The Interest Rate Channel of Monetary Policy in Nigeria. An Evaluation

Master's Thesis , 2021 , 86 Pages , Grade: 80.00

Economics - Monetary theory and policy

This study evaluates the direct and indirect interest rate channels of monetary policy in Nigeria. Quarterly data from 1993 to 2019 were sourced from the Central Bank of Nigeria’s Statistical Bulletin. The outcome variables were output and inflation and each channel consists of three steps of equations. Three Stage Least Squares estimation technique was used to perform a step-by-step estimation and evaluation of the channels. Then, the overall effect of monetary policy on output and inflation was determined.

Monetary policy is one of the two policies used by policymakers to adjust macroeconomic fundamentals when they deviate from their targets and to achieve a specific macroeconomic goal like full employment and price stability. The effectiveness of monetary policy in achieving these targets depends on the effectiveness of the monetary policy transmission channels. Theoretically, the interest rate channel of monetary policy transmission works directly through its effect on investment and indirectly through its effect on bank lending, asset prices, and exchange rate.

Table of Contents

CERTIFICATION

DEDICATION

ACKNOLEDGEMENTS

Table of Contents

List of Tables

List of Figures

Abstract

CHAPTER ONE: INTRODUCTION
1.1. Problem Statement
1.2. Objectives of the Study
1.3. Method of Analysis
1.4. Scope of the Study
1.5. Limitations of the Study
1.6. Plan of the Study

CHAPTER 2: BACKGROUND OF THE STUDY
2.1. Introduction
2.2. Overview of Monetary Policy in Nigeria
2.3. The Economic Environment
2.4. Policy Regimes
I. Monetary Targeting
II. Inflation Targeting
III. Price Targeting
IV. Exchange Rate Targeting
2.5. Monetary Dynamics

CHAPTER THREE: LITERATURE REVIEW AND THEORETICAL FRAMEWORK
3.1. Introduction
3.2. Theoretical Review
I. Direct Interest Rate Channel
II. Exchange Rate Channel
III. Asset Price Channel
IV. Bank Lending Channel
3.3. Methodological Review
3.4. Empirical Review
3.5. Framework of Analysis

CHAPTER FOUR: EMPIRICAL ANALYSIS
4.1. Introduction
4.2. Methodology
I. Data and Data Sources
II. Description of Variables
4.2.1. Model Specification
4.2.2. Estimation Techniques: Three Stage Least Squares
4.3. Descriptive Statistics and Pre-Estimation Test
4.4. Estimation Result
4.4.1. Analysis of the Direct Interest Rate Channel
4.4.2. Analysis of the Indirect Channel: Bank Lending
4.4.3. Analysis of the Indirect Channel: Exchange Rate
4.4.4. Analysis of the Indirect Channel: Asset Prices
4.5. Discussion of Results

CHAPTER FIVE: SUMMARY AND CONCLUSION
5.1. Summary
5.2. Recommendations
5.3. Conclusion

References:

List of Tables

Table 4.1: Selection of Optimal Lag for Monetary Policy Rate in the Lending Rate Equation19

Table 4.2: Optimal Lag Selection for Monetary Policy Rate in the Private Sector Credit

Table 4.3: Optimal Lag Selection for Monetary Policy Rate in the All Share Index Equation

Table 4.4: Optimal Lag Selection for Monetary Policy Rate in the Exchange Rate Equation

Table 4.4b: Apriori Expectation

Table 4.5: Summary Statistics

Table 4.6: Augmented Dickey-Fuller Test

Table 4.7: Phillips-Peron Test

Table 4.8:Three Stage Least Squares Estimate for Interest Rate Channel (Output)

Table 4.9: Three Stage Least Squares Estimates for Interest Rate Channel (Inflation)

Table 4.10: Three Stage Least Squares Estimates for Bank Lending Channel

Table 4.11:Three Stage Least Squares Estimates for Exchange Rate Channel (output)

Table 4.12: Three Stage Least Squares Estimates for Exchange Rate Channel (inflation)

Table 4.13: Three Stage Least Squares Estimates for Asset Price Channel (Output)

Table 4.14: Three Stage Least Squares Estimates for Asset Price Channel (inflation)

List of Figures

Figure 3.1: Schematic Representation of the Direct Interest Rate Channel

Figure 3.2:Schematic Representation of Exchange Rate Channel

Figure 3.3:Schematic Representation of Asset Price (Investment effect) Channel

Figure 3.4: Schematic representation of the asset price (wealth effect) channel

Figure 3.5:Schematic representation of the Bank Lending Channel

Figure 4.1: Time Series Plot of Nominal GDP

Figure 4.2: Time Series Plot of Inflation

Figure 4.3: Time Series Plot of Monetary Policy Rate

ACKNOLEDGEMENTS

All praise and adoration be to Almighty Allah, the lord of the universe. I bear witness that there is no deity worthy of worship apart from Almighty Allah. I seeks his blessing on the noble soul of Prophet Muhammad, his households, his companion and those that follow their footsteps to the day of reckoning.

