The Impact Of Fiscal And Monetary Policy On The Nigerian Economy

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The Impact Of Fiscal And Monetary Policy On The Nigerian Economy


This study investigates the nature of interactions between fiscal and monetary policies in Nigeria, as well as how these interactions influence the relative effectiveness of both policies within the new-Keynesian framework over the sample period 1970-2011 and at specific monetary regimes (1970-1993 and 1994-2011). Using the VAR approach, the study finds that the two policies seem to be counteractive for most part of the study period, especially during the direct control period (1970-1993); but evidence is also found in favour of accommodativeness at some points, mainly during the indirect control period (1994-2011). Also, using the Killick’s (1981) criteria, the study finds that, when analysed within an interaction framework, fiscal policy seems to be relatively effective compared to monetary policy in Nigeria. Furthermore, evidence is found in support of a non-Ricardian regime and the fiscal theory of price level (FTPL) determination which implies that inflation in Nigeria may not be unconnected with the fiscal recklessness of the government, and not necessarily monetary impotence. Overall, the study concludes that there seems to be fiscal dominance in the Nigerian economy, and advocates for proper coordination of fiscal and money policy, which is subject to cordial relationship and mutual commitments of the fiscal and monetary authorities.

Chapter One


1.1. Background of the Study

The use of economic policy as tools for economic stabilization by governments of different economies of the world cannot be overemphasized. Some of these policy measures may have economic-wide effect (e.g. the budget and inflation) while others may have specific effects such as the consumption tax on consumer good (Killick, 1981 and Black et. al., 2000). Policymakers around the world employ various policies, singly or mix, to stabilize the boom-bust cyclical swings of economic activities.

In macroeconomic management, the two most commonly employed policies are the fiscal and monetary policies. The Monetary policy, managed by the Central Bank, is conducted through changes in the money supply and the interest rate. While the Fiscal policy, which is managed by the government of that economy, is conducted through changes in government spending and taxes (Liborio, 2011; Hussain, Wijeweera and Hoang, 2012). Since 1980s, there has been a general consensus among economists in favour of monetary policy as a more effective stabilization tool relative to fiscal policy (Mishkin, 2004; Mankiw, 2005; and Bullard, 2012), though the recent global financial crisis of 2007 has renewed much interest on fiscal stimulus. In recent times, policymakers are prompted to employ unconventional actions to stabilize the national economy. Precisely, while monetary policymakers turn to quantitative easing (the purchase of financial assets so as to lower long-term interest rates, thereby increasing the money supply), fiscal policymakers increase government spending and reduce taxes so as to boost employment and output (Liborio, 2011).

Despite the fact that monetary and fiscal policies are implemented by two different bodies, these policies are far from being independent. There are various channels through which fiscal and monetary policy interact with each other, directly or indirectly. First and most common is the fiscal expansion linkage through fiscal deficits, which government may choose to finance through ‘ways and means’ of the central bank and thereby leads to an expansionary monetary policy, fueling inflationary pressure in the economy, causing exchange rate appreciation viz-a- viz balance of payments problems, and a potential threat to the nation’s currency and banking sector. Another interaction channel is through market financing of governments fiscal deficits which may crowd-out private investment and hamper economic growth and development, thereby becoming a serious issue to the monetary authority. The third channel of interaction may be viewed from the external (international) financing of domestic fiscal deficits which may pose severe risks on exchange rate management, and hence balance of payments equilibrium, which again becomes a serious worry to the central bank. Also, fiscal-monetary interaction may be seen via imposition of indirect taxes on prices of goods and services, thereby causing inflation and inflationary expectations which is the primary focus of the monetary authority (Hilbers, 2005 and Chuku, 2010). Similarly, the activities of the monetary authority on interest rates and money supply may influence government fiscal plan for the period. For instance, liquidity of government securities may be enhanced by monetary authority through open market operations and reserve requirements. Also, the stance of monetary policy may affect, to an extent, the initial financial cost of placing debt to government (Reddy, 2000).

