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the significant impact of monetary policy instrument on the inflation rate of Nigeria.

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CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

The word inflation ring bell in the market economy of the world, and has become a household name in most African countries today Nigeria inclusive.  Inflation is a monster that threatens any economy although some author argues that it moderate is required for sustainable economic growth; however it is noted that inflation is inimical to economic growth. The problem of inflation surely is not a new phenomenon because it has remained a major problem in the country over the past few years. In the words of Adenuga, et al (2012), it is a monster which threatens all economies because of its undesirable effects.  Inflation can be defined, as a significant and sustained increase in the general price level over a period of time.

According to Umaru and Zubairu, (2012), the concept of inflation can be defined as a persistence rise in the general price level spectrum of goods and services in the country over the long period of time.

Although several people, producers, consumers, professional, trade unionist, workers and the likes, talk frequently about inflation particularly if the malady has assumed a chronic character, yet only selected few knows or even bother to know about mechanics and consequences of inflation.

According to a report by Masha (CBN Economic and Financial Review, Vol. 28.no 2 2009), there have been four major episodes of high inflation in excess of 30 percent in Nigeria. The first period of inflation in the 30 percent range was in 1976 (CBN, 2009). This was attributed to the drought in northern Nigeria which destroyed agricultural production and pushed up the cost of agricultural food items coupled with excessive monetization of oil export revenue, which might have given the inflation a monetary character.

The period of Structural Adjustment Programme in the late 1980s, the effect of wage increases created cost push inflation. Hence, in 1985, inflation peaked at 40 percent at a time of relatively little growth in the economy. At that time, the government was under pressure from debtor groups to reach agreement with the International Monetary Fund (IMF), one of the conditions of which was the devaluation of the domestic currency. The expectation that devaluation was imminent fuelled inflation as prices adjusted to the parallel rate of exchange. Over the same period, excess money growth was about 43 percent (CBN, 2009)

The third high inflation episode started in the last quarter of 1987 and accelerated through 1988 to 1989. This episode is related to the fiscal expansion that accompanied in 1988 budget. However, with drastic monetary contraction initiated by the authorities in the middle of 1989, inflation fell, reaching one of its lowest points in 1991at 13% (CBN, 2009).

The fourth inflationary episode occurred in 1993, and persisted through the end of 1995. Though inflation gathered momentum towards the tail end of 1992, it reached 57 percent by the end of 1994, and by the end of 1995, it was 72.8 percent (CBN, 2009). This was equally attributed to a period of expansionary fiscal deficit and money supply growth. Between 1996 and 2011, inflation rate has fallen considerably though still in double digit.

There has been widespread debate between two schools of thought on the causes of inflation which led to different prescription about the appropriate policy response to be adopted. The traditional monetarists stress the importance of the link between money supply and inflation. They therefore emphasized measures such as reduction in government budget deficits and restraining credits to public enterprises as a panacea to inflation.

However, the structuralists school sees financial factors as forces propagating inflation rather than causing it. The structuralists’ are of the view that inflation can result from a number of special problems in developing countries, not just from excessive money growth, thus they favour income policies as a measure of controlling inflation.

According to Anyanwu and Oaikhenan (1995), the quasi competitive Keynesian theory of inflation states that at competitive equilibrium, “structural imperfections” inherent in a monetary economy generate upward pressure on the price level.

It is generally believed that the attainment of every other macroeconomics goals (full employment, economic growth etc) depends on the maintenance of a stable and low inflation environment (Ajide and Lawson, 2012).

It is on this background that this study would investigate the impact of monetary policy on inflation control in Nigeria.

1.2 Statement of the Problem

Monetary policy is known to be a vital instrument that a country can deploy for the maintenance of domestic price and exchange rate stability, as a critical condition for the achievement of a sustainable economic growth and external viability”(Amassona et al, 2011). In general terms, monetary policy refers to a combination of measures designed to regulate the value, supply and cost of money in an economy in consonance with the expected level of economic activity (Okwu et al, 2011; Adesoye et al, 2011).

Since its establishment in 1959, the Central Bank of Nigeria (CBN) has continued to play the traditional role expected of a central bank. This role is anchored on the use of monetary policy that is usually targeted towards the achievement of price stability among other goals. Over the years, inflation targeting and exchange rate policy have dominated CBN’s monetary policy focus based on the assumption that these are essential tools of achieving macroeconomic stability (Aliyu and Englema, 2009). The exchange rate regime was in vogue in Nigeria between 1959 and 1973 while the direct monetary control technique was in place from 1974 till 1993 when the CBN formally introduced its open market operation (OMO) as a major indirect tool of monetary policy; hence indirect monetary control has been in vogue from 1993 till date.

