supply (BMS) to gross domestic product (GDP) were employed as the independent variables, while GDP growth rate was used as the dependent variable. The results of Jarque-Bera (JB) test indicated that interest rate (INR) and exchange rate (EXR) have a normal distribution while gross domestic product’s growth rate (GDPGR), inflation rate (IFR) and ratio of broad money supply to GDP (BMS/GDP) do not have. The results of Phillips-Perron (PP) test showed that GDPGR, IFR and BMS/GDP were stationary at level; INR was stationary at first difference and EXR was stationary at second difference. The Ordinary Least Square (OLS) regression results revealed that IFR has a significant positive effect on economic growth proxied by GDPGR, while INR, EXR and BMS/GDP have a negative but not significant effect on economic growth in Nigeria. Durbin-Watson (DW) statistic indicated that there was no problem of autocorrelation. The Johansen Cointegration (JC) test results signaled the existence of a long-run relationship between the dependent and independent variables. The results of Granger Causality (GC) test revealed that a unidirectional causal relationship runs from exchange rate to economic growth. It also showed that a unidirectional causality runs from inflation rate to economic growth. Based on the findings, the study concluded that inflation is a significant and viable monetary policy instrument that affects economic growth in Nigeria and could be used by monetary authority in Nigeria to achieve a higher economic growth. Therefore, this study recommended that monetary authority in Nigeria should pay more attention to inflation rate in the economy as it has a significant effect on economic growth. Due to the fact that inflation rate has a positive effect, monetary authority should not target a very low level of inflation as economic growth would be affected negatively. Thus, in order to achieve a higher rate of economic growth, inflation rate should be moderate, above “single digit”. Also, interest rate, exchange rate and ratio of broad money supply to GDP should be low to enhance economic growth.
CHAPTER
ONE
INTRODUCTION
1.1 Background to the Study
Monetary policy is a deliberate action of the
Central Bank of Nigeria to use its monetary policy instruments such as interest
rates, open market operations, liquidity ratios, cash reserve ratios, statutory
reserves, and moral suasion amongst others to regulate and control the
availability of money in circulation in the economy. Monetary policy as the
name implies is one of the major economic stabilization weapons which involve
measures designed to regulate and control the volume, cost, availability and
direction of money and credit in an economy to achieve some specific
macro-economic policy objectives. It is a deliberate attempt by the monetary
authority (Central Bank) to control the money supply and credit condition for
the purpose of achieving certain broad economic objectives. It is also the
control of money and Bank credit thereby regulating cost of credit in such a
way it will affect aggregate demand in a direction that would continue to the achievement
of healthy balance of payment, price stability and job opportunity (Anyawu
1993). However, it will settle in this study that macro-economic stability is a
pre-requisite for sustainable growth and poverty reduction. Money supply is being
controlled by the government in that firm belief that its rate of growth has
something to do with rate of inflation.
Monetary policy as a technique of economic
management is to bring about sustainable economic growth and development. This
has been the pursuit of nations, as observed by Onyewu (2012) and formal
articulation of how money affects economic aggregates. And this view dates back
to the time of Adam Smith and later championed by the monetary economists.
Since the expositions of the role of monetary policy in influencing
macro-economic objectives like economic growth and development which include
employment generation, stability in prices, growth in Gross Domestic Production
(GDP), equilibrium in balance of payments and host of others monetary
authorities are saddled with the key responsibility of using monetary policy to
formulate and implement policies that gear toward driving the economy on an
even keel.
If the economy slows and employment declines, policy
makers will be inclined to soften monetary policy to stimulate aggregate
demand. When growth in aggregate demand is boosted above growth in the
economy's potential to produce, slack in the economy will be absorbed and
employment will return to a more sustainable path. In contrast, if the economy
is showing signs of overheating and inflation pressures are building, the
Central Bank will be inclined to counter these pressures by tightening the
economy through monetary policy to bring growth in aggregate demand below that
of the economy's potential to produce for as long as necessary to defuse the
inflationary pressures and put the economy on a path to sustainable expansion.