Based on these identified channels and more, it is obvious that a change in one of these policies may influence the effectiveness of the other and thereby the overall impacts of any policy change. Conflicts may arise between these policies in achieving a particular macroeconomic objective, hence the need to pursue a consistent fiscal-monetary policy mix as well as proper coordination of these policies to avoid frictions and inconsistencies (Hilbers, 2005).
In Nigeria, fiscal and monetary policies (especially the tools of government expenditure, money supply and monetary policy rate (MPR)) have been extensively used by the government and other policymakers to stimulate output. For instances, evidence from CBN (2012) shows that respective average growths of government expenditure and money supply were 34.8% and 33.3% in 1970’s; 23.2% and 17.2% in 1980’s; 41.2% and 31.6% in 1990’s; and 14.9% and 28.7% for the period 2000-2011. Whereas, World Bank (2012) reveals that Nigeria output growth fell from an average of 7% in 1970s to 0.93% in 1980s, and rose slightly to 3.06% in 1990s; while in the last decade (2003-2012), the Nigerian economy posted an increased average of 7% growth in output, which is one of the highest in the world for that period.

Figure 1.1: Growth Trend of Output (GQ), Govt Exp (GTGE), Money Supply (GM2) and Interest Rate (MPR)

In order to appreciate the policy-source of this variation in economic performance (as shown below) over the years, it is necessary to take a retrospective look at the conduct of fiscal and monetary policy in Nigeria.

Figure 1.2: Output (GDP) Gap

1.2. Fiscal and Monetary Management in Nigeria: A Retrospection

Fiscal policy conduct and administration in Nigeria is designed in line with the federal structure (one federal government, 36 state governments and 774 local governments) of the nation’s political system, while its implementation rest on the ministries, departments and agencies (MDAs), the public enterprises and the non-budgetary institutions with stakes in public policy. The primary objective of fiscal policy in Nigeria centres on high, rapid and sustainable economic growth among others, while the policy instruments being employed to achieve this objective include changes in tax rate, government expenditure and public debt operations of financing budgetary gap (Anyanwu, 1993 and 1997).

Prior to 1970, the constituent of government revenue is basically non-oil based (tax, loan, grant and aids etc.). However, since 1970s the government revenue constituent has drastically shifted to oil-based, which has made the nation’s economy to continually swing along the volatile international oil-market. Also, the Nigerian tax policy has been dynamic and decentralized though it is highly limited to the formal sector of the economy, while the informal sector is largely uncovered (Anyanwu, 1993). On the expenditure side, government expenditure profile has been on the rising side, with the recurrent expenditure continually outweighing the capital expenditure within a share range  of 30-70% in 1960 to about 80-20% in 2007 (Mordi, Englama and Adebusuyi, 2010). Although, the introduction of Medium-Term Expenditure Framework (MTEF) in 2003 has improved the spending structure of government, much of the government budgetary gap is still being financed through debt (internal and external) as the total federally collected revenue could not meet up with total government expenditure. The Nigeria’s debt profile shows that the debt-GDP ratio (the proportion of the GDP financed by debt) rose from 4.9% in 1960 to 77% in 1990, fell to 28.5% in 1998 and narrowed down to 11.9% in 2006 after the external debt concession/forgiveness granted by the London club and Paris club of creditors. The high profile of the public debt has been attributed mainly to the expanding deficit structure of the fiscal balance. In summary, the economy’s fiscal stance has been relatively unidirectional with much focus government expenditure (Udoh, 2009; Mordi, Englama and Adebusuyi, 2010). On the other hand, the conduct and administration monetary policy in Nigeria rest solely on the Central Bank of Nigeria (CBN) through the CBN Establishment Act of 1958 as amended. The objectives of monetary policy in Nigeria have been dynamic, depending on the prevailing monetary regime, but all of them revolve round price stability. During the period 1959 – 1973, exchange rate targeting was adopted as the monetary policy strategy while fixed exchange rate was the anchor. However, monetary policy conduct became difficult due to inflationary pressure on the economy resulting from the oil boom of the 1970’s (Ajayi and Ojo, 2006). To resolve this, the CBN in 1974 adopted monetary targeting as the official monetary policy strategy. Initially, narrow money (M1) was the nominal anchor but the CBN switched to broad money (M2) in 1986 because the latter was found to be more stable and highly correlated to output compared to the former, and it has been in use till date (Mordi, Englama and Adebusuyi, 2010).

