Effects of monetary policy on inflation in Nigeria (1986-2013)

CHAPTER ONE INTRODUCTION
1.1    Background to the Study
Inflation is a controversial    term which poses an enormous challenge to economists. Inflation can be define has the persistent rise in the general level.
Nigeria's monetary policy is anchored on the monetary targeting framework and price stability which represents the overriding objectives of monetary policies. Monetary policy is therefore defined as a policy employed by the central bank in controlling of the money supply as an instrument for achieving the objectives of economic policy. It is therefore a combination of the measure designed to regulate the value, supply and cost of money in the economy in consonance with the expected level of economic activities (Central Bank of Nigeria). Many economic scholars of economics are of the view that inflation is strictly a monetary phenomenon. These scholars argue that inflation occurs when the rate of growth of the money supply is higher than the growth rate of the economy (Akcay, et a1 2000).
 Nigeria, at independence was an agrarian economy, feeding and generating income from the products of agriculture and exporting her surplus output to other countries of the world. The Nigerian economy was able to accomplish that because of her serious attachment to this all important agricultural sector coupled with the fact that she is highly bestowed with fertile soil that is very conducive for varieties of crop production (World Bank, 2010). However, with the discovery of oil in commercial quantities there was a turnaround of the focused attention on agriculture, hence many Nigerians and the government shifted attention to the quick income flowing from oil sector referred to as Dutch disease. Oil revenues led the Nigerian government to ignore agriculture and she was compelled by this situation to import farm produce to feed her people. The high demand resulted in pressure on prices, thereby affecting consumption pattern by way of inflationary pressure. The modern quantity theory led by Friedman holds that “inflation is always and everywhere a monetary phenomenon that arises from a more rapid expansion in the quantity of money than in total output.” According to him, inflation is based on an increased demand for goods and services as people try to spend their cash balances. This excess spending is the outcome of a rise in the nominal quantity of money supplied to the economy. The monetarists employ the familiar identity of Fisher's Equation of Exchange MV=PQ, holding the velocity and quantity constant, it can be deduce that M=P. The Keynesian school of thought is usually referred to as demand side economist. Keynes economic theory proposes that changes in money supply will not directly affect prices and that visible inflation is the result of pressure in the economic expressing them in
 price. Keynes emphasizes that increases in aggregate demand are the source of demand- pull inflation.
The history of inflation in the term of hyperinflation can also be traced to Weimar Germany in 1923 after losing World War I, Germany was forced to repay huge war debts to the victors. However, Germany was forbidden to use its “Papiermark” currency to pay reparations, as the flat currency's value had already declined significantly due to heavy borrowing to pay war costs. In order to pay its debts, Weimar Germany was forced to sell huge amounts of the mark for foreign currencies eligible to make payments with. The German government started selling marks at any price to get cash in the door, which eventually led to hyperinflation. Adolf Hitler rose to power in part as a result of this period of crazy hyperinflation. With prices doubling every 3.7 days and inflation at 29,500%, Germans were exhausted by the post-war reparations and were all too eager to hear Hitler's message. World War II left Hungary economically devastated. Thanks to being in a warzone, Hungarian reserves were already largely depleted by the time the war was over. Of course, taking of a ton of debt to help Germany fight in the war — a debt that was never repaid — didn't help. After the war, Hungary was forced to repay reparations to the Soviets. As the Allies took control of its budget and reparations reached nearly half of all revenues, hyperinflation set in. At its peak, inflation reached a mind-boggling 13.6 quadrillion percent — per month. The largest bank note denomination was 100 quintillion. The world's worst hyperinflation caused prices to double every fifteen hours.
 Imagine prices doubling every twenty-four hours. That's exactly what happened in Zimbabwe's run-in with hyperinflation in №vember 2008, when inflation reached unheard of levels of 79 billion percent. Eventually, runaway inflation caused the Zimbabwe government to ditch their currency and use the South African Rand or the US dollar... long after their citizens wished to do the same, of course. After Robert Mugabe's “land reforms, the Zimbabwe economy came to a screeching halt for years. Just as happened in Rhodeia in the 1970s, attempts to redistribute land from settler farmers sent the economy into a free fall, prompted capital flight, and sent people running for the hills. Of course, pouring money into neighboring Congo's civil wars didn't help, either. During this period of hyperinflation, a loaf of bread cost 35 million Zimbabwe dollars.