While these policy choices seem reasonably straightforward, monetary policy
makers routinely face certain notable uncertainties because the actual position
of the economy and growth in aggregate demand at any point in time is only
partially known as key information on variables only come with lags such that
policy makers are constraint to rely on estimates of these economic variables
when assessing the choice of appropriate policy and therefore could act on the
basis of misleading information. More so, monetary policy is not the only force
acting on output, employment, and prices. Many other factors affect aggregate
demand and aggregate supply and, consequently, the economic position of
economic units. Some of these factors can be anticipated and built into
spending and other economic decisions while others like shifts in consumer and
business confidence, posture of creditors, natural disasters, disruptions in
the oil market that reduce supply, agricultural losses, and slowdowns in
productivity growth can be totally unpredictable and influence the economy in
unforeseen ways.
The works of Christiano et al. (1999); Mishkin
(2002); Bernanke et al. (2005); and Rafiq and Mallick (2008) showed that there
is substantial evidence of the effectiveness of monetary policy innovations on
real economic parameters in developed economies like the United States (US) and
some core European countries. However, there have been various regimes of
monetary policy in Nigeria. The economy often witnessed either expansionary or
contractionary monetary policy in an attempt to achieve its set objectives. Nevertheless,
studies by Gertler and Gilchrist (1991); Batini (2004); Folawewo and Osinubi
(2006); Onyemu (2012); Fasanya et al. (2013) observed that despite efforts made
towards achieving the desired macroeconomics objectives through monetary policy
that the results have not been sustainable enough as there are evidences of
relatively high rate of unemployment, increased poverty rate, low standard of
living, unacceptable rate of inflation etc. especially in less developed
economies. The prevalence of these macroeconomic vices as mentioned above
clearly showed that the issues of economic development especially in Nigeria
has not been visibly addressed by monetary policy.
Theoretical debate on the instruments of monetary policy has been
based on two major paradigms, monetarist vs. Wicksellian. Under the monetarist
view money supply is within the control of the central bank, so that Friedmaris
rule of maintaining a target rate of growth of the money supply is more apt in
determining optimal inflation and economic growth (Carlin and Soskice, 2006).
The Wicksellian paradigm deems money as endogenous so that the interest rate
becomes the appropriate instrument of monetary policy. However, recent
developments in mainstream monetary policy have led to the refutation of the
monetarist framework based on the premise that the interest rate paradigm
represents the true behaviour of central banks (Fontana, 2007).
Consequently, modern design of monetary policy has followed the
proposition of the New Consensus Macroeconomics (NCM). The basic principle of
the NCM is the use of short-term interest rate to achieve price-stability
(Meyer, 2001; Arestis, 2007). The objective of price-stability is centered on
the supply-side equilibrium and the inability of monetary policy to have any
long-run impact on real variables (Bean, 2007; Fontana, 2009). In the
short-run, however, the existence of nominal rigidities means that policy can
affect real variables temporarily.
Typical discussions of monetary policy like this, however, do not
distinguish between developed and developing countries (Huang and Wei, 2006).
Thus, central banks in developing countries are adopting inflation targeting
(IT), which is founded on the tenets of the NCM. This is based on the erroneous
but widespread belief that policies would have similar outcomes irrespective of
the development status of the country (Epstein and Yeldan, 2008). Generally,
most developing countries are characterized by weak institutions and financial
underdevelopment which ensure that the effectiveness, transmission and
implications of policy differ from those of advanced countries (Ghatak and
Sanchez- Fung, 2007). Therefore, the gains and costs of low inflation can vary
considerably between developing and developed countries.
Inflation targeting (IT) intrinsically requires central banks to be
highly averse to inflation or at least reputably more inflation averse than
political policymakers. The degree of aversion has important implications for
the cost of disinflation. According to Carlin and Soskice (2006), the
nonlinearity of the short-run Phillips curve causes the cost of disinflation to
increase with the degree of inflation aversion so that IT may be very expensive
overall. Hence, even if the NCM/IT approach is effective in stabilizing prices,
it may have adverse consequences on economic growth, employment, equality, and
poverty reduction particularly among developing countries (Cordero, 2008;
Epstein, 2008).
