The Impact Of Monetary Policy On The Nigerian Economic Growth

Project and Seminar Material for Economics

The Impact Of Monetary Policy On The Nigerian Economic Growth


This research work evaluates the responses of inflation, interest and exchange rate to shocks in Monetary Policy (captured by MPR) as well as the impacts of MPR on these Macroeconomic Variables. The study used monthly data spanning from December, 2006 (when the MPR was introduced) through February, 2012. Following Joao and Andrea (2006), the research used Structural VAR to estimate the model. The result shows that inflation responds to shocks in MPR only in a fairly unstable 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 rate of interest. On the other hand, exchange rate responds to shocks in MPR in a relatively downward fashion and quickly assumes upward trend from the second period lasting throughout the period, while interest rate, responds quickly and positively to shocks in MPR from the first thorough the last period.

Therefore, interest and exchange rates are more responsive to shocks in MPR than inflation and above all sometimes changes in MPR cannot guarantee the expected changes in Inflation (because of large informal sector as well as policy divergence between the monetary and fiscal authorities among other reasons). Hence, of all the three variables, inflation is the most difficult to deal with and stability of which is a necessary condition for the achievement of stability in the other two variables (interest & exchange rates). More so, interest and exchange rates as well as MPC meetings are better predictors of MPR (because of their high sensitivity to it) than the rate of inflation.

The result also uncovered that as the most difficult enemy of the economy, inflation cannot be effectively and efficiently conquered with the variation in MPR alone, other instruments particularly Cash Reserve Requirement (CRR) and especially Open Market Operations (OMO) should be prudently used to compliment the efficacy of MPR. Consequently, the paper further recommends the current monetary tightening stance of CBN but should be used with caution, improvement and expansion of the cash-lite policy and non-interest banking of the CBN, infrastructural development, harmonization of fiscal and monetary policy as well as the reduction in the number of MPC meetings to at most quarterly unless in case of emergency.

Chapter One


1.1 Background to the Study

Macroeconomic policy consists of the actions aimed at inducing appropriate changes in macroeconomic aggregates such as output, employment and the price level. The major components of macroeconomic policy include fiscal, monetary, debt management, exchange rate and prices and incomes policies. The objectives of macroeconomic policy include economic growth, balance of payments equilibrium, a satisfactory rate of growth and a high level of employment of the labour force. Monetary policy being one of the available tools of macroeconomic policy assists in the pursuit of these macroeconomic objectives.

Monetary policy refers to the actions undertaken by a central bank to influence the availability and cost of money and credit as a means of helping to promote national economic goals. The policy which aims at controlling the growth of the monetary aggregates is expected to assist the other policy tools in achieving the pre-stated macroeconomic objectives as well as economic growth. Monetary policy is very important because it can go further than some of the tools in helping to attain the overall policy goals but it must be supported by these other tools. The Central Bank of any country makes use of monetary policy instruments to influence the level of money supply in the economy.

The monetary policy instruments are the direct means available to the monetary authorities for influencing the intermediate variables to achieve the ultimate goals of policy. Monetary policy instruments are of two types: first, quantitative, general, indirect or market-based instruments; and second, qualitative, selective or direct control instruments. The direct control instruments are discretionally manipulated to achieve some set targets while the market-based instruments are employed in a well-developed financial system to influence market participants in such a way that the desirable targets are achieved. The indirect instruments include bank rate variations, open market operations and changing reserve requirements and they regulate the overall level of credit in the economy through commercial banks. The direct instruments on the other hand are aimed at controlling specific types of credit and they include changing margin requirements and regulation of consumer credit. While the indirect instruments have been used very extensively in the more developed market economies, the direct instruments predominate in less developed economies such as ours. Both techniques aim at influencing the cost and availability of banking systems credit.

The direct technique involves fixing of credit ceilings and interest rates by the monetary authorities for compliance by banks, while the indirect technique achieves the same objective through the financial markets. The most potent instrument of the indirect or market based technique is Open Market Operations (OMO).
In the Nigerian case, the design and implementation of monetary policy between 1970 and 1985 had the primary objectives of maintaining relative economic growth, a healthy balance of payments position and stimulation of output and employment. Throughout this period, monetary policy depended on the use of direct monetary instruments such as the prescription of aggregate credit ceilings, use of selective controls, imposition of special deposits, among others. The most popular instrument used at this time was the issuance of credit rationing guidelines to the commercial banks. A number of reserve requirement guidelines were also in use. The prolonged used of these direct controls generated considerable problems and became counter-productive. Some of these negative effects of direct controls include reduced competition in the financial system, leading to inefficiency and misallocation of resources in the banking sector. Credit ceilings generated arbitrary and high lending rates, lack of transparency in transactions and the employment of various ploys to circumvent the controls by window-dressing, the use of off- balance sheet items and the channeling of transactions through uncontrolled institutions, especially finance houses which mushroomed. This led to monetary policy under a liberalized economy.

In the specific environment of financial and economic liberalization, monetary policy objectives remained the same – promotion of economic growth, maintenance of external equilibrium and stimulation of output and employment. Monetary policy was also to stabilize the economy in the short-run and to induce the emergence of a market-oriented financial sector for effective mobilization of financial savings and efficient allocation of resources. The monetary control framework remained essentially the same at the initial stage of the programme, but several dynamic reforms were introduced ad the implementation of the programme progressed. Here, there was a shift in the policy instruments used from the direct instruments to the indirect instruments. As a result of the problems posed by the direct monetary control, the Central bank embarked on the selective removal of all credit ceilings of banks that met some criteria under the prescribed prudential guidelines and the indirect approach to monetary policy was initiated.

