Effect Of Interest Rate On Investment And Money Demand In Nigerian Economy

Project and Seminar Material for Economics

Effect Of Interest Rate On Investment And Money Demand In Nigerian Economy


Abstract


The research work examined the Effect of Interest Rate on Investment and Money Demand in Nigerian Economy for the year 2005 – 2014. The research adopted ex-post facts research design. Data for this study were mainly collected from secondary sources and were garthered through Central Bank of Nigeria (CBN) and Federal Office of Statistics (FOS).

An econometric model specification was then built and SPSS 20.0 software was used in computing the data regression analysis. Findings of the study were drawn and indicates that interest rate has significant impact on investment decision and that there is significant relationship between Interest rate and money demand

The research study was concluded with a detailed discussion and recommendations based on the findings.


Chapter One


Introduction

1.1 Background to the Study

Investment plays a very important and positive role for progress and prosperity of any country. Many countries rely on investment to solve their economic problem such as poverty, unemployment etc (Muhammad and Mohammed 2004).

Interest rate on the other hand is the price paid for the use of money. It is the opportunity cost of borrowing money from a lender to finance investment project. It can also be seen as the return being paid to the provider of financial resources, for using the fund for future consumption (Sleka, 2004). Interest rates are normally expressed as a percentage rate. The volatile nature of interest is determined by many factors, which include taxes, risk of investment, inflationary expectations, liquidity preference, market imperfections in an economy etc.

Banks are given the primary responsibility of financial intermediation in order to make fund available for economic agents. Banks as financial intermediaries move fund from surplus sector/units of the economy to deficit sector/units by accepting deposits and channeling them into lending activities (Afolabi, 2003). The extent to which this could be done depend upon the rate of interest and level of development of financial sector as well as the saving habit of the people in the country.

Hence, the availability of investible funds is therefore regarded as a necessary starting part for all investment in the economy which will eventually translate to economic growth and development (Uremadu, 2006).

As already discussed so far, it is quite clear that an understanding of the nature of interest rate behavior is critical and crucial in designing policies to promote savings, investment and growth. It is pertinent to note that this research attempts to investigate and ascertain the effect of interest rate on investment and money demand in Nigeria.


1.2 Statement of the Problem

The financial systems of most developing countries (like Nigeria) have come under stress as a result of the economic shocks. The financial repression largely manifested through indiscriminate distortions of financial prices including interest rates, has tended to reduce the real rate of growth and the real size of financial system, more importantly, financial repression has (retarded) delayed development process as envisage by Shaw (1973). This led to insufficient availability of investible funds, which is regarded as a necessary starting point for all investment in an economy. This decline in investment as a result of decline in the external resource transfer since 1982 has been especially sharp in the highly indebted countries, and has been accompanied by a slowdown in growth in all Least Developed Countries (LDCs) Cole and Obstraid (2005).

Both public and private investment rate have fallen, although the latter more drastically than the former. The observed reduction in investment in LDCS seems to be the result of several factors. First, the lower availability of foreign savings has not been matched by a corresponding increase in domestic savings. Secondly, the determinating of fiscal conditions due to the cut of foreign lending to the rise in domestic interest rate and the acceleration in inflation forced a contraction in public investment. Thirdly, the increase in macroeconomic instability associated with external shocks and the difficulties of domestic government to stabilize the economic has hampered private investment.

Finally, the debt at hand has discouraged investment, through its implied credit constraints in international capital markets (Omole and Falokun, 1999).

Declining investment ratio and level are problems; first of all, because investment matters for growth. Secondly, because low investment increases vulnerably in the economy (Niambon and Oshikoya, 2001). The main challenge that Nigeria is facing is to make policies that will help revive and raise investment in the country in order to stimulate and sustain economic growth.

The problem of volatility of interest rates affects personal investments and governmental decision making of any nation, Nigeria cannot be an exception as affirmed by Schwartzman (1992) that the movement of interest rates in one direction or another is influenced by a multitude of factors, including economic, inflationary, monetary, fiscal, global, and political factors.

