CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND TO THE STUDY
The economic and financial situation of a country is largely based on the monetary policy being implemented by the Central Bank of the country. It is widely agreed that monetary policy can contribute to sustainable growth by maintaining price stability. According to Christiano and Fitzgerald (2013), when the rate of inflation is sufficiently low households and businesses do not have to take into account when making everyday decisions. A government manages its economy through the combined actions of fiscal and monetary policies. The notable and visible element in fiscal policy making which is directly influenced by government’s expenditures both recurrent and investments, the government adjusts its spending levels in order to monitor and influence the nation’s economy.
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. Its official goal is to usually include relatively stable prices and low unemployment. In practice, all types of monetary policy involve modifying the amount of base currency in circulation. This process of changing the liquidity of base currency through the open sales and purchases of (government-issued) debt and credit instruments is called open market operations.
The constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate. Monetary theory provides insight into how to craft optimal monetary policy, this is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it (Lipsey et al., 2011). Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living in a country. McMahon (2017) defined it as an increase in the price a person pays for goods.
During inflationary periods opportunity cost of holding money is increased causing inefficient use of real resources in transactions. Therefore, inflation weakens the purchasing power of money and sinks the standard of living of the citizenry. Policy makers have tried to adopt appropriate policies that can combat inflation and ensure price stability. Generally, the level of money supply and the stock of goods and services are two crucial factors that determine the level of inflation in an economy. When inflation becomes persistent, the duo becomes the primary targets of policies. An excess or shortage in the supply of money could either induce excess aggregate demand resulting in higher inflation rate or induce stagnation thus retarding economic growth and development. While fiscal policy proves helpful in combating inflationary pressure, monetary policy has been the principal tool often employed by the central banks to ensure price stability. While it is not arguable that monetary authority have formulated various policy measures as an attempt to curbing inflationary menace, the effectiveness of policy pursuit to curb inflationary environments is questionable as most economies, particularly developing ones still experience inflationary challenges.
1.2 STATEMENT OF THE PROBLEM
Because of the impact monetary policy has on financial condition in the economy (not just the cost, but also the availability of credit or bank’s willingness to assume specific risk) but also because of its influence on expectations about economic activity and inflation, monetary policy can affect the prices of goods, assets prices, exchange rate as well as consumption and investment (Oesterreichische National Bank, 2002). Every monetary policy impulse (e.g. an interest rate change by the Central Bank, change in the monetary base resulting from changes in minimum reserve rate) has a lagged impact on the economy. Moreover, it is uncertain how exactly monetary policy impulses are transited to the price level or how real variable develop in the short and medium term.
The difficulty of the analysis is to adjust the effect of the individuals channels for external factors e.g. supply and demand shocks, technical progress or structural change may be superimposed on the effect of central bank measures, and it is difficult to isolate monetary policy effects on various variables for analytical purposes. Moreover, the time lag in the reaction of the real sector to monetary measures renders the analysis more difficult. Hence monetary policy must be forward looking (Oesterreichische National Bank, 2002). As far as Nigeria concerns regarding inflationary effects it has been experienced worst consequences reflected by poverty, food crises, price hike etc.
Mahmood et al, (2015) concluded that inflation causes poverty. Day to day increase in prices of commodities especially of non-food items like oil and gas snatch money from savings of consumers and uncertainty of prices, both food and non-food items, generate enthusiasm among people toward earn more and more therefore, people prefer to work over recreation underestimating their Health. Muoghalu, et.al. (2010) found that the inflation brings negative impact while exports and investment brings positive impact on Nigeria economy and suggested that we should encourage a larger scale of export promotion activities to enhance the economic growth. It will create numerous job opportunities which increase the per-capita earnings and standard of living.
1.3 OBJECTIVES OF THE STUDY
The main objective of this research is to empirically examine the impact of monetary policy in controlling inflation in Nigeria between the year 1980 to 2013. Specifically, the study also seeks:
(i) To examine the various types of monetary policy that can be used to combat inflation and other macro-economic problems.
(ii) To highlight the relevance of monetary policy in combating inflation
(iii) Proffering appropriate framework based on the policy recommendations made.
1.4 RESEARCH QUESTION
This study aims at answering the following research questions:
i Does a long or short run relationship or both exist between monetary policy and inflation?
ii. To what extent has Nigeria’s monetary policy controlled inflation?
iii. What are the factors that hinder appropriate monetary policy?
iv. What has the factors that has spur the incessant rise in inflation?
1.5 RESEARCH HYPOTHESIS
The following hypothesis will be tested in the course of this study:
1. H0: liquidity ratio has no significant impact in controlling inflation in Nigeria.
H1 Liquidity ratio has significant impact in controlling inflation in Nigeria.
2. H0: Money supply has no significant impact in controlling inflation in Nigeria.
H1 Money supply has significant impact in controlling inflation in Nigeria.
