The Dynamics of Monetary Policy and Infl
The Dynamics of Monetary Policy and Infl
The Dynamics of Monetary Policy and Infl
e-ISSN: 2321-5933, p-ISSN: 2321-5925.Volume 10, Issue 2 Ser. I (Mar. – Apr.2019), PP 37-49
www.iosrjournals.org
Abstract: This study evaluated the dynamics of monetary policy and inflation in Nigeria. Monthly data from
2009-2017 were used to estimate the model derived. The Augmented Dickey-Fuller (ADF) unit root test,
Johansen Cointegration test and Error Correction model (ECM) were adopted. The findings of the ADF
revealed that except for money supply and exchange rate that are integrated at order two1(2), all other
variables are stationary at order one 1(1). The Johansen Cointegration test reveals the presence of a long run
relationship between inflation and all the variables adopted. The ECM result for the two estimated models show
a self-equilibrating mechanism of 5.2% and 9.4% for the first and second models respectively. The findings
brought us to the conclusion that money supply, exchange rate, monetary policy rate, treasury bills rate, reserve
requirement and liquidity ratio have significant and effective impact on the inflation rate. Based on the
foregoing, it is recommended that the CBN stay focused on its current foreign exchange rate policy as well as
making an unrestricted use of the monetary policy tools in its attempt to arrive and remain at the 6-9% inflation
threshold for Nigeria.
Keywords: CBN, ECM, exchange rate, inflation rate, monetary policy rate, money supply.
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Date of Submission: 27-02-2019 Date of acceptance:13-03-2019
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I. Introduction
Progress made in science and technology has brought countries all over the world into greater
economic cooperation and integration. The impact of this integration can be felt in the closer economic
integration of various countries in the world. Thus, “…no country is immune to external economic shocks which
cause fluctuations of macroeconomic variables like output and inflation (Gajic, 2012 [1]; Okotori, 2017[1]).
Inflation which is a sustained rise in general price levels in itself cannot be said to be adverse, but its rate of
increase must fall within levels and bands that are peculiar to each country as regards its inflation threshold. De
Grauve and Polan (2005[1]) observed that this country specificity increases as inflation increases.
Inflationary pressures in Nigeria are revealed through increases in prices of commodities in the country
and these increases have drawn the attention of those who are in charge of the economy (Orubu, 2009[2]).The
foregoing is controlled via macroeconomic policy which has two basic strands; (i) monetary policy and (ii)
fiscal policy, though the International Monetary Fund (IMF) adds structural reforms as a third strand to
complete an effective triad for macroeconomic stabilization.
Monetary policy is the use of money supply or interest rates to achieve macroeconomic goals, while
fiscal policy deals with the use of tax revenue to influence economic activities in a country. Ajie et al (2007[1])
did state that macroeconomic policy has been the main tool for achieving output stabilization in the short run
and a diversified self- sustaining economic growth in the long run.
Buiter (2014)[1] observed concerning the monetary/fiscal policy dichotomy that the unwillingness or
inability of governments to use countercyclical fiscal policy measures has left monetary policy as the only tool
in town. The economic and financial situation of a country is said to be based largely on the monetary policy
being implemented in the country, (Ahiabor, 2013[3]).The Central Bank of Nigeria (CBN) had commenced the
use of the monetary policy rate (MPR) as its main tool of stabilization by 2009 in an inflation targeting regime
(Job, 2009[4]). In 2014 it seems the bank had soft pedaled on that move (Bassey & Essien, 2014[5]).
The CBN promised that open market operations (OMO), remained the main instrument of monetary
policy, to be complemented by reserve requirement and discount window operations as well as the monetary
policy rate (MPR) ( Central Bank of Nigeria [CBN], 2015[2]; Okotori, 2017). The main thrust of the CBN’s
strategy for 2014/2015 was monetary targeting as well as a close monitoring of growth in money supply (MS).
Policy makers don’t need only to specify a set of objectives in order to succeed, but they need to understand the
effects of policies designed to arrive at those objectives ( Altavila & Ciccarelli, 2009[2]).
