1.1 BACKGROUND OF THE STUDY
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. For most economies, the objectives of monetary policy include price stability, maintenance of balance of payments equilibrium, promotion of employment and output growth, and sustainable development. These objectives are necessary for the attainment of internal and external balance, and the promotion of long-run economic growth (Nnanna, 2001).
The importance of price stability is derived from the harmful effects of price volatility, which undermines the ability of policy makers to achieve other laudable macroeconomic objectives. There is indeed a general consensus that domestic price fluctuation undermines the role of money as a store of value, and frustrates investments and growth. Empirical studies (Ajayi and Ojo, 1981) on inflation, growth and productivity have confirmed the long-term inverse relationship between inflation and growth. When decomposed into its components, that is, growth due to capital accumulation, productivity growth, and the growth rate of the labour force, the negative association between inflation and growth has been traced to the strong negative relationships between it and capital accumulation as well as productivity growth, respectively. The import of these empirical findings is that stable prices are essential for growth.
The success of monetary policy depends on the operating economic environment, the institutional framework adopted, and the choice and mix of the instruments used. In Nigeria, the design and implementation of monetary policy is the responsibility of the Central Bank of Nigeria (CBN). The mandates of the CBN as specified in the CBN Act of 1958 include; issuing of legal tender currency, maintaining external reserves to safeguard the international value of the currency, promoting monetary stability and a sound financial system and acting as banker and financial adviser to the Federal Government.
However, the current monetary policy framework focuses on the maintenance of price stability while the promotion of growth and employment are the secondary goals of monetary policy (see, Nnanna, 2001). In Nigeria, the overriding objective of monetary policy is price and exchange rate stability (see, CBN, 2001). The monetary authority’s strategy for inflation management is based on the view that inflation is essentially a monetary phenomenon. Because targeting money supply growth is considered as an appropriate method of targeting inflation in the Nigerian economy, the Central Bank of Nigeria (CBN) chose a monetary targeting policy framework to achieve its objective of price stability. With the broad measure of money (M2) as the intermediate target, and the monetary base as the operating target, the CBN utilized a mix of indirect (market-determined) instruments to achieve it monetary objectives. These instruments included reserve requirements, open market operations on Nigerian Treasury Bills (NTBs), liquid asset ratios and the discount window (see IMF Country Report No. 03/60, 2003).
Onafowora (2007 say the CBN’s focus on the price stability objective was a major departure from past objectives in which the emphasis was on the promotion of rapid and sustainable economic growth and employment. Prior to 1986, the CBN relied on the use of direct (non-market) monetary instruments such as credit ceilings on the deposit money of banks, administered interest and exchange rates, as well as the prescription of cash reserves requirements in order to achieve its objective of sustainable growth and employment. During this period, the most popular instruments of monetary policy involved the setting of targets for aggregate credit to the domestic economy and the prescription of low interest rates. With these instruments, the CBN hoped to direct the flow of loanable funds with a view to promoting rapid economic development through the provision of finance to the preferred sectors of the economy such as the agricultural sector, manufacturing, and residential housing (see, Onafowora, 2007).
During the 1970s, the Nigerian economy experienced major structural changes that made it increasingly difficult to achieve the aims of monetary policy. The dominance of oil in the country’s export basket began in the 1970s. Furthermore, the rapid monetization of the increased crude oil receipts resulted in large injections of liquidity into the economy, induced rapid monetary growth. Between 1970 and 1973, government spending averaged about 13 percent of gross domestic product (GDP), and this increased to 25 percent between 1974 and 1980. This rapid growth in government spending came not from increased tax revenues but the absorption of oil earnings into the fiscal sector, which moved the fiscal balance from a surplus to a deficit that averaged about 2.5% of GDP a year. This new era of deficit spending led the government to borrow from the banking system in order to finance the domestic deficits. At the same time, the government was saddled with foreign deficits, which had to be financed through massive foreign borrowing and the drawing down of external reserves. To reverse the deteriorating macroeconomic imbalances (declining GDP growth, worsening balance of payment conditions, high inflation, debilitating debt burden, increasing fiscal deficits, rising unemployment rate, and high incidence of poverty), the government embarked on austerity measures in 1982. The austerity measures was successful judging by the fall in inflation rate to a single digit, the significant improvement in the external current account to positions of balance. However, these improvements were transitory because the economy did not establish a strong base for sustained economic growth (see, Onafowora, 2007).
Having examined the objectives of monetary policy in Nigeria, this study intends to find out the impact of monetary policy through the use of open market operation in enhancing economic stability in Nigeria.