The rate of interest paid by banks to depositors is on the high, investors can not patronize the banks the more and fewer investors invests on the capital market. This leads to decrease in money demand and capital investment in the economy.

The above identified problems can be summarized as follows;

  1. High Interest rate which affects investment decision
  2. Interest rate has lowered the demand for money in Nigeria

1.3 Objectives of the Study

The general objective of this study is to examine interest rate in Nigeria in relation to its impact on investment. To achieve that, this topic will pursue the specific under listed objectives.

  1. To ascertain if interest rate instruments have impact on investment in Nigeria, if it does to ascertain the relationship.
  2. To examine if long run relationship exists between interest rate instruments and investment in Nigeria .
  3. To examine if causality exists between interest rate instruments and Investment in Nigeria.

1.4 Hypotheses of the Study

The following hypothesis will guide this study:

  1. H0: Interest rate, rate of investment and inflation do not respond to shocks in interest rate rate (MPR).
    H1: Interest rate, rate of investment and inflation responds to shocks in monetary policy rate (MPR).
  2. Hi: Interest rate instruments have significant impact on investment in Nigeria.
    Ho: Long run relationship does not exist between interest rate instruments and Investment in Nigeria

1.5 Significance of the Study

This work is mainly for academic purpose. However, it will be of great importance to researchers who would want to embark on any research on interest rate and investment decision.

Also this piece of research work would go a very long way in assisting any person or organizations in making investment decisions in Nigeria.


1.6 Scope of the Study

The study focuses on the effect of interest rate on investment and demand for money in Nigeria. The population of this research covers the entire country as secondary data was used. The study area of this research is Nigeria. Data were gathered from Central Bank of Nigeria (CBN) and Federal Office of Statistics (FOS). The research last for an academic session.


1.7 Limitations of the Study

Upon the assertion that every pros have some cons, this study cannot be exception. Some hitches and setback are foreseen. First among the list is data unavailability. For this reason, investment variable would be provided by Gross Fixed Capital Formation (AFCF).

Secondly, time and financial construct cannot be left out in the list setback and hitches.

The cost of sourcing materials from the internet is exorbitant because of epileptic and erratic power supply of the Power Holding Company of Nigeria (PHCN). Thus, the cyber café power their systems with power generating sets which increases their cost of production which they eventually pass to us (the consumers of their services).

Despite all these hitches and setbacks mentioned above, this research work would have been a perfect work.


1.8 Definition of Terms

Interest Rate:

It is the opportunity cost of borrowing money from a lender to finance investment project

Investment:

Is a monetary asset purchased with the idea that the asset will provide income in the future or appreciate and be sold at a higher price

Demand for Money:

Is the desired holding of financial assets in the form of money

Economic Growth:

An increase in the capacity of an economy to produce goods and services, compared from one period of time to another.

Financial Market:

Is a market in which people and entities can trade financial securities, commodities, and other fungible items of value at low transaction costs and at prices that reflect supply and demand.


Chapter Five


Summary, Conclusion and Recommendations

5.0 Summary

The study theoretically and empirically investigated how inflation, interest and rate of investment respond to shocks in interest rate (captured by MPR). The research work used monthly data, beginning from December, 2006 (when the MPR was introduced) through February, 2020. The Structural VAR was employed to estimate the model, where the impulse response revealed how the inflation, interest and rate of investments responded to shocks in MPR and the variance decomposition brought to the limelight the impact of MPR on these Macroeconomic variables. The Granger Causality was equally used to disclose the causal direction among the variables, while Augmented Dickey Fuller (ADF) was conducted on all the variables before the estimations to establish the absence of stochastic process.