3. H0: Exchange rate has no significant impact in controlling inflation in Nigeria.
H1 Exchange rate has significant impact in controlling inflation in Nigeria.
4. H0: Interest rate has no significant impact in controlling inflation in Nigeria.
H1 Interest rate ratio has significant impact in controlling inflation in Nigeria.
1.6 SIGNIFICANCE OF THE STUDY
The findings of this study will provide an insight as to whether monetary policy has any significant impact in controlling inflation in Nigeria’s economy. Hence, policy makers will be able to formulate an articulate and comprehensive policy with respect to monetary instrument in Nigeria. This research will also provide an objective view to the relevance of monetary policy in controlling inflation in Nigeria. Government will benefit immensely from this research works as the topic is very relevant in the field of macro-economic policy formulation. The findings of this research will also serve as a useful reference material for further research on the impact of monetary policy in controlling inflation in Nigerian economy.
1.7 RESEARCH METHODOLOGY
The analysis that will be made in this study shall be based on macroeconomic data in Nigeria economy. Due to the linearity nature of the model formulation, Ordinary Least Square (OLS) estimation method would be employed in obtaining the numerical estimates of the coefficients in the model using Eviews. Two multiple regression models shall be used in the estimation. The model shall seek to investigate the impact monetary policy in controlling inflation in Nigeria. This is a follow up on the objectives of study stated earlier.
1.8 SCOPE OF THE STUDY
The economy is a large component with lot of diverse and sometimes complex parts; this research work will only look at a particular part of the economy (Macro economy policy). This work cannot cover all the facets that make up macro economy, but will look at monetary policy has been used by the government for the stabilization, and attaining economic development. The empirical analysis and estimation covers the period between 1980 and 2013. This restriction is unavoidable because of the non-availability of some data. The data for this study would be obtained mainly from secondary sources; particularly from Central Bank of Nigeria (CBN) publications such as the CBN Statistical Bulletin, CBN Annual Reports and Statements of Accounts, and National Bureau of Statistics publications.
1.9 LIMITATIONS OF THE STUDY
Finance is one of the elements that assist a good research. Financial constraint created difficulties in the process of this research work; however, it did not hinder the research. The main limitation of this study is time constraint. The time allotted for the completion of this research is not adequate based on recent and contemporary happening with respect to the impact of monetary policy in controlling inflation in Nigerian economy.
1.10 ORGANISATION OF THE STUDY
This study shall be divided into five chapters. The first chapter provides the background of the subject matter justifying the need for the study. Chapter two presents related literature concerning monetary policy and inflation in Nigeria. The research methodology, which includes the theoretical framework, sources of data, model formulation, estimation techniques etc, are stated in chapter three while data presentation, analysis and interpretation of regression result were made in chapter four. Concluding comments in chapter five reflects on the summary, conclusion, recommendations and suggestion for further studies based on the findings of the study.
1.11 DEFINITION OF TERMS
Expansionary Monetary Policy: Is a monetary policy that seeks to increase the size and volume of money supply, it can be increase by buy bonds in exchange for hard currency payment to adds that amount of currency to the money supply.
Contractionary Monetary Policy: This is the policy that can be implemented by reducing the size and volume of monetary base by the way of sell bonds in exchange for hard currency, by so doing it removes that amount of currency from the economy.
Reserve Requirement: Commercial banks are required to maintain certain reserve requirement in order to control their liquidity and influence their credit operations, these are usually expressed as a percentage of customers deposits.
Discount Rate: The discount rate is the rate of interest the monetary authorities charge the commercial banks on loans extended to them. If the Central Bank wishes to increased liquidity and investment, it reduces the discount rate, and on the other hand if the Central Bank wishes to reduce liquidity in economy, it raises the discount rate.
Liquidity Ration: The Central Bank imposes upon the bank a minimum liquidity ratio, being vary to the needs of the situation. It is designed to enhance the ability of bank to meet cash withdrawals in them by their customers. Such liquidity ratio stands for the proportion of specified assets.
Open Market Operation (OMO): This involves the Central Bank Discretionary power to sell or purchase securities in the financial market in order to influence the volume of credit and interest rate which consequently affect money supply. The securities include treasury certificates, treasury bill and development stock
Moral Suasion: Is the act of public pronouncements or outright appeal on the apart of monetary authorities to the banks requesting them to operate in a particular direction for the realization of specified government objectives.
Economic Growth: This is a process whereby the real per-capital income of a country increases over a long period of time. Economic growth is measured by the increase in the amount of goods services produced deposits are savings and currents account of deposits in a commercial bank.
Money Supply: Is a currency with the public and demand deposits with commercial banks. Demand deposits are savings and current account of depositors in a commercial bank.
Economic Life Cycle: This refers to a view of product design, each stages of the product’s life is assessed in terms of cost, at each stage of this life cycle choice have to be made.