My appreciation goes to my parents – Mr and Mrs Oladepo – who stood by me with their financial and spiritual support during the course of this programme. My sincere appreciation also goes to Alhaji Rasheed Oladepo for all his support right from the secondary school till date. My appreciation goes to my wife who has been my pillar of support for the duration of this programme.

I appreciate the effort of my dependable and approachable supervisor – Professor Remi Ogun – who despite his busy schedule took his time to provide guidance to me throughout the course of writing this thesis. I must confess you have made an indelible impression on me. Thank you, Sir.

I also appreciate my siblings, all of them, for their support and prayers. I also appreciate all my colleagues in the department and outside the department, friends and well-wishers. I say thank you all.

Abstract

Monetary policy is one of the two policies used by policy maker to adjust macroeconomic fundamentals when they deviate from their targets and to achieve a specific macroeconomic goal like full employment and price stability. The effectiveness of monetary policy in achieving these targets depend the effectiveness of the monetary policy transmission channels. Theoretically, interest rate channel of monetary policy transmission works directly through its effect on investment and indirectly through its effect on bank lending, asset prices and exchange rate. Thus, this study evaluate the direct and indirect interest rate channels of monetary policy in Nigeria. Quarterly data from 1993 to 2019 were sourced from the Central Bank of Nigeria’s Statistical Bulletin. The outcome variables were output and inflation and each channels consists of three steps of equation. Three Stage Least Squares estimation technique was used to perform a step-by-step estimation and evaluation of the channels. Then, the overall effect of monetary policy on output and inflation was determined. Before estimating the model, a stationarity test was conducted and we found that all variables except GDP growth were I(1). We therefore adjusted the model by using the first lag of the variables as instruments in all the equation. The result showed that indirect interest rate channel through the asset price and bank lending are the most effective transmission channels of monetary policy in Nigeria. The direct interest rate is weak while the indirect channel through exchange rate is inoperative in Nigeria.

CHAPTER ONE: INTRODUCTION

1.1. Problem Statement

Monetary policy serves two major purposes to monetary authorities. First, it is used to adjust macroeconomic fundamentals when they deviate from their targets. Second, it is used to achieve a specific macroeconomic goal like full employment and price stability. While the monetary policy may generate the desired outcome, it may not generate the desired outcome. (Cevik and Tescos, 2012). The effectiveness of monetary policy transmission channels greatly determines systematic policy changes designed to achieve one or more macroeconomic goals (Iddrisu and Alageide, 2020). The mechanism through which monetary policy transmits to the economy is one of the most unsettled issues in Nigeria and other emerging market economies (Obafemi and Ifere, 2015). As enshrined in section 2(a) of the Central Bank of Nigeria’s (CBN) Act of 1958, the CBN is charged with the mandate of promoting price stability, and recent debate has grown on the need of expanding the primary mandate to reduce unemployment which connotes promoting economic growth (CBN, 2017).

The CBN has monetary policy tools at her disposal which she adjusts to affect economic activities and achieve the desired aim. The traditional view of the monetary policy transmission was the interest rate channel. In this channel, an increase in the money supply reduces the interest rate. The fall in interest rate increases investment which in turn leads to a rise in output. However, it was later discovered that apart from the direct link between interest rate and investment, change in interest rate could transmit through equity prices or loanable funds to investment. These are the asset price and bank lending monetary policy transmission channels respectively. In addition, the interest rate may influence the net export through the exchange rate. This link is known as the exchange rate channel. Thus, the channels of monetary policy include interest rate, bank lending, asset price, and exchange rate channels. However, it is yet unclear whether all of the channels are effective. Suppose not all of the channels are effective; which of the channels effectively transmit the effect of CBN’s activities to the real economy?

The CBN has taken different measures to achieve its objectives. However, the policy has failed to have the desired impact, and the transmission mechanism remains largely uncertain (Obafemi and Ifere, 2015). For example, the CBN moved from a direct approach to a market-based approach to eliminate ineffectiveness in the financial system. The Open Market Operation (OMO) was the main instrument adopted and reserve requirement was later introduced to complement OMO so as to achieve the objectives of price stability and stable output. Foreign exchange interventions were also adopted to stabilize the exchange rate (CBN, 2017; Igharo et al., 2020). Despite these efforts, output fluctuation, unemployment, inflation, and exchange rate fluctuation remain high.