In a developing country such as Nigeria, the importance of money and its supply cannot be over-emphasized. This is due to the fact that excess supply of money in an economy results in excess demand for goods and services, which would cause rising prices and deterioration of balance of payment positions. On the other hand, an inadequate supply of money could induce stagnation thereby retarding growth and development. Over the years, the objectives of monetary policy in Nigeria have remained the attainment of internal and external balances. Consequent to this, the monetary authorities must attempt to keep the money supply growing at an appropriate rate to ensure sustainable economic growth and maintenance of internal and external price stability through the use of effective monetary policy instruments. The Central Bank of Nigeria does this with respect to the Central Bank of Nigeria Act of 1958 where it has been empowered as the sole institution for the operation of monetary policy measures.
Inflation has been a problem in Nigeria since the 1970s when the country's weak economic base became problematic, especially as from the late 1970s. There were all sorts of disequilibria in the economy resulting from an imbalance between the spending power and the productive capacity of the economy. The disequilibria were caused by the rapid depletion of the external reserves thus leading to disequilibrium in the balance of payments, and a rapid expansion of overall monetary expenditure in the economy which helped to drive up prices (Omofa 2006). Also the Nigerian economy before the civil war experienced rapid credit expansion but owing to the civil war in 1970, the Nigerian economy witnessed an inflationary pressure such that the rate of inflation was recorded at 13.9%. (Gbosi, 1960). Other factors that fuelled inflation in the post civil war period were the unrealistic wage increase awarded by the Adebo and Udorji Commissions in 1971 and 1974 respectively. It was made known that since the mid-1970's it became increasingly difficult to achieve the aims of monetary policy which include; full employment, rapid economic development, maintenance of price stability and balance of payment equilibrium. Mbuto (2010) points out that market based instruments were not feasible before the war because of the under developed nature of the financial markets and the deliberate restraint on interest rate, hence the economy experienced inflationary fluctuations such that the rate of inflation increased to 16.02% in 1971 from 13.9% in 1970. In 1975, this rate skyrocketed to 33.9% though in 1980 it reduced to 9.97% probably because that was the year government resorted to borrowing from the Central Bank to finance huge deficits when oil receipts were not enough to meet increasing levels of demand. In 1981, 1983, 1984 and 1985, inflation rates stood at 20.56%, 23.21%, 39.58% and 5.52% respectively (CBN, 2001). This drastic fall in the rate of inflation could be attributed to the introduction and implementation of price control (maximum and minimum price legislation) and credit rationing of essential goods by the Buhari's and Idiagbo’s administration .
The Structural Adjustment Programme (SAP) was adopted in 1986 against the crash in the international oil market and the resultant deteriorating economic conditions in the country. The monetary policy was aimed at inducing the emergence of a market oriented financial system for effective mobilization of financial savings and efficient resource allocation. The main instruments of the market —based framework is the Open Market Operation (OMO) which was conducted using the Nigerian Treasury Bills Rate complemented by the cash reserve requirements and Discount Window Operations.
In August 1990, the use of stabilization securities for purposes of reducing the bulging size of excess liquidity in banks was re-introduced. The commercial banks' cash reserves requirements were increased in 1989, 1990, 1992, 1996 and 1999 (Anderson, 1988). In recognition of the fact that well — capitalized banks would strengthen the banking system for effective monetary management; the monetary authority increased the paid —up capital of commercial and merchant banks in February 1990 to N 50 and N 40 million from N 20 and N 25 million, respectively. Distressed banks whose capital fell below existing requirement were expected to comply by 31st March, 1997 or face liquidation. The minimum paid- up capital of commercial and merchant banks were equally raised to a uniform level of N 500 million with effect from 1st January 1997 and by December 1998, all existing banks were to recapitalize. The inflation rates between 1997 and 1998 were 8.549c and 9.98% respectively.
