Wednesday, June 10, 2015 5.41PM/CBN
The Central Bank of Nigeria (CBN) 2007 Act requires the Bank to achieve monetary and price stability in consonance with the general consensus that price stability (low and stable inflation) aids growth, while inflation creates uncertainty and is inimical to economic growth. Most central banks aim to achieve price stability as a key objective of monetary policy, whether explicitly stated in their enabling laws or not.
The CBN has employed two monetary policy frameworks: exchange rate targeting up to 1973 and monetary targeting subsequently in pursuit of the price stability mandate. In principle, monetary targeting remains the framework for monetary policy in Nigeria, though, actual implementation has in recent times paid increased attention to short term interest rate (CBN 2012). The increased focus on short-term interest rates gained traction with the implementation of an interest rate corridor in 2006, when the CBN introduced the Standing Lending/Deposit Facilities to address liquidity issues in the short term money market.
In many countries, the reliability of the monetary aggregates as the main signal for the conduct of monetary policy has become increasingly questionable due in part to the phenomenon of a weakening relationship between money and inflation. In Nigeria, it has been observed that moderation in inflation has not kept pace with the slowdown in growth of the monetary aggregates, particularly since the global financial crisis; raising concerns about the stability of the underlying assumption of the theoretical relationship between the intermediate target of monetary policy, broad money supply, and prices. It is in this context that this paper re-visits the thesis (money/inflation) underpinning the conduct of monetary policy in Nigeria.
Following this introduction, Section 2 reviews the relevant literature while Section 3 presents a trend analysis of the data. Empirical analysis and discussion of key findings are presented in Section 4. The paper is concluded with a brief discussion of policy implications in Section 5.
2.0 Literature Review
The relationship between the monetary aggregates and the level of economic activities has received much attention in the literature. In one of the earliest contributions, the Quantity Theory of Money (QTM) provided a fundamental basis for monitoring and targeting the monetary aggregates in controlling inflation. In the QTM, it was shown mathematically that since MV = PT, there was a direct relationship between money supply and price level.
Thus, a product of the quantity of money (M) in circulation and the number of times the money changes hand (V) must be equal to the product of the price level (P) and volume of transactions (T) carried out in a particular period. Friedman (1956) noted: …any interpretation of short-term movements in economic activity is likely to be seriously at fault if it neglects monetary changes and repercussions and if it leaves unexplained why people are willing to hold the particular nominal quantity of money in existence.
Accordingly, central banks have used the monetary aggregates principally as indicators of monetary conditions and, invariably, as predictor of inflation in the economy for several years. The proponents of monetarism have tried to show that the velocity of money (V) is stable over time. The volume of transactions (T) which reflects the real output of the economy is also assumed stable in the short run. The assumption of the stable V and T allows changes in the money supply to directly impact on the price level. Thus, central banks could target growth in money supply in order to achieve a desired level of price. This proposition underpinned the conduct of monetary policy by most central banks up to the early 1990s as the monetary aggregates were used as nominal anchors.
Opinions, based on empirical evidence, have however differed markedly about the signalling ability or efficiency of the monetary aggregates as monetary policy anchors. Using evidence from the United States, Friedman and Schwartz (1963) noted that nominal income responds to movement in the money stock. However, there are contradictory arguments in the literature on the nexus between the monetary aggregates and real economic activities. While Sims (1980) found a weak relationship between the monetary aggregates and inflation, Stock and Watson (1989) showed that money supply was a significant predictor of the future of economic activity. Darrat (1985) empirically examined the inflation levels in Nigeria, Libya and Saudi Arabia and found that money played a critical role in achieving the inflation objective. For the three countries, he concluded that higher money supply coupled with real income growth were associated with higher inflation. Taint (1989), on the other hand, argued that movements in the monetary aggregates did not provide reliable signals about movement in either consumer demand or inflation. In New Zealand, he noted, changes in the monetary aggregates proved unreliable in providing signals for developments in inflation.
Generally, instances of disconnect between the monetary aggregates and inflation were associated with market developments including financial innovation, deregulation as well as changes in interest and taxation rates which provide increased demand for various categories of money and credit, thereby changing the money supply landscape significantly. Of particular importance is the resulting instability of the money multiplier, a situation that complicates or limits the usability of a monetary aggregate as an intermediate target of monetary policy (Taint 1989).
In recent times, the relationship between money supply (Ms) and price has proved to be less robust. Contrary to the assumption of the QTM, the velocity of money has become increasingly unstable in many countries leading to a breakdown in the relationship between changes in money supply and inflation. Goodhart’s law, explains that as the monetary authorities attempt to reduce inflation by targeting a particular monetary aggregate, the empirical relationship between that aggregate and inflation tends break down, especially in the short-term (Goodhart 1998).
Recent studies have found that rapid innovations in the financial system might have altered this relationship. Friedman (1996) reported a decreasing predictive role of money supply in the 1990s. According to Astley and Haldane (1997), the strict relationship between money supply and output as enunciated by the QTM, which provides a fundamental background for monetary targeting, seems to have broken down apparently. They reported that the monetary aggregates in the 1990s, failed to provide early-warning signals for the economy.
Tallman and Chandra (1996) using Australian data also reported that the monetary aggregates contained no significant information for explaining subsequent fluctuations in output in that country. Katafono (2000) using a simple correlation co-efficient and Granger Causality tests under a Vector Auto-Regression (VAR) framework, similarly showed the absence of a robust relationship between the monetary aggregates and the economic activity variables. This development has tended to undermine the attractiveness of monetary targeting as a framework for monetary policy implementation among central banks. Indeed, Friedman (1996) wrote:
…whether the central bank makes money growth a target or uses it as an information variable, however, the whole concept is senseless unless observed fluctuations in money do anticipate movements of prices, or output, or whatever constitutes the ultimate objective of monetary policy...
Thus far, in the literature, we can infer that the key sources of disconnect between money supply and inflation include institutional changes, financial innovations and market based policies. These developments have tended generally to affect the form in which economic agents hold money balances.
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