Understanding the mechanism through which monetary policy affects the economy is important for evaluating monetary policy stance in a particular period. For example, a lower interest rate is seen as expansive, but when the effect on other asset prices and quantities is known, the policy may be restrictive (Boivin et al., 2010). Moreover, using the right policy for the situation depends on a correct assessment of the policy's timing and effect on the economy. Adequate knowledge of the mechanism through which monetary policy transmits to the real economy is essential to making such an assessment (Boivin et al., 2010). Furthermore, the economic effect of a monetary policy measure is altered by the economic structure changes, which necessitates that the central banks be alert to the impact of these structural changes. Thus, the channels through which the monetary policy affects the economy need to be continuously reinterpreted and re-evaluated (Kamin et al., 1998)

Empirical evidence on monetary policy transmission in Nigeria is mixed and contradictory (Ndekwu, 2013; Hassan, 2015; Obafemi and Ifere, 2015; Adeoye and Shobande, 2018; Igharo et al., (2020). Obafemi and Ifere (2015), Philip and Muibi (2011) found that the interest rate channel is effective but Hassan (2015) found it very weak. Adekunle et al. (2018) found that the exchange rate is the most effective channel. The position was supported by the findings of Hassan (2015), Philip, and Muibi (2011). However, Obafemi and Ifere(2015) found that the exchange rate channel is less effective. Similar contradictory results were found for the other channels.

The inconclusive result has been found for both developing countries and developed market economies. One major reason for such a result is the fundamental flaw inherent in the formulation of models and techniques used in the studies. Theoretically, the different channels through which the monetary policy affects the economy are: the traditional interest rate channels, exchange rate channels, bank lending channels, and asset price channels (Hassan, 2015; Iddrisu and Alagidede, 2020; Kamin et al., 1998) with the effectiveness of these channels are assessed by looking at the effect of variables representing each channel on an outcome variable. For example, the interest rate channel is interpreted as the effect of interest rate on output. The effect of the exchange rate on output is interpreted as the exchange rate channel while the effect of equity price on output is interpreted as the asset channels. This kind of analysis failed to capture the whole picture of the monetary policy transmission process. Understanding the reason for this claim requires the understanding of the important role interest rate plays, not only the traditional interest rate channel but also all the other transmission channels. In the lending channel, an expansionary monetary policy that reduces interest rate increases liquidity in the banking system. The increase in the supply of loans reduces the lending rate which in turn affects households’ and firms’ consumption and investment decisions and ultimately increases economic activity. The exchange rate channel works thus: an expansionary monetary policy that reduces the interest rate makes the exchange rate depreciate. The depreciation in the exchange rate is transmitted to the output through net export. In the same vein, the interest rate affects asset prices such as bonds and equity. Thus, the mechanism of transmission for all channels is triggered by the interest rate and the effectiveness of these transmission channels depends on how well variables like exchange rate, asset prices, and lending rate respond to the interest rate. Estimating the effectiveness of each channel requires taking account of the important role of interest rate in all the channels. Unfortunately, this important role of interest rate in other transmission channels has not been accounted for in the empirical analysis.

The second drawback relates to the estimation method because previous studies have utilized Vector Autoregressive Model (VAR) and its variants to understand the mechanism through which monetary policy affects the real economy. However, as Bernanke et al. (2004) pointed out, the transmission of monetary policy shocks relies on the ordering of variables in the VAR system. The ordering of variables should be informed by theory. Still, the theoretical ordering of variables remains subjective as it relies on the authors' judgment, thereby leading to different inferences depending on how each researcher ordered the variables in the VAR system. The VAR model only identifies monetary shocks' effect, which forecloses central banks' ability to tailor monetary policy to achieve the desired outcome systematically. Moreover, the trigger effect of interest rate on other monetary policy channels cannot be accounted for in the VAR system.

Based on the identified gaps, this study aims to account for the important role of interest rate in other transmission channels that is besides the traditional interest rate channel. Moreover, we undertake a step-by-step estimation through the three-stage least squares technique, which can measure the effect of monetary policy for each link in the transmission chain. Based on CBN's goals identified earlier, we focused on the monetary policy transmission to domestic price level (Inflation) and output through the interest rate, exchange rate, asset prices, and bank lending channel. Hassan (2015) took a comprehensive study of the monetary policy transmission channels for Nigeria but the study adopted the traditional VAR model with weakness and deficiency been identified earlier.

1.2. Objectives of the Study

The overall objective of this study is to evaluate the direct and indirect interest rate channels of monetary policy. The specific objectives are the following:

I. To ascertain the effectiveness of the direct interest rate channel in promoting price stability and economic growth.
II. To ascertain the effectiveness of the indirect channel through bank lending in promoting economic growth
III. To ascertain the effectiveness of the indirect channel through the exchange rate in promoting price stability and economic growth.
IV. To ascertain the effectiveness of the indirect channel through the asset price in promoting price stability and economic growth.