Outlines of Major Findings
  1. Inflation responds to shocks in MPR only in a volatile manner (a pattern that is almost unpredictable); in the first four periods, positive shocks in MPR could not bring down inflation but thereafter, any further increase in MPR produced gradually declining but positive interest rate.
  2. Rate of investment responds to shocks in MPR in a relatively downward fashion and quickly assumes upward trend from the second period lasting throughout the periods.
  3. Interest rate responds quickly and positively to shocks in MPR from the first thorough the last period. Therefore, MPR has its greatest influence on interest rate (prime lending rate).
  4. Of all the three macroeconomic variables, inflation is the most difficult to deal with and cannot always be successfully conquered with the manipulation of MPR alone.
  5. Low and stable interest and rate of investment can only be achieved when inflation is low and stable. Hence, inflation is the greatest enemy of our economy.
  6. Changes in the interest and rate of investment as well as MPC meetings can be used to predict MPR.

5.1 Conclusion

The study concludes that both interest (prime lending rate) and rate of investments respond quickly and almost in a predictable way to shocks in MPR. However, changes in MPR do not automatically and consistently produce changes in inflation and above all inflation responds to shocks in MPR only in a volatile manner (a pattern that is almost unpredictable). Hence of all the three variables, inflation is the most difficult to deal with (stability of which could leads to stability in the remaining two) and could not be totally addressed by mere manipulations of MPR. Hence low and stable inflation is a necessary condition for the achievement of low and stable interest and rate of investment. We also conclude that MPR is also responsive to interest rate Committee (MPC)meetings.


5.2 Recommendations

  1. Other interest rate instruments particularly Cash Reserve Requirements (CRR) and especially, OMO should be prudently used to compliment MPR in achieving Economic growth.
  2. The current monetary tightening stance of the CBN is a step in the right direction but should be used with caution. Considering the dual objective of CBN, the interest rate should be tailored to promote real sector lending while trying to achieve low and stable inflation.
  3. There is the need for policy harmonization between the monetary and fiscal authorities. Budget deficit should be avoided and more fund be appropriated for capital as against the recurrent expenditures.
  4. CBN should license more banks to operate non-interest banking so as to boost financial deepening and inclusion. The large informal sector in the country that cripples the transmission mechanism of interest rate and constraints the ability of CBN to control money supply was to some extent caused by cultural and religious belief that interest is unlawful; this could be avoided by introducing more non-interest banks.
  5. The “cashless policy” of CBN should be maintained, made more efficient and user friendly. Researches have shown that a system that is cash based is inefficient and distorts transmission mechanism. More efficient point of sale (POS) terminals, multifunctional ATMs as well as mobile payment compatible system should be put in place.
  6. There is the need for proper enlightenment of the public about any new CBN policy initiatives (e.g. non-interest banking & cash-lite policy). The communication strategy should be clear and concise.
  7. The physical and social infrastructures of the economy should be improved to reduce the cost of doing business and by extension the interest charged by the banks.
  8. The three tiers of Government should exercise fiscal prudence and fiscal responsibility act be fully implemented. More so, Banks and Other Financial Institutions should improve their operational efficiency by cutting down overhead and any other unnecessary expenses.
  9. The CBN should reduce or strike out any unnecessary stringent documentation requirement for the purchase of forex in the official market. This would kill patronage and by extension the life of parallel market/street trading.
  10. To ensure policy continuity and consistency, the rate of turnover of CBN Governors should be checked and the frequency of MPC meetings be reduced to at most quarterly unless in case of emergencies.
  11. The Oil and Gas sector should be fully deregulated, corruption in the sector and other sectors of the economy be fought to the latter and above all the saved subsidy proceeds be used to boost physical infrastructure. This would reduce pressure on forex demand as well as cost of doing business and in addition boost external reserve in the country.
  12. Last but not the least, CBN should avoid policy summersault, a situation where CBN would initiate a policy that originally supposed to be applicable to all economic agents (e.g. cash-lite) and latter begin to exonerate some agents (e.g. government parastatals, foreign embassies, Primary Mortgage Banks, Microfinance Banks etc.) from compliance, would not augur well for the economy. If interest rate must strive, the credibility of CBN should be held in high esteem especially under condition of uncertainty.

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