1.1 Background to the Study
A sound monetary policy formulation presupposes theoretically coherent and empirically robust model of money demand. To monetary authorities, the stability of the money demand function is necessary for understanding how the formulation and implementation of an effective monetary policy is crucial in offsetting the fluctuations that may arise from the real sector of the economy. If the relationship between the demand for money and its determinants shift around unpredictably, the central bank loses the ability to derive results from the implementation of its policies. In such a case, variations in the money demand function is an independent source of disturbance to the economy. (Bhatta, 2013,p.1).
The identification of a stable relationship between the demand for money and its determinants provides empirical evidence that monetary targeting is an appropriate framework for economic stabilization policy (Rutayisire [as cited in Bhatta, 2013, p.1). Monetary targeting is an attempt by central banks to describe or determine the optimum money stock that will yield the desired macroeconomic objectives. Theoretically, the choice of target is normally between the stock of monetary aggregates and interest rates. Poole; and McCallum (as cited in Owoye and Onafowara, 2007, p.1) expressed that whenever the money demand function is unstable, interest rate is generally the preferred target, otherwise, the money stock remains the appropriate target.
The primary objective of the Central Bank of Nigeria (CBN), in its conduct of monetary policy, is to maintain a stable price level that supports sustainable economic growth and employment (Owoye and Onafowora, 2007,p.1). The CBN has relied on setting predetermined growth rates for the broad money (M2) as a tool for achieving price stability. This is based on the belief that inflation cannot be sustained over the long-term, if it is not accommodated by excessive growth in money supply (Doguwa, Olowofeso, Uyaebo, Adamu and Bada, 2014, p.16). In the conduct and implementation of monetary policy, the assumption that the money demand function is stable is very important, because, the money demand function is used both as a means of identifying medium term growth targets for money supply and as a way of manipulating the interest rate and reserve money for the purpose of controlling both the inflation rate and the total liquidity in the economy (Owoye and Onafowora, 2007, p.1).
Given the importance attached to money demand in the success or failure of monetary policy, it is not surprising that the demand for money is one of the most controversial and heavily researched areas in macroeconomics. If the central bank relies on control of monetary aggregates as its policy instruments, Cameron (as cited in Bhatta, 2013), states that:
it must believe in a known and reliable connection between changes in that aggregate and changes in the arguments of the money demand function in order for its policy to have predictable effects on those arguments. If instead the central bank relies on interest rates as targets and adjusts the monetary aggregate through daily reserve management to whatever level is required to hit them, instability of the demand for money could make the required reserve changes both large and unpredictable. In such a case, disorderly financial markets might well result. (p.2).
Laumas and Mehru (as cited in Ogunsakin and Awe, 2014, p.2) stipulated that the stability of money demand is crucial for the understanding of the monetary policy transmission mechanism. It is crucial because a stable money demand function means that the quantity of money is predictably related to a set of key variables that link money to the real sector of the economy. A stable money demand function always require appropriate instruments and intermediate targets of monetary policy. It enables a policy driven change in monetary aggregates so that the desired values of targeted macroeconomic variables such as fiscal policy, exchange rate, stock market, consumption expenditure, savings and investments, imports, exports, inflation and interest rates are ensured (Sober, 2013, p.32). Therefore, it is important to have knowledge of the determinants of money demand in order to ensure a stable relationship exists between these determinants and the money stock.
1.2 Statement of the Research Problem
The stability of the money demand function is the focal point for any central bank’s policy. It is in this regard that the stability of money demand is seen as a guiding issue for the efficacy of monetary policy. It helps decide whether to use the monetary targeting strategy or inflation targeting strategy in achieving the desired macroeconomic objectives. This concern has been triggered further by the abandonment of monetary targeting strategy by many developed countries such as Australia, Brazil, Canada, New Zealand, Norway and Turkey, as they switched to inflation targeting strategy arguing that the money demand function is tending to become unstable (Bhatta, 2013, p.2). Unpredictability of velocity caused by the volatility of interest rate is the key reason policymakers have given for abandoning monetary targeting (Omer, 2010, p.5).
The recent instability of the money demand function calls into question whether our theories and empirical analyses are adequate. It casts doubt on setting rigid money supply targets in order to control aggregate spending in the economy as this may not be an effective way to conduct monetary policy (Mishkin, 2010, p.516).