1.3. Method of Analysis

This study adopted three-stage least squares (3SLS) techniques to study the monetary policy transmission mechanism’s efficiency. This technique’s choice is based on the fact that a step-by-step effect of monetary policy is to be estimated and, as such, requires a simultaneous equation model. Even though various methods exist for estimating equations, the 3SLS provides the most consistent and efficient estimates. Each of the equations may be estimated by the Ordinary Least Squares (OLS), but the OLS assumed that the right-hand side variables are exogenous and, thus, uncorrelated with errors. Violation of such an assumption, which is a must for a simultaneous equation model, leads to inconsistent and biased estimates. This problem can be surmounted by the instrumental variable techniques where a two-stage regression that gives a consistent estimate even with an endogenous explanatory variable is employed. However, where the simultaneous models’ errors are correlated, the two-stage least squares do not provide efficient estimates. The solution for correlated errors is to use seemingly unrelated regression, which accounts for the correlation between errors but is inefficient when explanatory variables are endogenous. In the case where some right-hand side variables are endogenous, the seemingly unrelated regression (SUR) must be complemented with the two-stage least squares (2SLS). The combination of SUR and 2SLS results in the three-stage least squares (3SLS) technique. The 3SLS provides asymptotically efficient estimates because information inherent in the correlations among errors is utilized (Nosier and El-Karamani, 2018).

1.4. Scope of the Study

This study investigates the effectiveness of monetary policy transmission channels for Nigeria using quarterly data from 1993 to 2019. 1993 was chosen as the start point because it marked the transition of Nigeria’s Central Bank from a direct approach to monetary policy to market-based instruments. The endpoint was selected to reflect data availability as reliable data beyond 2019 is not available yet. The data were sourced from the Central Bank of Nigeria’s Statistical Bulletin of 2010-2019.

1.5. Limitations of the Study

The limitation of this study is that there is no developed diagnostic test for the method employed. This implies there is no way to test if the model violates some assumptions or not. As a result, the usual ceteris paribus assumption is made in respect of the findings.

1.6. Plan of the Study

The study is organized into five chapters. Chapter one introduces the study. Chapter two provides the background to the study. Chapter three presents the review of theoretical, methodological and empirical literature. Chapter four presents the result of empirical analysis. Chapter five summarizes the result and concludes

CHAPTER 2: BACKGROUND OF THE STUDY

2.1. Introduction

This chapter provides the background for the study of monetary policy. It is divided into four sections. Section 2.1 introduces the chapter. In section 2.2, an overview of monetary policy in Nigeria was provided. Section 2.3 discussed the economic environment in which the CBN conducts its monetary policy. Section 2.4 discusses the different monetary policy regimes.

Policy regimes like inflation targeting (IT), price targeting, exchange rate targeting, and money targeting were discussed.

2.2. Overview of Monetary Policy in Nigeria

The Central Bank of Nigeria was established by the CBN act of 1958 to oversee and administer the monetary and financial sector policies of the Federal Government (CBN, 2021). 1964 marked the year when the CBN put forward, for the first time, a bundle of monetary policy to combat the problem of inflation and the country’s depleting external reserves (Ndekwu, 2013). The external reserves had fell from a yearly average of $161.60 million in 1960 to $159.69 million in 1962 and further to $133.94 million in 1963 (CBN’s Statistical Bulletin, 2010). The CBN during this period used one or a combination of varying Minimum Rediscount Rate (MDR), moral suasion, provision of administrative compositional variation in the liquid assets of the commercial banks, and control of commercial bank’s loans and advances (CBN,1979; Ndekwu 1990). The CBN had reduce MDR from 6.25% in 1960 to 4% in 1963 but increased it to 5% from 1964 till 1968 (CBN’s Statistical Bulletin, 2010).

Monetary policy in the Pre-SAP era focused on stabilization and was mainly to support the fiscal operations of the government. Even though an attempt to strengthen the CBN was made through various amendment decrees to the CBN and the banking sector. For example, the Banking decree promulgated by the military administration of General Yakubu Gowon extended CBN’s power to include monitoring and approval of bank’s advert. Moreover, CBN authorization is now needed for opening and closing of banks. There was also upward review of bank’s paid up capital from £250,000 to £300,000 for indigenous banks and £750,000 for foreign banks (Okanya and Paseda, 2019). The CBN relied on the government’s fiat to support its operation. The period is a period of monetary control where fiat was used to administer monetary variables like commercial bank’s lending rate, deposit rates, allocation, and growth of credit. Moreover, there is direct control of capital flows, and a fixed exchange rate was the order of the day. The CBN during this period is largely dependent and operated as a department of the Finance Ministry (Mordi, 2009).

Fiscal policy dominated monetary policy during this period which can be described as an era of fiscal dominance and financial repression. For example, a 1968 military decree granted monetary and banking policy authority to the Federal Executive Council. Monetary policy instruments like allocation of credit, interest rate, and banks’ liquidity ratio were used to support the government’s fiscal operation. The fiscal authority has much influence on the level of interest rate which was usually fixed and the CBN’s MRR was used as a ceiling on loan rates. For example, MRR was fixed at 5% between 1964 and 1968 and at 4.5% for the next seven years till 1975. Credit allocation was fully controlled such that banks were given the rationing formula i.e. they were told what specific percentage of loan to be allocated to a given sector of the economy. Part of the monetary policy process during this period is that CBN is to ensure that the target growth rate of credit and money supply be maintained. The exchange rate was controlled to regulate the movement of capital (Ndekwu, 1990; 2003,).