Deregulation of interest rates was a major policy instrument early in the programme. Early in 1987, the interest rate structure was adjusted upward to improve efficiency in savings mobilization and resource allocation. The use of stabilization securities was reintroduced in 1990 to put a check on the incidence of excess liquidity. The minimum paid up capital for commercial and merchant banks was also raised to ensure the soundness of the banking sector for effective monetary management.

In September 1, 1992, there was a major change in monetary operating techniques, from the use of direct control to indirect control operating techniques. The CBN, lifted credit ceiling imposition on individual banks that met CBN requirements on selective basis in respect of minimum capital base, capital adequacy ratio, cash reserve and liquidity ratio requirement, prudential guidelines, sectoral credit allocation and sound management. On June 30, 1993, CBN commenced OMO in treasury securities with banks through discount houses on a weekly basis. With the introduction of indirect monetary control instrument, CBN now controls the stock of money (from banks and non-bank public) through manipulating the monetary base or reserve aggregates. This study is of great importance since it will provide an insight into the extent to which monetary policy can be relied upon for the attainment of macroeconomic objectives in the country.

1.2 Statement of the Problem

Nigeria as a country has been plagued by many macroeconomic problems, including low level of economic growth and instability. As a result, there has been a need for all stakeholders to contribute their quota in ensuring that the economy’s performance is at its peak. The government, as well as the Central Bank is instrumental in achieving this.

The government carries out its obligations of ensuring a healthy macroeconomic environment by way of administering fiscal policies while the Central Bank carries out its own duty by means of monetary policies. The state of economic degradation brings about the need for appropriate and workable monetary policies to ensure that pre-determined macroeconomic objectives are achieved.

The adoption of monetary policies in Nigeria is not a recent development but is one that has been in use since the early 1970s. Since then, there have been a lot of problems in the conduct of monetary policy in the economy. This resulted in the shift from the use of direct monetary policy instruments to the indirect monetary policy instruments that are in use till date.

There has been a growing interest on economic growth as a major goal of monetary policy. This is as a result of recent developments in economic theory which tend to show that a reduction in the inflation rate impacts measurably and positively on economic growth (Uchendu, 2000).

1.3 Research Questions

  1. How do interest rate, exchange rate and inflation respond to shocks in monetary policy rates (MPR)?
  2. What is the impact of monetary policies on economic growth of Nigeria.

1.4 Objectives of the Study

The General objective of the study is to find out the extent to which monetary policy (captured by MPR) could bring about Economic growth (stability in inflation, interest and exchange rates) in Nigeria. Consequently, the following is the specific objective of the study:

To investigate how interest rate, exchange rate and inflation respond to shocks in monetary policy rate (MPR).

1.5 Hypotheses

  1. H0: Interest rate, exchange rate and inflation do not respond to shocks in monetary policy rate (MPR).

1.6 Scope of the Study

The study attempts to examine the relationship between monetary policy and economic growth in Nigeria in the period of 1971 to 2005. The choice of this period is necessitated by various factors. First, both positive and negative effects of monetary policy have been observed especially in the period before the Structural Adjustment Programme. During this period, direct control measures were used to regulate the money supply in the country. This therefore resulted in a lot of malfunctioning in the economy. Also, indirect controls were put in place by the Central Bank. Till date, both the direct and indirect controls are in use by the Central Bank to control the price level in the economy. The choice of the above period is also necessitated by the availability of data for the research work.
The study focuses mainly on the money supply because of the belief that the institution of various monetary policy instruments is meant to change the volume and value of money supply.

1.7 Limitations of the Study

One of the major limitations of the study is the use of MPR as a proxy to capture monetary in Nigeria. In practice, CBN uses other instruments like OMO, Liquidity ratio and Cash reserve

Requirement to compliment variation in MPR in achieving Economic growth. The use of prime lending rate (excluding the maximum lending rate) for interest rate could also be a challenge toward producing the accurate and most reliable outcome. In a nutshell, there is likelihood that the research model has omitted some important explanatory variables.

Furthermore, the accuracy and the reliability of the data produced by NBS, CBN etc. used in this study cannot be guaranteed. Finally, the study might be seen as restrictive because any development (in the variables examined) before December, 2006 and after February, 2012 is considered to be beyond the scope of this study.

1.8 organization of Study

The work is divided into chapters to ensure that there is a clear understanding of the issue of monetary policy and economic growth in Nigeria. The study is arranged as follows. Chapter 1 consists of the introduction, statement of the problem, objectives, research problem, justification of the study, scope of the study, and outline of the study. Chapter 2 contains the literature review and analytical framework. This is a simple and brief general review of issues surrounding the topic of study as well as an examination of past and relevant literatures done by others in relation to the topic of study. Chapter 3 comprises the research methodology and it seeks to find and explain an economic theory which can be associated with the study. Chapter 4 shows the empirical analysis which is simply the presentation of results and their analysis and interpretation. Chapter 5 consists of summary, conclusion, policy recommendation, and suggestions for further research.

Chapter Five

Summary, Conclusion and Recommendations

5.1 Summary

The study theoretically and empirically investigated how inflation, interest and exchange rate respond to shocks in monetary policy (captured by MPR). The research work used monthly data, beginning from December, 2006 (when the MPR was introduced) through February, 2012. The Structural VAR was employed to estimate the model, where the impulse response revealed how the inflation, interest and exchange rates 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. Exchange rate 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 exchange rate 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 exchange rate as well as MPC meetings can be used to predict MPR.

5.2 Conclusion

The study concludes that both interest (prime lending rate) and exchange rates 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 exchange rate. We also conclude that MPR is also responsive to Monetary Policy Committee (MPC) meetings.

5.3 Recommendations

  1. Other monetary policy 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 monetary policy 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 monetary policy 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 Monetary Policy must strive, the credibility of CBN should be held in high esteem especially under condition of uncertainty.

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