For developing countries, the inflation threshold - which is the
level beyond which inflation becomes harmful - is variously estimated at 11-18
per cent (Dada, 2011; Khan and Senhadji, 2001; Pollin and Zhu, 2006). In this
regard, moderate inflation rate may therefore be optimal for developing
countries rather the very low rate advocated for developed countries (Huang and
Wei, 2006). There would thus be little justification for low inflation as the
dominant objective of monetary policy in developing countries. The negative
effect of inflation targeting on growth and employment triggers the need for
the alternative monetary policy approach, especially for developing countries
(Pollin et a/, 2007; Epstein and Yeldan, 2008; Cordero, 2008).
In Nigeria, monetary policy is conducted with the use of the
short-term interest rate as the key instrument, while price stability is the
paramount objective. Price stability in this context is defined as achieving
and sustaining a single-digit rate of inflation; thus, giving the Central Bank
of Nigeria (CBN) an asymmetric target below a 10 percent threshold. Nigeria is,
however, characterized by weak institutional features, underdeveloped financial
sector and a dominant government sector. These factors weaken the conduct of
monetary policy and diminish its reliability. Furthermore, financial market
underdevelopment can abate the ability of the monetary policy to influence the
money market interest rates. Such ineffectiveness would bring about a weak
transmission mechanism and emphasizes the need for an alternative approach
(CBN, 2007). In the medium term, thus, the CBN plans to migrate to a full-fledged
inflation targeting framework. This would entail the declaration of a specific
inflation target (IT) around which the effectiveness of the Bank's policy
actions would be judged. Adopting IT requires CBN’s independence, credibility,
an adequate understanding of the transmission mechanism of monetary policy and
the willingness to sacrifice other macroeconomic objectives (such as economic
growth and employment) for the attainment of price stability (Ononugbo, 2012).
Inadequate knowledge of the economic system can deter policy
actions from having the desired effects. Similarly, inadequate understanding of
the consequences of monetary policy would lead to misjudgment and would
substantially increase the costs of achieving any given goal. In Nigeria, uncertainty
about the transmission mechanism and incomplete understanding of the system has
remained a major challenge for monetary policy (Uchendu, 2009). This is
compounded by the existence of a vibrant informal sector, which has ambiguous
structures. Monetary policy in Nigeria is, therefore, undermined and characterized
by uncertainty and inadequate knowledge (by policymakers and others) of the
economy. These challenges are believed to contribute to volatility and slow
economic growth in Nigeria (Batini, 2004; Balogun, 2007). This therefore gave
rise to the need to investigate the effectiveness and the potential side
effects of the monetary policy toolkit developed over the past decades.
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1.2 Statement of the problem
Most studies on the design of monetary policy in Nigeria have
generally tended to investigate the effectiveness of the monetary policy in
terms of money supply changes rather than other toolkits like interest rates,
with narrow focus on it costs. Feridun, Folawewo & Osinubi (2005) found
that the monetary policy approach in Nigeria, though ineffective, has resulted
in increased instability in inflation and exchange rate. This instability,
according to Adam and Goderis (2008) and Olubusoye and Oyaromade (2008), can be
further attributed to the disruptive effect of crude oil price volatility on
monetary policy efforts. Crude oil price volatility impacts on monetary policy
through its impact on the fiscal revenue and monetary expansion.
The current practice of monetary policy, in many countries, is in
agreement with the assumptions, conclusions and recommendations of the New
Consensus Macroeconomics (NCM), with the short-term nominal interest rate as
the instrument and price stability as the objective. The NCM assumes among
other things that the financial market is adequately developed and capable of
effectively conducting policy impulses to the rest of economy. In addition, low
inflation is assumed to be achievable at minimal cost. However, Nigeria's
financial system is relatively underdeveloped, shallow, bank dominated and characterized
by inadequate market instruments and securities. This can impede the
pass-through from policy rate changes to market rates; thus, diminishing policy
effectiveness. Besides, the fact that banks may be more willing to hold
risk-free government securities rather than lend to private investors implies
that monetary policy interest rate changes may not affect aggregate demand as
suggested by the NCM (Ononugbo, 2012). This further undermines the
effectiveness of monetary policy.