Under the monetary targeting framework, two broad policy regimes have been adopted, namely: direct and indirect monetary control. During the period of direct monetary control (1974 – August, 1993), the CBN imposes different credit controls and quantity restrictions on interest rates, while loans and advances were directed to specific sectors of the economy in order of priority. However, under this regime, the CBN lacks instrument autonomy as monetary policy was directed my ministry of finance, hence the possibility of incessant political interference. Meanwhile in September 1993, in line with the Basel Accord, the CBN embarked on indirect monetary control by using market-based instruments to regulate the growth of major monetary aggregates and dismantling all credit ceilings. The main instrument of CBN was the Open Market Operations (OMO) and complemented by cash reserve requirements and discount windows. But the CBN was not granted full instrument autonomy until 1998 (Ajayi and Ojo, 2006; CBN, 2010).

Prior to 2002, the CBN designed its monetary policy alongside fiscal duration of one year. However, due to the incessant problems of time-inconsistency in policy implementation and over-reaction of monetary policy to shocks, the CBN in 2002 commenced a two-year Medium- Term Monetary Framework (MTMF) which is still based on monetary targeting and market- driven instruments. The implementation of MTMF was successful to a great extent as there was significant improvement in output and other policy indicators (Mordi, Englama and Adebusuyi, 2010).

With this confidence, the CBN in December 2006 reverts to the one-year duration, but this time, under a new monetary policy framework (NMPF) which has lasted till date. The aim of this new monetary policy framework is to reduce interest rate volatility and prepare the transition to full-fledged inflation targeting. Under this framework, a combination of inter-bank rate and money base are used as the operating targets while the intermediate targets are M2 and Prime Lending Rate (PLR). There was also the introduction of Monetary Policy Rate (MPR) to replace Monetary Rediscount Rate (MRR), interest rate corridor with ±3% band for lending and deposit facilities respectively and a Standing Lending Facility at a fixed rate above MPR for deposit money banks (DMBs) (Ezema, 2009). More so, recent trend in monetary policy management has witnessed the use of quantitative easing by CBN, the pegging of MPR at 12% since January 2012 till date, the cashless and cash limits policies and so on. All these are directly or indirectly gear towards influencing aggregate output.

1.3. Statement of the Problem

Over the years, fiscal and monetary policies have been choicely employed by policymakers in Nigeria to influence and stabilize the behavior of the aggregate economy; with more focus on the tools of government expenditure, broad money and monetary policy rate (MPR) as the operating instruments. However, neither of these policies, individually, could be unanimously said to have effectively stimulated economic performance consistently over time. For instance, evidence from CBN (2012) shows that, although government aggressively pursue expansionary fiscal and monetary policy in 1974-75 period (early days of monetary targeting), however, output dipped by 5.2% in the same period. In another policy scenario in 1993-94 period (early days of partial monetary instrument autonomy) when contractionary fiscal policy is combined with easing monetary policy, output rose by a paltry rate of 0.1%. But in 2004-05 fiscal year (under the MTMF), when government moderately pursued expansionary fiscal and monetary policy, output increased significantly by 5.4%. While 2010-11 fiscal period (under the new monetary policy framework), when government pursued expansionary fiscal policy with tight monetary policy, output rose by 6.7%. From this analysis, it is unclear what the interaction between fiscal and monetary policy improves their effectiveness in influence economic performance.