Akintola (2007) notes that in 2002, monetary policy implementation was faced with some challenges as the problem of excess liquidity persisted and the demand pressure in the foreign exchange market intensified. In order to encourage banks to reduce interest on lending, the Minimum Rediscount Rate (MRR) was reviewed downwards accompanied with moral suasion. These developments led to a fall in bank deposit and lending rate, particularly during the second half of 2002. The inflation rate during these periods of short and medium term regime stood at 13.68% in 2002, 14.02% in 2003, and in 2004. With the raising of the recapitalization policy to N 25billion, the inflation rate stood at 15.02% and in 2005 went up to 17.82%. It is indeed worthy of mention that the monetary policy strategy has remained unchanged till date and the resultant effect shows that inflation rates within 2008, 2009 and 2010 were 8.61%,
12.40% and 11.8% respectively (CBN, 2001).
Since independence, the monetary authority has employed regulatory policies to keep the economy in the right direction, but often times, there has been instability especially in prices of goods and services. This results in inflation which lessens the purchasing power or the disposable income of the people and therefore reduces their standard of living. This fluctuation in the rates of inflation raises doubt on the effectiveness of monetary policy tools and calls for urgent attention.
1.2    Statement of Research Problem
A study of this nature always gives rise to certain problems. The main problem that initiates this work is recurrence of general price instability, high levels of inflation in the economy, in spite of the numbers of monetary policies adopted and applied over the years. Increase in prices has always been a compelling problem to both policy makers and entire economy of Nigeria. There is per adventure more discussion on the question of prices than any other issue these days.
Also high level of inflation can destroy the store of value and role of money in an economy. It destroys the ability of households to use prices as a reflection of quality as it pushes prices away from what is perceived as normal. The result is that the use of profit criterion in investment decision making is diminished, medium of exchange role of money is also negatively affected.
Recently, these inflationary pressures have succeeded in bringing about depreciation in Nigeria's currency. Furthermore price increase in one sector of an economy will easily be spread to other sectors and most often the responsiveness may not be proportionate. The questions which this research attempt to address are:
•    What is the effect of monetary policy on inflation?
•    To what extent has the Apex monetary authority-the Central Bank of Nigeria addressed adverse changes in price?
•    What is the impact of the demand for reserve currencies (Dollars, Euros, Pounds, etc) on Nigeria's monetary policy?
1.3    Objectives of the Study
The study seeks to achieve the following objectives:
•    To examine the effects of monetary policy on inflation in Nigeria from 1986- 2013.
•    To analyze the impact of other determinants on inflation in Nigeria.
•    Nigeria's monetary policy and the demand for hard currencies (Dollars, Euros, Pounds, etc)
1.4    Statement of Hypothesis
This study has been designed to test the hypothesis that the monetary policies of the CBN and general inflation in Nigeria are unrelated. The research hypothesis will test two main hypotheses which are stated thus:
Ho: Monetary policy does not affect inflation in Nigeria. Hi: Monetary policy affects inflation in Nigeria
1.5    Significance of Study
This study is significant in the following ways:
•    The result of this research will explain how the apex monetary authority-the Central Bank of Nigeria addresses the changes in prices over time.
 •    The result will also tell us the function of government in influencing economic activities because inflation needs to be curtailed to avoid distortion.
•    The result of this research will tend to add to the existing works on the subject.
•    At the end of this research, the result will give us insight on the need to ascertain the effectiveness of policy in controlling inflation which is one of the major economic problems in Nigeria.
1.6    Scope and Limitation of the Study
The focus of this research is on the effectiveness of monetary policy to control inflation in Nigeria. The study relies on the secondary data of which the sources are the Central Bank of Nigeria (CBN), International Monetary Fund (IMF), World Bank, Federal Bureau of Statistics and other institutions publications. The study covers the period of 1986-2013.
1.7    Organization of the Study
This research work will comprise of five (5) chapters and they are organized as follows:
Chapter one will be the introduction; it will consist of the background of the study, statement of research problem, objectives of the study, scope of the study and organization of the study.
Chapter two will be the review of related literature on monetary policy effectiveness to control inflation. It contains the following headings; concept of monetary policy, monetary policy regime in Nigeria, the concept of inflation, objectives of monetary policy theoretical framework, and empirical study on the effect of monetary policy on inflation in Nigeria 1986-2013.
Chapter three will focus on the research methodology which embodies model specification, nature and sources of data, analytical tool and the concept of co-integration. Chapter 4 contains the presentation and discussion of result and policy issue.
Chapter 5 will be the summary of the findings, conclusions and policy recommendations.