1.2 STATEMENT OF THE PROBLEM
Results of monetary policy outcomes suggest that Nigeria does not often enjoy ideal conditions to adopting a monetary policy regime aimed primarily at stabilizing prices under a freely floating exchange rate. There could be possible reasons for this. The Nigerian macroeconomics environment often do faces a very volatile macroeconomic environment and a more acute inflation-output trade-off than other emerging market economies which have embraced price stabilization programs and thereby abandoned their exchange rate anchors. Moreover, it could often observed that Nigeria has an intense exchange of goods and services with the rest of the world, and one that is stronger than other emerging market economies, thanks to its mainly oil-exporting-oriented economy. This can make it particularly exposed to price and quantity-type external shocks, which renders price stabilization all the more complicated. Although Nigerian consumer price index is not that sensitive to commodity price shocks notably shocks to the price of oil changes in the Nigerian exchange rate are passed through sizably and significantly (Batini and Morsink, 2004). Thus, given the above, the problems associated with the use of open market operation as monetary policy tools given the objectives of monetary policy in an economy of maintaining stability are: price instability and exchange rate instability in Nigeria.
Nigerian consumer prices is so volatile, and more dramatic than in other emerging market economies countries, this have created problems for the conduct of a monetary policy aimed at price stability because optimal policy responding to exchange rate shocks depends on the source and duration of the shock, which are typically unknown and hard to decipher in an unstable macroeconomic environment. Judging by the risk premium on dollar-denominated Nigerian sovereign debt relative to same risk premia of other emerging market economies’ debt, the Nigerian fiscal policy appears extremely vulnerable a reflection of the fact that the Nigerian central bank is fiscally dominated in the sense of Masson et al (1997). The size and volatility of the Nigerian risk premium on government debt means that the Nigerian exchange rate, as well as short- and long-term rates, may vary endogenously with the debt-to-GDP ratio. Both facts indicate that it is hard, if not impossible, in the current circumstances to talk about active monetary policy in Nigeria of whatever kind. As emphasized in Favero and Giavazzi (2003), large and variable term premia and credit risks reinforce the possibility that a vicious circle might arise, making the fiscal constraint on monetary policy more stringent. Given these conditions, it is reasonable to expect that aiming for and adopting a stable prices/free float regime in the long run in Nigeria may not lead to successful outcomes. In addition to not achieving the intended aims, it could be argued that pursuing unsuccessfully a price stabilization regime may harm the credibility of the central bank going forward. Sims (2003), for instance, emphasized that when conditions are such that an inflation targeting commitment has a high probability of proving unsustainable like when the necessary fiscal backup to monetary policy is not available embracing nevertheless explicit inflation targets can be unproductive or lead to an initial success that only amplifies a later failure.
Exchange rate target results in the loss of independent monetary policy. With open capital markets, an exchange-rate target causes domestic interest rates to be closely linked to those of the anchor country. The targeting country thus loses the ability to use monetary policy to respond to domestic shocks that are independent of those hitting the anchor country. Furthermore, an exchange-rate target means that shocks to the anchor country are directly transmitted to the targeting country because changes in interest rates in the anchor country lead to a corresponding change in interest rates in the targeting country (Clarida, Gali and Gertler (1997). Exchange rate targets have been pointed out forcefully in Obstfeld and Rogoff (1995), where they say exchange rate targets leave countries open to speculative attacks on their currencies. An exchange rate target in emerging market countries that suggests that for them this monetary policy regime is highly dangerous and is best avoided except in rare circumstances. Exchange rate targeting in emerging market countries is likely to promote financial fragility and possibly a fully fledged financial crisis that can be highly destructive to the economy. To see why exchange-rate targets in an emerging market country make a financial crisis more likely, we must first understand what a financial crisis is and why it is so damaging to the economy.
Studies evaluating the costs of inflation have long established the desirability of avoiding not only high but even moderate inflation (Fischer and Modigliani, 1978; Fischer, 1981; and more recently Driffill, et., al, 1990 and Fischer, 1994), However, there is still a serious debate on whether the optimal average rate of inflation is low and positive, zero, or even moderately negative (Tobin, 1965 and Friedman, 1969). An important issue in this debate concerns the reduced ability to conduct effective countercyclical monetary policy when inflation is low. As pointed out by Summers (1991), if the economy is faced with a recession when inflation is zero, the monetary authority is constrained in its ability to engineer a negative short-run real interest rate to damp the output loss. This constraint reflects the fact that the nominal short-term interest rate cannot be lowered below zero the zero interest rate bound (Hicks, 1937 interpretation of the Keynesian liquidity trap and Hicks, 1967). This constraint would be of no relevance in the steady state of a non-stochastic economy. Stabilization of the economy in a stochastic environment, however, presupposes monetary control which leads to fluctuations in the short-run nominal interest rate. Under these circumstances, the non-negativity constraint on nominal interest rates may occasionally be binding and so may influence the performance of the Economy. Although inflation targeting does appear to be successful in moderating and controlling inflation, the likely effects of inflation targeting on the real side of the economy are more ambiguous. Economic theorizing often suggests that a commitment by a central bank to reduce and control inflation should improve its credibility and thereby reduce both inflation expectations and the output losses associated with disinflation. Experience and econometric evidence (see Almeida and Goodhart, 1998, Laubach and Posen, 1997, Bernanke, Laubach, Mishkin and Posen, 1998) does not support this prediction, however. Inflation expectations do not immediately adjust downward following the adoption of inflation targeting. Furthermore, there appears to be little if any reduction in the output loss associated with disinflation, the sacrifice ratio, among countries adopting inflation targeting.