Although a number of studies attempted to investigate the interaction and effectiveness of fiscal and monetary policy in Nigeria, however, they differ considerably on the best policy approach. The pro-monetary effectiveness studies (Ajayi, 1974; Asogu, 1998; Adefeso and Mobolaji, 2010; Okpara and Nwaoha, 2010; Iyeli, Enang and Emmanuel, 2012) argue that the effectiveness of the government fiscal policy in a developing country like Nigeria is very doubtful because of weak correlation between budget performance and economic outcomes. Also, with a large informal sector which is mostly untaxed and unaffected by the various tax reforms, fiscal policy is less effective (Ogbuabor, 2013).

On the other hand, the pro-fiscal effectiveness studies (Aigbokan, 1985; Egwaikhide, Enoma and Saheed, 2012) argue that, in country like Nigeria where the financial system is at best rudimentary while government plays a significant role in major sectors of the economy, monetary policy conduct is pretty difficult with very few chances of influencing the aggregate economy significantly. This is because the CBN policy rate (MRR/MPR) which is the primary signal of the money market seems to be weak in channeling financial resources from surplus entities to deficit entities. This implies that interest rate may not be the stimulating/deciding factor in saving and investment decisions in the economy (CBN, 2010). Corollary to this is the weak link between interest rates and aggregate output performance of the economy. Also, due to the structural imbalance in the real (productive) sector of the Nigerian economy, growth in money aggregates translates into inflation rather than output/productivity growth, thereby leaving monetary policy conduct with much questions than results (Egwaikhide, Enoma and Saheed, 2012).

Despite the plausibility of various arguments portrayed by these strands of studies on Nigeria, very few of them (Chuku, 2010 and Okafor, 2013) have considered the interaction between fiscal and monetary policy, which might have affected their outcomes. Whereas, recent evidences on macroeconomic policy management have shown that for effective performance of both fiscal and monetary policy, individual policy transmission is not sufficient, rather, there is a need for policy-mix or interaction as well as a mutual coordination between fiscal and monetary authorities (Leith and von Thadden, 2006; Raj, Khundrakpam and Das, 2011). And it is expected that the nature of this interaction, complementarity or confliction, between these policies may have severe consequences on their ability to effectively stabilize the economy or dampen business cycles (Okafor, 2013).

In the light of the above analysis, one may wonder how fiscal and monetary policies interact with each other in Nigeria; the nature of interaction between them – whether these policies conflict (substitute) rather than complement each other or whether any of the policies have dominated the other in the process of transmission; how these policies have influence economic performance- both singly and interactively; why these policies have continually missed their economic targets despite the special attention given to them and the cost of running them; and what institutional framework need to be put in place in order to harness the potency of these policies, singly and interactively. Guided by the Killick’s (1981) criteria for assessing policy efficiency, this study seeks to answer the following questions:

  1. What is the nature of interaction between fiscal and monetary policy in Nigeria over time?
  2. How do fiscal and monetary actions transmit to response of economic performance?
  3. What is the nature of interaction between fiscal and monetary policy at various policy regimes in Nigeria?
  4. How do these regime-specific interactions affect the relative effectiveness of fiscal and monetary policy?

1.4. Objective of the Study

The broad objective of this study is to analyse the role of policy interaction in the assessment of the relative effectiveness of fiscal and monetary policy on output performance in Nigeria. Specifically, the study aims:

  1. To ascertain the nature of interaction between fiscal and monetary policy in Nigeria over time.
  2. To analyse the transmission path of fiscal and monetary policy on economic performance
  3. To determine the nature of interaction between fiscal and monetary policy for various policy regimes.
  4. To examine the effect of regime-specific interactions on the relative effectiveness of fiscal and monetary policy.

1.5. Research Hypotheses

In line with the specific objectives of this study, this research is guided by the following hypotheses:

Ho1: There is no interaction between fiscal and monetary policy in Nigeria.