The introduction of the Structural Adjustment Programme (SAP) changed the face of monetary policy in Nigeria. The SAP was a policy aimed at liberalizing the economy and removing the distortions occasioned by the previous monetary control regime. There was decontrol and deregulation of prices and incomes and enhancement of interest rate and exchange rate variability. Interest rate that was below 10% during the pre-SAP era increased to 18.5% in 1989 and have reached 26% by 1993 (CBN’s Statistical Bulletin, 2010). Financial deepening was enhanced during the SAP period with an increase in the size of banks and financial institutions. By 1988, the number of commercial banks had grown to forty-two from twenty in 1980 while merchant banks grew to 24 from six in 1980 (Ibe, 1992). The total number of bank branches had grown by 50% from 1000 branches in 1984 to 1500 branches in 1988 and by 1991 the branches had increased to 2,140 comprising 57 commercial banks and 47 merchant banks (Ibe, 1992). Commercial banks’ assets was N 52.2 billion while the merchant bank’s asset was N 52.2 billion. This development however suffered a setback in the late 1980s and early 1990s when financial institutions had to exit due to financial distress and insolvency. 32 banks failed and wound up between 1994 and 1998 (NDIC, 2021). Moreover, the CBN took over the management of 18 distressed banks between 1994 and 1995. This development posed a great challenge for CBN in terms of developing policy that will make financial operations more sound and efficient. The SAP was expected to make the economy and financial sector market-driven but this was largely underachieved. The deregulation turned the real economy and financial sector from a controlled, public-driven sector to a private, market-driven sector. There was greater flexibility in CBN’s monetary policy operations. Even though SAP had its downside, nevertheless, it provides the opportunity for the CBN, in its monetary policy and bank consolidation initiative, to fully radicalize the financial sector (Mordi, 2009).

By the start of the new millennium, the CBN had realized the need to increase the efficiency in operation and service delivery of the financial sector, especially the banking sub-sector, which is essential to her monetary policy programming and effectiveness. However, the current structure of banks with the banking sector dominated by small and medium-sized banks with limited innovation in an era where advances in information and communication technology (ICT) have led to the development of e-banking, e-business, and e-commerce. This led the central bank to review and increase the minimum capital requirement in order to attain economies of scale in the banking sector. The CBN increased the banks’ capital base to N 25 billion in July 2004 (Babalola, 2011).

The interest rate was the principal instrument of monetary policy after the bank consolidation and is supported by open market operations (OMO). The Monetary Policy Rate (MPR) replaced the Minimum Rediscount Rate (MRR) as the anchor rate in December 2006. An amendment to the CBN act in 2007 saw the creation of the Monetary Policy Committee (MPC) headed by the CBN governor. The MPC assesses the country’s monetary and economic condition and based on the situation, the MPC sets the MPR to support the economy. Variation in the MPR is the most important tool of monetary policy after the consolidation of the banking sector. The CBN supports the MPR with the Open Market Operation (OMO) to mop up excess liquidity of the banking system if it is suspected. The total OMO bills of CBN as at 2019 totaled N13.8 trillion held by local banks, corporates and foreign investors (CBN, 2019). Allocation and supply of credit to banks and exchange rate policy are additional tools used by the CBN in the post-consolidation era. (Ndekwu, 2013).

2.3. The Economic Environment

The economic environment in Nigeria is one that poses a great challenge to CBN’s ability to meet its major goal of price stability and economic growth. The Nigerian economy is highly dependent on crude oil as it constitutes around 90% of export since the 1970s till date (Emefiele, 2019). Therefore, the Nigerian economy is exposed to shocks in crude oil price. During the oil boom of 1970s, total revenue from government increased by 20% from N1,168 million in 1970 to N1,405.10 million in 1971 and by 1973 it as quadrupled to N4,537.40 while it increased in six-folds to N6,765.90 in 1975. By the end of the decade, government revenue has reached as high as N15, 233.50 million. During this period, oil contribution to revenue increased from 26.28% in 1969 to as high as 81.38% in 1978. However, with the oil glut in 1980s, government revenue fell for the next four years falling from N15, 233.50 million in 1979 to N13, 290 million in 1980 and further down to N10, 508. 70 million in 1982. Revenue from oil also fell from N12, 353.30 million in 1979 to N7, 253 million in 1982¹.

The major recessions that the country has faced over the years are associated with a collapse in the price of crude oil in the world market except for the 2008 financial crisis. Crude oil is the major source of revenue to the government and due to the undeveloped manufacturing sector and less developed tax collection mechanism as well as corruption in the tax system; revenue from taxation is very low. Thus, when the oil price falls in the international market, there is low revenue, and the government resorts to domestic borrowings which the central bank may need to mop up in the long run. During the fall in global crude oil price in 2015, government’s revenue fell from N10, 068.85 billion in 2014 to 5,616.40 billion in 2016 while domestic borrowing increased by 40% from N7, 904.03 billion in 2014 to $11,058.20 billion1. In addition to the decline in global oil price, civil unrest and destruction of oil infrastructures in the oil-producing regions reduce the daily production capacity creating a two-fold reduction in revenue generated from oil.