Over the years, the objectives of monetary policy have remained the
attainment of internal and external balance of payments. However, emphasis on
techniques/instruments to achieve those objectives has changed over the years
(CBN, 2014).
It is on record that the direct approach to monetary management was
the main technique of monetary policy implementation in Nigeria before the
introduction of the Structural Adjustment Programme (SAP) in 1986. Between 1986
and 1993, the CBN made efforts to create a new environment for the introduction
of indirect approach to monetary management (CBN, 2013). A major action taken
as part of the monetary reforms programme was the initial rationalization and
eventual elimination of credit ceilings of selected banks that were adjudged to
be sound. After the initial test run of the indirect monetary management
approach, monetary management shifted to the indirect approach in which Open
Market Operation (OMO) was the principal instrument of liquidity management
(CBN, 2013). Since the introduction of the indirect approach, the primary and
secondary markets for treasury securities have been developed to take advantage
of liberalization introduced through the reforms. Discount houses, banks and
some selected stockbrokers tend to be very active in the primary market for
treasury bills.
In August, 1987, the CBN liberalized the interest rate regime and
adopted the policy of fixing only its minimum rediscount rate to indicate the
desired direction of interest rate. This was modified in 1989, when the CBN
issued further directives on the required spreads between deposit and lending
rates. In 1991, the government prescribed a maximum margin between each bank's
average cost of funds and its maximum lending rates. Partial deregulation was,
however, restored in 1992 when financial institutions were required to only
maintain a specified spread between their average cost of funds and maximum
lending rates. The removal of the maximum lending rate ceiling in 1993 saw
interest rates rising to unprecedented levels in sympathy with rising inflation
rate which rendered banks' high lending rates negative in real terms, in 1994,
direct interest rate controls were restored. As these and other control
introduced in 1994 and 1995 had negative economic effects, total deregulation
of interest rates was again adopted in October, 1996 (CBN, 2013). In 2014,
monetary policy was focused on achieving the objective of price and exchange
rate stability. Accordingly, the bank sustained its tight policy stance with a
view to ensuring that electioneering spending did not result in uptick in
inflation (CBN, 2014). Thus, it is in the light of the various reforms in
monetary policy management that this study looks at the effect of monetary
policy on economic growth in Nigeria.
Despite the various reforms in monetary policy management, the
overall objective of monetary policy which is the attainment of overall
macroeconomic stability has not been achieved. The pursuit of price stability
has not yielded the desired result as inflation rate is still dangling. Also,
exchange rate continues to be volatile and this does not augur well with the
economy. Moreover, the rate of unemployment remains high. Thus, the reported growth
of the economy is not evidenced in the standard of living of the people. Small
and Medium Enterprises are struggling to survive. The above facts question how
effective monetary policy is in Nigeria. This necessitated this economic
assessment of the effectiveness and the potential side effects of the monetary
policy toolkit developed over the past decades.
1.3 RESEARCH QUESTIONS
The following questions have been put forward to address the
research objectives;
i.
Does interest rate affect the growth rate of
gross domestic product in Nigeria?
ii.
To what extent does exchange rate effect the
growth rate of gross domestic product in Nigeria?
iii.
How has
inflation rate effect the growth rate of gross domestic product in Nigeria?
iv.
How has broad money supply effect the growth
rate of gross domestic product in Nigeria?
1.4 OBJECTIVE OF THE STUDY
this study is an economic assessment on the effectiveness and the
potential side effects of the monetary policy toolkit developed over the past
decades. Consequently, the specific objectives include:
1. To examine the effect of interest rate on the growth rate of
Gross Domestic Product in Nigeria
2. To determine the effect of exchange rate on the growth rate of
Gross Domestic Product in Nigeria
3. To assess the effect of inflation rate on the growth rate of
Gross Domestic Product in Nigeria
4. To examine the effect of broad money supply on the growth rate
of Gross Domestic Product
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