1.3 OBJECTIVES OF THE STUDY
As a result of the problems stated above, the main objectives of this study are;
- To examine the impact of Open market operation on the maintenance of Exchange rate price stability in Nigeria
- To determine the impact of Open market operation on the maintenance of consumer price stability in Nigeria
1.4 RESEARCH QUESTIONS
As a result of the above objectives, the following research questions emanate:
- To what extent does Open market operation in Nigeria assist in the maintenance of exchange rate price stability? and
- To what extent does Open market operation impact on the maintenance of consumer price stability in Nigeria?
1.5 RESEARCH HYPOTHESES
Following the research questions raised above, the following hypotheses are stated;
- Open market operation does not have a significant positive impact on exchange rate price stability in Nigeria
- Open market operation does not have a significant positive impact on consumer price stability in Nigeria.
1.6 SCOPE OF THE STUDY
This study covers the period 1993 to 2008. OMO was introduced at the end of June 1993 and is conducted wholly on Nigerian Treasury Bills (NTBs), including repurchase agreements (repos). OMO entails the sale or purchase of eligible bills or securities in the open market by the CBN for the purpose of influencing deposit money, banks’ reserve balances, and the level of base money and consequently the overall level of monetary and financial conditions. In this transaction, banks subscribing to the offer, through the discount houses, draw on their reserve balances at the CBN thereby reducing the overall liquidity of the banking system and the banks’ ability to create money via credit. In implementing the OMO, the Research Department of the CBN advises the trading desk at the Banking Operations Department, also of the CBN, on the level of excess or shortfall in bank reserves. Thereafter, the trading desk decides on the type, rate and tenor of the securities to be offered and notifies the discount houses 48 hours ahead of the bid date. The highest bid price lowest discount rate quoted) for sales and the lowest price offered (highest discount offer) for purchases, with the desired size or volume, is then accepted by the CBN (Nnanna, 2001).
1.7 SIGNIFICANCE OF THE STUDY
This study will be significant to the following groups;
- MONETARY POLICY MAKERS
Monetary policy decisions are made in real time and are based, by necessity, on preliminary data and estimates that contain considerable noise and are often substantially revised months or years after the event. While part of everyday life for policymakers, this aspect of the monetary policy process is often neglected in theoretical formulations of monetary policy, introducing a wedge between the promise of macroeconomic theory and the reality of macroeconomic practice. Recognition of the complications resulting from the presence of noise is important for the study of monetary policy for two reasons: First, the evaluation of past policy is incorrect when it is based on the wrong data. That is, our understanding of the past becomes distorted. Second, the evaluation of alternative policy strategies is unrealistic and likely to mislead if it is based on the assumption that policy can react to either data that are not really available to policymakers when policy must be set or that are only available with substantial noise. That is, recommendations for better policy in the future become flawed, thus, this study will assist policy makers in formulating policies that conforms with the objectives of monetary policy.
- ACADEMIC PURPOSE
The conduct of monetary policy in Nigeria under the colonial government was largely dictated by the prevailing economic conditions in Britain. The instrument of monetary policy at that time was the exchange rate, which was fixed at par between the Nigerian pound and the British pound. This was very convenient, as fixing the exchange rate provided a more effective mechanism for the maintenance of balance of payments viability and for control over inflation in the Nigerian economy. This study thus will trace the history of monetary policy in Nigeria, especially the use of open market operation as a tool of monetary policy in Nigeria since 1993. There, it will contribute to the volume of literatures in this area of finance.
- GENERAL AND INTERESTED PUBLIC
It is argued that if residents evaluate their asset portfolio in terms of the domestic currency, a depreciation of the exchange rate that increases the value of their foreign holdings would enhance wealth. To maintain a fixed share of the wealth invested in domestic assets, residents will shift parts of their foreign holdings to domestic assets, including domestic currency. The increase in the share of wealth held in domestic assets, including domestic currency, suggests a rise in the demand for the domestic currency. Thus, this study will be significant to the general and interested public because it will help them to decide on how to increase economy wellbeing.
1.8 DEFINITION OF TERMS
The following terms as they relate to this study are defined:
Monetary Policy: 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 (Nnanna, 2001).
Open Market Operation: OMO entails the sale or purchase of eligible bills or securities in the open market by the CBN for the purpose of influencing deposit money, banks’ reserve balances, and the level of base money and consequently the overall level of monetary and financial conditions (Nnanna,