The shock in oil price also transmits to the Nigerian economy through the foreign exchange market. Since the country relies solely on oil proceeds for foreign reserve, a fall in oil price results in depleting foreign exchange and it becomes difficult for manufacturers and traders, who need foreign exchange to purchase inputs, to access foreign exchange. They resort to the unofficial market which affects the exchange rate. For example, between 2014 and 2016, the average monthly foreign exchange inflow fell from $3.4 billion to $500 million (Emefiele, 2019). The exchange rate rose from ₦200/$ in 2015 to ₦525/$ in 2017. Inflation rose from single digit in 2016 to 18% in 2017 (Emefiele, 2019). Real GDP was growing at 6.2% in 2014 but fell to -1.6% in 2016 with the economy entering a recession in the second quarter. The CBN responded by raising interest rates to attract capital inflow and tame inflationary pressure through exchange rate pass-through. Moreover, to conserve the foreign exchange, CBN restricted access to 43 items on the import bill.

The low level of manufacturing in the country implies that the economy relies on imports to meet the demand of basic to complex needs. Vegetable products constitutes 8.54% and 6.24% of import bill in 2017 and 2018 while foodstuff constitutes 7.69% and 5.54% of import bill for the same period. The reliance on import made the country vulnerable to exchange rate shock and it is observed that any depreciation/devaluation of the exchange rate is reflected in the price level. During the 2016 oil price fall, with the exchange rate devaluated from N196 to N306; the consumer price index (CPI) rises from 213.6 in December 2016 to 246.4 in December 2017 and further to 274.6 in December 2018. Moreover, unemployment is rising as millions of youths are unemployed due to largely undeveloped industries. According to statistics from National Bureau of Statistics (NBS), unemployment increased from 16.20% in 2017Q2 to 23.13% in 2018Q3. Agriculture still constitutes a major source of employment although it is done mostly in rural areas. The contribution of agriculture to total employment is between 34.97% and 50.57% from 1991 till date². The ease of doing business is very low as a lot of administrative bottlenecks coupled with poor infrastructure, limited access to capital makes establishing small businesses an uphill task. The ease of doing business increased from 133 of 190 countries in 2011 to 170 in 2015. By 2019, the ease of doing business is 131 of 190 countries and Nigeria ranked the 8th country in West Africa³. Unemployment and youth unemployment are therefore on the rise over the years which has increased the poverty level in the country. 39.1% of the population live below $1.90 per day in 2018⁴. Even though the primary objective of the CBN is price stability, they cannot ignore the importance of ensuring a stable exchange rate, reducing unemployment, stabilizing output as they have implications for the achievement of their ultimate target.

2.4. Policy Regimes

These are discussed under different subsections as follows:

I. Monetary Targeting

The quantity theory of money proposed that assuming constant velocity and aggregate output, a directly proportional relationship exists between money supply and price level. This means that other things being equal and under the stated assumption, the price will rise one-for-one for a given change in the money supply. This relationship forms the basis for which a central bank targets money supply under the monetary targeting framework. Therefore, monetary policy targeting is a framework where monetary aggregates are adjusted to achieve the macroeconomic goal of price stability (CBN, 2017). The central bank varies its instrument to control monetary aggregates to a level that supports the long-run goal. The effectiveness of monetary targeting depends on the stability of its relationship with the goal variable and its relationship with the monetary policy instruments (Croce and Khan, 2000). The major drawback with monetary targeting is that it is difficult to determine the appropriate monetary aggregate to target. Similarly, the selected monetary aggregate may not be difficult to manage with precision.

II. Inflation Targeting

Under inflation targeting (IT) the central bank has an explicit target for inflation rate and they inform the public of the inflation rate that is being targeted. Countries adopt IT because they believe the objective of long-run goals is best supported by price stability. Moreover, an attempt to manipulate monetary policy in the short run so as to achieve high employment or output may lead to price instability. Under this framework, the monetary policy adjustment depends on the divergence between the forecasted future path of inflation and the inflation target.