The Central Bank of Nigeria adopted M2 as an intermediate target for monetary policy and this poses two specific questions:
- Is monetary targeting still relevant in the conduct of monetary policy?
- Is the real M2 money demand function stable as an intermediate target? The monetary implications inherent in these questions cannot be over-emphasized.
The recent developments in the Nigerian monetary system and the impact of financial liberalization may have caused the instability of the money demand function and rendered the monetary policy ineffective (Nduka, Chukwu and Nwakairre, 2013, p.4).
Thus, if the money demand function is unstable and experiences pronounced shifts, then the velocity of money will be unpredictable, and the quantity of money may not be a good predictor of economic activities (Onafowora and Owoye, 2004, p.57; Nduka et.al., 2013,p.4). In other words, the choice of M2 as an intermediate target portends serious economic problem for the central bank if M2’s demand function is found to be unstable. Therefore, the stability issue of the money demand function needs an intense focus for justifying the working of the monetary targeting strategy (Bhatta, 2013, p.2).
1.3 Objectives of the Study
The main objective was to examine the determinants of demand for money and to determine its stability in Nigeria. The specific objectives were to:
- Evaluate how income, interest rate, inflation rate, exchange rate and foreign interest rate affect the quantity of money demand in Nigeria.
- Examine the money demand function and to understand its long-run cointegrating relationship with the selected macroeconomic variables – real income, interest rate, inflation rate, exchange rate and foreign interest rate?
- Study the short-run dynamics of the money demand function in Nigeria so as to incorporate both short-term deviations and long-run expectations.
1.4 Research Questions
- To what extent does income, interest rate, inflation rate, exchange rate and foreign interest rate affect the quantity of money demand in Nigeria?
- How relevant is the long-run cointegrating relationship among the selected macroeconomic variables – real income, interest rate, inflation rate, exchange rate and foreign interest rate?
- To what degree is the reversion speed of short-run deviations towards long-run equilibrium?
1.5 Hypotheses of the Study
- Income, interest rate, inflation rate, exchange rate and foreign interest rate do not have a predictable impact on the quantity of money demand in Nigeria.
- There is no cointegration between the money demand function and the selected macroeconomic variables-real income, interest rate, inflation rate, exchange rate and foreign interest rate.
- The short-run deviations of the money demand function and its speed of adjustment to long-run equilibrium is not statistically significant.
1.6 Scope of the Research
This empirical assessment of the determinants of demand for money and its stability in Nigeria covered the period 1991-2014 and employed the autoregressive distributed lag approach to cointegration and the error correction model. Earlier years were excluded because it was in 1991 that the Banks and other Financial Institutions Act (BOFIA) and the Central Bank of Nigeria Decree no 24 were proclaimed to replace both the CBN Act of 1958 and the Banking Act of 1969 in order to strengthen the powers of the Central Bank of Nigeria.
1.7 Significance of the Study
- Academia: The level and stability of the demand for money has received enormous academic attention because an understanding of its causes and consequences can usefully inform the setting of monetary policy (Kumar, Webber and Fargher, 2010, p.2). This study would provide some reference points concerning the behaviour of money demand in Nigeria, which in turn will help researchers in carrying out further research.
- Policy Makers: The analysis of the money demand function help monetary authorities to predict the demand for money, thereby setting the threshold of monetary growth rate (Mansaray and Swaray, 2012, p.64). Thus, the results of this research work will help the Central Bank of Nigeria in its efforts to maintain monetary and price stability and in keeping inflation at projected level by determining the key variables that influence the demand for money in Nigeria.
- 3. Monetary Economists: A stable money demand function makes it possible for monetary authorities to effect desired and predictable changes in targeted macroeconomic variables such as income, interest rate and prices by appropriate changes in monetary aggregates (Abdulkheir, 2013, p.31). This research work would attract great attention of monetary economists as it has important implications for how monetary policy should be conducted and because there are only few studies devoted to money demand in Nigeria.
1.8 Operational Definitions of Terms
- Monetary Targeting: This is a strategy used by central banks to determine the optimum money stock that will yield the desired macroeconomic objectives.
- Stability of Money Demand: A stable demand function for money means that the quantity of money is predictably related to a set of key variables linking money to the real sector of the economy.
- Determinants: These are the drivers or variables that influence long-run demand for money in Nigeria
4. Short-run Dynamics: Quarter to quarter movements in real money balances because there are transitory shocks to desired money ho