Giving that during inflation, money losses value and people are discouraged from savings which ultimately affect the volume of money in the money market and investment as well, various governments had introduced lots of policy measures in Nigeria prominent among which are fiscal and monetary policy. But despite the intensified use of these policies over the years, inflation still remains a major threat to Nigeria’s economic growth which raises the following questions:

  1. Are government economic policies not effective in Nigeria?
  2. Why is inflation steadily on the increase despite the intensive use of monetary and fiscal policy?
  3. Are there alternate policy measures to the conventional theories?

The extent to which price stability have been achieved as a result of the adoption of various policies of monetary control in Nigeria is an economic issue that requires investigation. Hence, the main thrust of this study shall be to evaluate the impact of CBN’s monetary policy on inflation in Nigeria.

1.3 Research Questions

This research shall be guided by the following questions.

  1. To what does monetary policy impacted on price stability in Nigeria?
  2. Is there any observed long-run relationship between monetary policy and price stability in Nigeria?

1.4 Statements of Research Objectives

The main objective of this study is to assess the effectiveness of the monetary policies in ensuring price stability in Nigeria. However, the following specific objective would also be achieved, to:

  1. Examine the impact of monetary policy on price stability in Nigeria.
  2. Investigate if there is observed long-run relationship between monetary policy and price stability in Nigeria.
    • Hypothesis of the Study
  3. H0:There is no significant impact of monetary policy instrument on price stability in Nigeria.
  4. H0: There is no long-run relationship existing between monetary policy instrumentsand price stability in Nigeria.

1.6 Significance of the Study

This study will make meaningful contribution to the general knowledge and understanding of the nature of monetary policy and its application in the Nigerian environment. It is also envisaged that it could arouse interest adequately to stimulate further research in the area of inflation.  The study would also provide an econometric basis upon which to examine the effect of monetary policy on inflation in Nigeria.

Lastly, it would provide policy recommendations to policymakers on ways to combat price fluctuations.

1.7 Scope and Limitations of the Study

This study will focus on inflation rate as a macroeconomic variable. It will cover many facets that make up the monetary policy and empirically investigate the effect of the major ones on inflation. The empirical investigation shall be restricted to the period between 1987 and 2011. Data and information for this study shall be sourced from the internet, library and from Central Bank’s statistical reports for the years under review. Secondary date would be used in this study.

            The major factor which inhibited the success of this work is date accessibility. Access to secondary date posed a lot of problem since it was common to observe inconsistent data on the same economic variable for the same period. Time constraint was equally a factor since the researcher had to decide how best to allocate his limited time among his numerous attention- seeking engagements.

In spite of these problems, a lot of efforts were put in place to enhance the quality of this study.

 

CHAPTER TWO

LITERATURE REVIEW

A study of the impact of monetary policy on price stability in Nigeria requires a number of reference materials which have treated the topic in one way or the other. This chapter is therefore meant to expatiate on the various theories, ideas and suggestions of different authorities relevant to the study in question.

2.1 Theoretical Literature

2.1.1 The Quantity Theory of Money

The classical school evolved through the concerted efforts and contributions of economists like Adam Smith, J.B Say, David Ricardo, A.C Pigou and others who share the same belief. The classical model is based on Say’s law of the market which states that “supply creates its own demand”. Thus they believe that the economy automatically tends towards full employment level and hence decided upon the quantity theory of money as their basis for analyzing inflation.  In its simplest form, it states that the general price level in the economy depends on the supply of money (Sloman, 1994) i.e. P=f (Ms).  Under this theory inflation is simply caused by a rise in money supply. This theory is one of the oldest explanations of price changes and it comes in various versions.

While the quantity theory was more formally developed in the 19th century by writers such J.S mill and Irvin Fisher, early writers like Jean Bodin came to much similar conclusions many years before them.  Bodin was one of the fist thinkers to look at how growth in the supply of money affected price levels and while he did not develop any mathematical description or fully describe the mechanism at work, he did lay the foundation that later writers built upon. Therefore, the quantity theory of money in its crudest form was postulated   by Jean Bodin and this theory states that “increase in money supply will bring about a proportionate increase in the general price level” (Onwukwe 2011). To elucidate this theory, jean Bodin meant that if money supply increases by say 20 percent over a period, then prices of goods and services would increase by the same percentage (Onwukwe, 2011).

Two versions of the quantity theory of money; the cash transaction version and the Cambridge/cash balance equation will be reviewed for the purpose of this research work.

2.1.1a Cash Transaction/Fisher Version

Fisher expounded his famous equation of exchange in his book “the purchasing power of money” (1911). According to this theory, quantity of money is the main determinant of the price level or value of money. Any change in the quantity of money brings about a proportionate change in the price level. in the words of fisher, “other things remaining the same, as the quantity of money in circulation increases, the price level also increases in direct proportion and the value of money decreases and vice versa”.

Fisher explained his theory using the equation of exchange below

MV = PT

Where:             M= Money supply or money stock

V = Velocity of money circulation

P =Average price level

Q = Quantity of items traded

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