Successful use of the inflation target requires the independence of the central bank. The central bank should be free to choose instruments used to achieve the inflation rate it deems appropriate. This implies the culture of fiscal dominance should not exist is such a country i.e. there is low or no borrowing from the central bank by the government and the government does not significantly depend on seignorage but has a broad revenue base. Moreover, for IT to be effective, the central bank should be willing not to target any other indicators such as employment or exchange rate. This implies that a country operating a fixed exchange rate regime will hardly be able to practice IT. Such a central bank will face credibility issues because the public is not certain of which it is willing to give precedence. Apart from meeting these two requirements, the monetary authorities must announce an explicit target for inflation and indicate to the public that meeting the inflation target takes precedence over any other thing. In addition, a model to forecast inflation must be developed and a forward-looking procedure for manipulating monetary policy instruments to achieve the stated target (Debelle et al.,1998)

III. Price Targeting

Another alternative policy regime is the price targeting (PT) monetary framework. Under price targeting, the price level is kept on a steady growth path by the monetary authorities. This implies that the very long-run average inflation rate is kept at the growth rate of the price level. The difference between this approach and IT is when the inflation rate deviates from targets, the price-level targeters commit to reversing the temporary deviation (Bernake, 2017). Price-targeting has two advantages. One, it is consistent with low long-run average inflation. Second, it gives policymakers more scope to adjust interest rate during periods of zero lower bound (Hatcher and Minford, 2014).

IV. Exchange Rate Targeting

Under this regime, the central bank uses interest rate changes and direct foreign exchange interventions to stabilize the nominal exchange rate of the local currency in terms of an anchor currency (usually the US dollar). Exchange rate targeting is successful where the inflation differential between the adopting country and the anchor country is low. Also, it requires a sufficient level of international reserves. In addition, the credibility of the adopting country in terms of the legislative and institutional framework, competitiveness, and political stability are important factors. A country targeting an exchange rate, however, will lose its monetary policy autonomy. First, any shock in the anchor country’s economy will be reflected in the adopting country’s interest rate (Peturrson, 2000). Moreover, when there is a shock in the adopting economy, the ability of the central bank to use monetary policy is restricted.

2.5. Monetary Dynamics

Money is important in the life of any exchange economy because it is the only generally acceptable commodity in the exchange of goods and services. By this, it overcomes the inefficiencies of double coincident of want associated with a barter system. Similarly, money ensures that purchasing power can be carried over time as it is a store of value (Papademos and Stark, 2010). The ability of money to however effectively perform its role as a store of value is limited by inflation which was eventually labeled as a monetary phenomenon by Friedman.

The effectiveness of monetary policy has been debated. While the Keynesians believe there is a limited role for monetary policy, the Monetarists believe that monetary policy is effective. They believe that inflation is a monetary phenomenon and any central bank whose main objective is price stability should pay close attention to money (Papademos and Stark, 2010). The theoretical link between price, economic activity, and money is based on the quantity theory of money expressed as

Abbildung in dieser Leseprobe nicht enthalten

Equation 2.1 shows that the product of the total stock of money (M) and its velocity (V) must equal the nominal value of final output, PY, where Y is the real output and P is the price index. No inference could be made from equation 2.1 as it is purely an identity equation. However, if it is assumed that changes in nominal money are exogenous i.e. it is driven by money supply, equation 2.1 manifests a causal link going from money balances to the nominal value of output. It is assumed that velocity is constant which means the effect of an increase in M is shared by price and real output. The hypothesis of long-run neutrality of money proposes that money has no long-run effect on output. This implies that any change in nominal money will cause a proportional change in price. Thus, income and employment are determined, in the long run, by real factors like productivity and technology growth, labor force growth, and the institutional and political framework in an economy.

From the analysis, we could summarize the implication of the quantity theory of money for monetary dynamics in three points:

- Monetary policy is not effective in pushing real variables as money growth is reflected one-on-one in the price level.
- Monetary growth is temporarily reflected in real quantities and relative prices in the short run.
- The effect is from money in both short and long-run relationships between money, price level, and real quantities.

CHAPTER THREE: LITERATURE REVIEW AND THEORETICAL FRAMEWORK

3.1. Introduction

This chapter reviewed relevant literature relating to monetary policy transmission. The chapter contains four additional sections. Section 3.2 presents the theoretical review where theories relating to the monetary policy transmission channels were discussed. Section 3.3 presents the review of methodology while section 3.4 presents the review of the empirical literature. Finally, section 3.5 presents the framework of analysis.

3.2. Theoretical Review

Monetary policy is the use of monetary instruments to affect the level of economic activities towards achieving one or more macroeconomic goals. Monetary policy achieves these objectives through its impact on the financing condition of the economy, its effect on the cost of capital, changing the bank's appetite for certain risks, and reducing/improving banks' ability to create credit through variation in loanable funds. Moreover, monetary policy affects expectations regarding the level of economic activities. This affects agents’ consumption and investment decisions.

The monetary policy transmission mechanism is a process through which the central bank's policy, involving manipulation of interest rate or money supply, is reflected in the real economy through various channels (Hassan, 2015). Monetary policy can affect the economy from different channels. For example, when the central bank reduces the interest rate, there is a fall in the cost of borrowing. This action will affect the consumption decision of households and investment decision of firms. The reduction of interest rate leads to a decline in savings and investors may see investment in stock as more lucrative. The reduction in interest rate also reduces returns to international portfolio investors and discourages new investors thereby depreciating the exchange rate. The exchange rate depreciation is transmitted into the economy through export and import (Adekunle et al., 2018).