There is a need to investigate whether these monetary policy variables actually had the impact as stated
in apriori expectation when tested empirically; (i) did the monetary policy variables adopted by the CBN have
the desired significant effect on the inflation rate? (ii) did the combined effect of these variables have the desired
significant impact on the inflation rate? When there is a potent monetary policy instrument, it is expected that
contractionary monetary policy shocks should be able to reduce inflationary pressure (Bonga-Bonga, 2017[3]).
is said to specify how expansionary monetary policy creates disequilibrium in the money and goods market,
(Nasser, 2005; Toujas-Bernate, 1996[8]; Sacerdoti & Xiao, 2001[9]).
Mordi (2009)[9] saw the underpinning theory as the quantity theory and that was the basic reason the
CBN in its monetary policy framework targets money. The operating target, base money is set on the
relationship between money supply and base money and this is based on the assumption of a stable money
multiplier k, which is illustrated as follows;
M2=kBM
Where M2 is broad money supply, k is the money multiplier and BM is base money.
The impact of the foregoing was well illustrated by Yu and Ming (2001)[7] that when the monetary
authority adjusts the monetary base, then the financial fields will experience changes in money supply and
interest rates leading to lending activities of deposit money banks and the financial situation of financial markets
.In summary, monetarism suggests that in the long run prices are mainly affected by the growth rate of money,
while having no real effects on economic growth. That if the growth in the money supply is higher than the
economic growth rate, inflation will result (Assenmacher-Weche & Gerlach, 2006[11]).There is therefore the
claim that in order to control inflation monetary policy must be used ( Adalid & Detken, 2007[10]; Barro &
Grilli,1994[7]; Markin, 2010[8]). Kilindo(1997)[12] opined that monetarist approach that money supply growth
causes inflation can be tested by observing the correlation between the rate of inflation and the rate of monetary
growth and that causality can be determined by statistical analysis and institutional evidence.
The Central Bank of Nigeria [CBN] (2011a) identified three issues that arise in its selection and use of
the goals, intermediate variables, operating targets and instruments;
(i)Effort at establishing the existence or otherwise of a stable and predictable relationship between the ultimate
goal variable, intermediate variables and operating targets.
(ii)Determine if the monetary authorities can actually achieve the desired level of the operating target with the
instruments at their disposal.
(iii)Establishing the nature of the lag structure (short or long i.e. when a policy is made, implemented and when
its effect is felt) which has the implication of influencing prediction of the future course of the economy as it
becomes increasing less precise in the case of long lags, ( Okotori, 2017).
The Central Bank of Nigeria’s (CBN) use of monetary targeting is still its preferred monetary policy
framework in Nigeria and this is based on its capacity in enabling the CBN handle domestic issues and the
ability to immediately signal its policy stance ( Okoroafor, et al (2018) [13].
broad money supply are statistically significant in explaining changes in inflation in Nigeria.
Gbadebo and Mohammed (2015)[17] explored the relationship between inflation and monetary
impulses, adopting cointegration and error correction method approach on quarterly times series data spanning
from 1980 Q1 to 2012 Q4. Their finding was that interest rate, exchange rate, money supply and oil price are the
major causes of inflation in Nigeria. That the money supply variable shows a significant positive impact on
inflation both in the short and long run. Hence, Nigeria’s inflationary situatiation is driven by monetary
impulses. While this is revealing there is the need to identify individual variable significance and the quantum
impact of the combined variables that are operating and intermediate targets of the CBN.
Chuku(2015)[18] used structural Vector Autoregression (SVAR) model to trace the effects of monetary
policy shocks on output and prices in Nigeria, found evidence that monetary policy innovation carried out on
quantity based nominal anchor (M2) has modest effect on output and prices with a very fast speed of
adjustment. While shocks on price based anchors (MRR and REER) has neutral and fleeting effects on output,
concluding that the CBN should lay more emphasis on using quantity based nominal anchors. But Naoyuki et al
(2012)[19] though discovered through their empirical analysis a strong support for the optimality of monetary
over interest rate instruments, yet suggested that a combination of both instruments is superior to the two used
separately. Tule et al(2015)[13] discovered that money supply as a policy instrument has a weakening effect on
inflation in Nigeria, attributing this to the increasing sophistication of the Nigerian economy.