Ho2: Economic performance does not respond to fiscal and monetary policy transmission.

Ho3: There is no specific interaction between fiscal and monetary policy at various policy regimes.

Ho4: The regime-specific interactions have no effect on the relative effectiveness of the policies.

1.6. Significance of the Study

This study belongs to the area of Macroeconomic Public Policy (MPP) which deals with policy simulation, evaluation and analysis within a macroeconomic framework. By analyzing the interaction between various fiscal and monetary instruments, this study will improve the understanding of the policymakers on the nature, extent and effect of policy interaction on macroeconomics targets, like output, in Nigeria. And the examination of the nature of policy interaction under different policy regimes in the country will guide the fiscal policymakers and monetary authority on the optimal policy-mix for a specific target under a similar scenario of a particular policy regime in the future.

Also, the outcome of this study will help the government and the monetary authority to discover some areas of weakness in the choice and usage of specific policy instruments and how to improve on them for effective stabilization. Moreover, the study will help both fiscal and monetary policymakers to design better policies, as well as make good economic forecasts based on the chosen policy instruments. Furthermore, the study will add to existing literature on the interaction of fiscal and monetary policy, especially for developing nations, like Nigeria, where the government has been playing a prominent role while the financial system is at best rudimentary. Finally, the study will lend a voice to the ongoing advocacy for a cordial, mutual relationship between the fiscal (government) and monetary (CBN) authorities, especially in the area of policy management and macroeconomic stabilization.

1.7. Scope / Delimitation of the Study

This research is a country-specific study and it concentrates on the analysis of fiscal and monetary policy interaction and effectiveness within the domestic economy of Nigeria. For relevance and in-depth analysis, this study span through the period 1970-2011, using annual series. Although there are many instruments of fiscal and monetary policy that have been employed in empirical research, for the purpose of this study, fiscal balance and interest rate are employed as proxies for fiscal and monetary policies respectively, while economic performance is captured with GDP gap and inflation.

Chapter Five

Conclusion and Policy Recommendation

5.1 Conclusion

The interactions between fiscal and monetary policy has become one of the most debated issues in the field of macroeconomics in the last two decades, especially after the global financial crisis in 2008. Although, prior to these period, the debate on the relative effectiveness of these two policies has become a household issue among economists, the recent discussion on policy interaction has taking a further step to investigate what could make such policies to become responsive to various macroeconomic shocks, how they effects changes in the macroeconomic environment and how they collectively adjust to each other’s shock in order to influence a particular macroeconomic target.

In this study, the relevant literatures relating to the debates on fiscal-monetary interaction and effectiveness are reviewed. The literatures on relative effectiveness of both policies are first considered, both from the Keynesians and Monetarist perspectives. Then, the theories of policy interactions are reviewed, with more emphasis on the fiscal theory of price level determination (FTPL) and the theory of “strategic interactions”. Various empirical studies, with different methodologies adopted, are also reviewed extensively.

This study analyzes the interaction of fiscal and monetary policy within the Nigerian macroeconomic setting, and how such interaction influences the relative effectiveness of both policies over the sample period and at various policy regimes (non-monetary autonomy and monetary autonomy regimes). This analysis is founded on the New-Keynesian framework which is built on the assumptions of rational expectations, sticky-price and the intertemporal optimization choice of the agents. The New-Keynesian model is then estimated using the Sims (1980) VAR approach. To capture the objectives of the study, two different sets of the VAR model are estimated. First, the General VAR model is estimated over the entire sample period (1970-2011) in order to ascertain the nature of the interaction between fiscal and monetary policy, and how key macroeconomic performance indicators respond to these policies over the period. Then, the Regime-Specific VAR models are estimated so as to analyse the nature of interactions between these policies at various regimes (1970-1993 and 1994-2011), and how these regime-specific interactions influence the relative effectiveness of both policies.