I. Direct Interest Rate Channel

This is the most traditional channel of monetary policy rooted in the interest rate effect on the user cost of capital. The demand for capital depends on the cost of capital which may be expressed as:

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Where i represents the nominal interest rate, pc is the relative price of new capital, is the rate at which capital asset price is expected to appreciate and is the depreciation rate. Eqn (3.1) can be rewritten as

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Equation (3.2) shows that the user cost of capital depends on the new capital’s relative price and the difference between post-tax real interest rate and expected real rate of capital asset appreciation. (Boivin, 2010). An accommodative monetary policy makes the long-run real interest rate fall which boosts investment and in turn boosts output. This suggests that it is the real interest rate that matters but not the nominal interest rate and also, the long-term interest rate matters but not the short-term interest rate (Mishkin 1996). However, the link between nominal and real interest rate as well as between short- and long-term interest rate have been supported by macroeconomic theory. The link between nominal interest rate and real interest rate is based on theories of price and wage rigidities (Loayza and Hebbel, 2002). The price stickiness ensures that policy that reduces short-term nominal interest rate also reduces short-term real interest rate (Mishkin, 1996). The expectational hypothesis of the term structure of interest rate provides the link between short- and long-term interest rates (Loayza and Hebbel, 2002). The hypothesis of the term structure of interest rate states that “long-term interest rate is an average of expected future short term interest rate, suggests that lower real short-term interest rate leads to a fall in the real long-term interest rate” (Mishkin, 1996).

The proposition that real interest rate is important for the interest rate channel has an important implication as it is proof against the liquidity trap. Even if the interest rate hits the floor of zero, an expansionary monetary policy may raise the expected price level and inflation. The real interest rate will fall and this stimulates investment spending and output (Mishkin, 1996). The interest rate channel is be represented schematically in fig 3.1

Figure 3.1: Schematic Representation of the Direct Interest Rate Channel

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Source: Designed by the Author

II. Exchange Rate Channel

Loayza and Hebbel (2002) suggested that the exchange rate channel of monetary policy transmission works in two ways. The first is the aggregate demand effect where a fall in interest rate under an accommodative policy leads to high net export and aggregate demand. Exchange rate depreciation triggered by the accommodative leads to high domestic prices for imported goods. For the aggregate supply effect, the price of intermediate input rises with exchange rate depreciation leading to a reduction in supply and price increases.

The effectiveness of monetary policy transmission through exchange rate depends on the exchange rate regime. Monetary policy shocks are less fairly transmitted to the economy under a fixed exchange rate compared to a floating exchange rate. Under a fixed exchange rate, monetary policy is often used to support the fixed rate (Mishkin, 1996; Loayza and Hebbel, 2002). The exchange rate transmission channel can be represented schematically as follows

Figure 3.2:Schematic Representation of Exchange Rate Channel

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Source: Designed by the Author.

III. Asset Price Channel

Monetary policy works through the asset price channels under the investment effect and wealth effect.

Investment Effect

Tobin (1969) formulated the q theory to explain how monetary policy is transmitted into the economy through its effect on equity price. According to him, q is the ratio of the firm’s existing shares’ market value to the replacement cost of capital. i.e.

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Where vt is the market value of a firm’s share and rc is the replacement cost of capital and t denotes the time dimension. When q is high, it means the firms’ market price is higher compared to the cost of replacing capital (Boivin, et al., 2010). Thus, if the stock price rises in relation to the cost of new capital and equipment, the firm is motivated to invest in new plants and equipment because the profit is higher. The equilibrium level of q is when q is 1. However, if q>1, the firm may gain more profit by investing more while when q<1, it is better for the firm to divest to reduce its holding of assets as they are bringing lesser returns on investment. Intuitively, an accommodative monetary policy that reduces interest rate raises economic activities and purchasing power of people. The surplus income is not spent on consumption but investment in the stock market. Increase demand for stock raises the price of the stock and consequently q. The high q means firms will increase acquisition of plant and equipment which leads to a rise in output and price level. The transmission channel is represented schematically in fig 3.3.

Figure 3.3:Schematic Representation of Asset Price (Investment effect) Channel

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Source: Designed by the Author

[...]

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¹ Data gotten from CBN statistical bulletin while the percentages were calculated by the author using the same data.

² World Development Indicator (WDI) data

³ https://www.doingbusiness.org/en/data/exploreeconomies/nigeria

⁴ World Development Indicator (WDI) data

• College: University of Ibadan
• Grade: 80.00
• Author: Riliwan Oladepo (Author)
• Publication Year: 2021
• Pages: 86
• Catalog Number: V1172300
• ISBN (PDF): 9783346598820
• ISBN (Book): 9783346598837
• Language: English
• Tags: interest, rate, channel, monetary, policy, nigeria, evaluation