Emerenini and Eke (2014)[20] in investigating the determinants of inflation in Nigeria using monthly
data from January 2007 to August 2014 adopted ordinary least squares (OLS) method and found that expected
inflation, exchange rate and money supply influenced inflation, while annual treasury bills and monetary policy
rate though rightly signed did not influence inflation in Nigeria within the period of investigation. The estimated
model displayed that all the explanatory variables used for the analyses accounted for 90% variation in
explaining the direction of inflation as regards its increase or decrease. The cointegration test showed that a long
run relationship existed among the variables and they were stationary at order one 1(1). Though the analyses
used monthly data for almost all the variables, the use of annual data for a very useful tool of monetary policy
that is issued almost weekly in open market operation will tend to limit the predictive capacity of the annual
treasury bills rate data employed. It might not adequately answer the two questions that were raised in this
study; (i) did all the variables adopted by the CBN have a significant effect on the inflation rate? (ii) did the
combined effect of all the variables have impact on the inflation rate?.The conclusion of Fatukasi(2015)[21] was
that the causes of inflation in Nigeria are multidimensional, requiring a full knowledge at any point in time to be
able to proffer solutions to inflationary trends in the economy(Okotori, 2017). This choice of policy instruments
mix to be adopted in any given economic environment is hence very important..
Where;
INF= Inflation rate
MS= Money Supply (MS2/GDP ratio)
EXR=Exchange rate
MPR= Monetary policy rate
TBR= Monthly Treasury bills rate
REQ= Reserve Requirement
LQR= Liquidity ratio
e= Error term
The mean and median in the table above were computed to find the central tendency of each variable
for 108 observations. The standard deviation indicates the sample’s dispersion (spread) level of the variables.
According to the above table, the average inflation rate is 12.1% which means the consumer price index during
the period under study is approximately 12%, while money supply (MS), Exchange rate (EXR), monetary policy
rate (MPR), treasury bill rate (TBR), reserve require (REQ) and liquidity ratio (LQR) recorded an average of 23
billion naira, 185 naira, 10.8% 14.9% 2.1% and 43%.
4.2 Multicollinearity
Table 4.2(a) 4.2(b) presents the correlation matrix and variance inflation factor (VIF) for all the
independent variables used in the analysis. According to the results, there are no multicollinearity problems
among the variables since the inter-correlations among the explanatory variables are low i.e. below 0.80 as the
bench mark. To check further, another diagnostic test for multicollinearity is used, with the variance inflation
factor (VIF) calculated for independent variables as follows: VIF (Bi) = 1/ (1-R2), where R2 is the squared
multiple correlation coefficient between independent variables. When R2 is equal to zero, then VIF has its
minimum value of one (Maddala, 2001[11]). Therefore the closer the value of VIF to one, the degree of
multicollinearity is lower. If one of the VIFs is greater than 10, then the multicollinearity is a problem (Gujarati,
2004[12]). Based on the results in table 4.2, all the VIF values are much lower than 10. Therefore there is no
multicollinearity problem among the independent variables in model one and two.
8 Mean 1.04e-15
Median 0.031826
Maximum 0.244830
6 Minimum -0.318469
Std. Dev. 0.157735
4 Skewness -0.491747
Kurtosis 2.297362
2 Jarque-Bera 6.574320
Probability 0.037360
0
-0.3 -0.2 -0.1 0.0 0.1 0.2
8 Mean 2.14e-16
Median 0.008899
Maximum 0.483478
6 Minimum -0.367854
Std. Dev. 0.238834
4 Skewness 0.236967
Kurtosis 2.301678
2 Jarque-Bera 3.205203
Probability 0.201372
0
-0.3 -0.2 -0.1 0.0 0.1 0.2 0.3 0.4 0.5
Source: Authors own computation using E-views
From the above table the result shows that the variables are normally distributed because the value of
the Jaque-Bera test statistic is greater the table value. Likewise the probability value is less than 5% which is
statistically significant. Therefore the null hypothesis is rejected which state that the variables are not normally
distributed.
Table 4.4 above presents the summary results of the ADF unit root tests. The results show that the null
hypotheses of a unit root test for first and second difference series for all the variables (INF, MS, EXR, TBR,
REQ and LQR) can be rejected at 5% critical value, indicating that the level series which is largely time-
dependent and non-stationary can be made stationary at the first and second difference. Thus, the reduced form
models follow an integrating order of 1(1) and I (2) process, respectively; and are, therefore, stationary at order
one and two. Furthermore, this indicates that the short run static regression result is spurious and cannot be used
for analysis. That is to say, all the variables are individually stationary and stable.