From the results of the analysis conducted, it is found that there exist significant interactions between fiscal and monetary policy over time and at various policy regimes, which is in accordance with Okafor’s (2013) study. Precisely, there seems to fiscal dominance over the period and at various policy regimes. The two policies tend to be counteractive during the direct monetary control period, while evidence is found in favour of accommodativeness (complementarity), at some points, during the indirect monetary control period, which supports the findings of Chuku (2010). Also, the study finds evidence in support of the FTPL in Nigeria. Evidence obtained from the overall sample and the no-autonomy period seems to play along the non-Ricardian regime, while no such evidence is found for the monetary-autonomy period.

Finally, the study is able to investigate the cause of the discrepancies among previous studies on the Nigerian economy with regards to the relative effectiveness of fiscal and monetary policy. In line with the Killick’s (1981) criteria for evaluating policies, this study finds evidence in favour of relative fiscal effectiveness. This might not be unconnected to the dominance of fiscal policy for most part of the study period which inhibited the performance of the monetary policy, as well as the prominent presence of the government in the day-to-day performance of the economy.

5.2 Policy Recommendation

One of the significant conclusions made in this study is that there tends to be fiscal dominance in the Nigerian economy, and this has constrained the performance of monetary policy for most of the period. In order to ease the excessive influence of fiscal actions on monetary policy, the financial/monetary system of the economy must be further strengthened to complement the CBN autonomy and credibility. Also, the fiscal authority, while setting monetary commitments for the Central Bank when necessary, must also commit itself appropriately by playing to the rule of the game. This will not only enhance monetary effectiveness but also enhance the credibility of monetary policy emanating from the CBN.

Similarly, the study reveals that, for most part of period, fiscal and monetary policies tend to counteract each other, which thereby inhibited their relative effectiveness. In order to effectively address this menace, there is a need for proper coordination of both policies. Both fiscal and monetary authorities must cordial operate and set macroeconomic targets based on chosen policy variables.

Furthermore, both fiscal and monetary authorities need to properly cordially coordinate their respective policy instruments in order to address the menace of inflation Nigeria, as evidence from the study reveals that neither of the policies is strong enough to influence this menace. The fiscal authority also needs to constantly check its spending, especially the non-productive spending, which leaks, unabatedly, into the economy and induce inflation.

More so, policy makers must take caution when assigning targets to policy instruments. Comparative evidence from this study and other studies on Nigeria, and other foreign studies, reveals that the choice of policy instruments could significantly alter obtainable outcomes. Thus, the effect of a one percent change in interest rate may not be the same as that of a one percent change in money supply, even though both of them are monetary policy instruments and can be used to achieve similar objectives. This applies also to fiscal instruments.

In conclusion, it is recommended that the national statistical bodies should do more to constantly update the nation’s statistical database in order to further reduce the variations among studies on this topic, so that reliable estimates could be obtained and valid forecast made. This has immense implications on the conduct and performance of fiscal and monetary policy in the country. For instance, a reliable estimate and forecast of inflation will enable agents to make appropriate decisions on inflation expectation, which may ease tension on policy conduct and performance.

5.3 Value Added by the Research

With regards to the analysis of fiscal and monetary policy interaction and effectiveness in Nigeria, this study is novel in the sense that it builds the foundation of its analysis on the New- Keynesian theory which allows for interaction and effectiveness of policy rules. The study’s ingenuity can also be seen in the construction of a regime-specific VAR model to capture policy interactions at various regimes, which is the first of its kind among Nigerian studies.

5.4 Suggestions for Future Research

The debate on the interactions and effectiveness is still on-going. Researchers interested in this line of debate may improve on this study by considering Nigeria as a small-open economy that responds significantly to external shocks which may be captured with exchange rate shock, import-share or degree of openness. Interested researcher may also decide to calibrate the equations of the NK model and then simulate them with the respective policy rules. Rather than estimating a VAR model for the NK framework, alternatively, interested researcher may estimate a DSGE model.

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