The above result revealed that there are six (6) cointegrating equations in the model. Since Johansen
tests showed that the trace and maximal Eigen statistics reveals the existence of six and four cointegrating
relationships between inflation (INF) and its determinants at 5% level of significance (Table 4.5). The
conclusion drawn from this result is that there exist a unique long run relationship between monetary policy
variables and inflation in Nigeria. Since there are six cointegrating vectors, an economic interpretation of the
long-run relationship between monetary policy dynamics and inflation in Nigeria can be obtained by
normalizing the estimates of the unconstrained cointegrating vector on monetary policy instruments.
The coefficient of determination i.e. R-Square (R2) of the estimated model 1 indicates that about 64%
of the variations in constant increase in the prices of goods and services are explained by the combined effects
of all the determinants (money supply, exchange rate and monetary policy rates). The F-Statistics is 5.7605,
which is greater than the table value of 5% level. Both coefficient of determination (R-square) and F-statistics
show that the overall regression model is significant at 5% levels. Furthermore, given the DW value of 1.99,
there was no suggestion of serial or autocorrelation problems.
As shown in the table, money supply (MS) and exchange rates are positively related to inflation rate
and are statistically significant at 5% level. This result is in agreement with a priori and theoretical expectation.
The result revealed that if money supply increases by 100% general price level will increase also by 13% all
things being equal. Likewise increase in the price of dollar by 100% will also increase the general price level in
Nigeria by 56%.
On the other hand, Interest rate has a negative impact on inflation rate in Nigeria and is statistically
significant at 5% level. That is if the cost of borrowing increase by 100%, it will increase the price of goods and
services by 5%.
The over parameterized model from which the parsimonious ECM emanated is presented above. The
examination of the econometric models in Table 4.7 above shows that treasury bill rate, required reserve
requirement and liquidity ratio variables explains 69% of the total variations in inflation rate in Nigeria. This is
indicated by the values of the R2 (0.693282). Given the F-values of 5.085740, reveals that the overall regression
is statistically significant while the Durbin–Watson statistics of 2.15 indicated the absence of serial
autocorrelation. As shown in Table 4.7, all the variables have the expected signs and conform to economic
theory as well as significant both at 5% levels of significant. The coefficient of the error correction term is
statistically significant and carries the expected negative sign at 5% level of significant. Hoverer, the speed of
adjustment is slow, that is 9.4% of the adjustment to equilibrium inflation rate is expected to occur in the long
run. This result indicates that ignoring error correction in non-stationary time series analysis would lead to
misspecification of the underlying process to achieve real price stability in the Nigerian economy.
hypotheses with respect to the aforementioned variables. In model two, at 5% level of significance with a degree
of freedom of 104(108-4), the tabulated value (t-statistics) is 1.96 for a two tailed test. The calculated ( t-
statistic) for the three variables( Treasury bills rate, Reserve requirement and Liquidity ratio) are 2.61, -2.14 and
3.40 respectively, since the calculated value is greater than the tabulated value for a two tailed test, it can be
concluded that Treasury bills rate, Reserve requirement and Liquidity ratio have significant impact on the
inflation rate in Nigeria, thereby also rejecting the null hypothesis concerning these variables. The variables in
model 1 and 2 had combined impact of 64% and 69% respectively on the inflation rate in Nigeria for the period
under study.
V. Conclusion
Conclusively, we submit that the results show a causal relationship between the inflation rate and the
selected monetary policy instruments as the determinants of the inflation rate in Nigeria, namely, broad money
supply, exchange rate, monetary policy rate, Treasury bill rates, reserve requirement, and liquidity ratio. The
relationship is not only significant, but they contributed to impacting on the inflation rate for the period under
study. There is need for the CBN to have periodic research that determines the changing dynamics of the
established relationship in order to have a far more effective policy intervention that will have traction on the
economy as the inflation band of 6-9% is attained. The study is supportive of the notion that monetary policy
impulses introduced by the CBN do have desired effect on the economy as the variables are effective at
transmitting these impulses via the various channels of monetary policy transmission. The Central Bank of
Nigeria has to identify the speed of transmission through the various policy channels in order to know the level
of policy shocks to introduce and the anticipated effect. This calls for further research on the monetary policy
transmission channels in Nigeria.
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Tonprebofa Waikumo Okotori. “The Dynamics of Monetary Policy and Inflation in Nigeria.”
IOSR Journal of Economics and Finance (IOSR-JEF) , vol. 10, no. 2, 2019, pp. 37-49.