ABSTRACT
This study examines the long-run demand for real broad money function and its stability in Nigeria for the period from 1970 to 2012 inclusive. The study employs the Augmented- Dickey Fuller and Phillips-Perron tests for unit root, the Gregory-Hansen (1996a, b) cointegration test to capture endogeneous structural breaks in the cointegrating vectors of Nigerian long-run money demand function, cumulative sum of recursive residuals (CUSUM) and cumulative sum of recursive residuals squares (CUSUMSQ) tests for structural stability proposed by Brown, Durbin and Evans (1975). In estimating the canonical specification models, extended specifications are also presented. The results of the cointegration test suggest that demand for real broad money went through a regime shift in 2005. The results further confirm that there exists a long-run relationship amongst real broad money demand, real income, real domestic interest rate, real exchange rate, rate of inflation and foreign interest rate. However, the result of CUSUMSQ shows that the demand for money function is stable, but has undergone some temporary periods of instability. Hence, the apex bank in Nigeria should target the broad money (M2) aggregate to achieve macroeconomic objectives. Keywords: Demand, Money, Cointegration, Stability, Structural.
CHAPTER ONE INTRODUCTION
1.1 Background to the Study
Conventionally, a good understanding of the stability and determinants of the demand for real money balances forms the core in the conduct of monetary policy as it enables a policy- driven change in monetary aggregates to have predictable influences on output, interest rate, and ultimately price (Sriram, 1999; Nachega, 2011; Halicioglu and Ugur, 2005). Hence, a stable money demand function serves as a stabilization policy which depends on the ability of central bank to adjust money supply to its demand in order to prevent monetary disturbances from inhibiting real output. It is argued that the relationship between money supply on one hand and prices, income, and balance of payment on the other is determined by the demand for money, and such relationship plays an important role in macroeconomic theory. Several important factors have influenced and shaped the evolution of empirical research on the demand for money. First, there is evolving nature of theories on the demand for money. Second, the growing arsenal of econometric techniques that has permitted more sophisticated investigation of dynamics, functional forms, and expectations. Third, and most importantly, research has been spared by the apparent breakdown of existing empirical models in the face of newly emerging data (Tahir, 1995).
Thus, faced with the objective of maintaining price stability, the Central Bank of Nigeria (CBN) strives to promote and maintain monetary stability through efficient management of debt and exchange rate stability. In essence, appropriate demand and supply management policies by the CBN necessary for economic development requires money to be stable and functional (Nwafor, Nwakanma, Nkansah and Thompson, 2007). Therefore, considerable effort has been made in the empirical literature – for both industrialized and developing countries – to determine the factors that affect long-run demand for money and assess the stability of the relationship between these factors and various monetary aggregates (Nachega,
2001). In sum, with the presence of structural changes in the economy such as the structural adjustment programme (SAP) of 1986, political instability, political crises, the global economic and financial crisis which started in 2008 and innovations in the financial sector, it remains imperative to question whether monetary targeting remains relevant in the conduct of monetary policy.
1.2 Monetary Policy Management Framework in Nigeria
The main objective of monetary policy in Nigeria is price stability. Inflation is a monetary phenomenon which the apex bank uses monetary policy instruments to manage. Hence, the target on money supply growth as a method of targeting inflation. As a result, inflationary pressures continue to moderate partly in response to the tight monetary policy and base effect (CBN, 2013).
1.2.1 Price and Monetary Developments
In 2012, inflation moderated but remained a double digit. The year-on-year headline inflation declined from 12.9% in June to 12.0% in December. The decline was attributed to the stability in the supply of petroleum products, following the partial removal of the subsidy on premium motor spirit (PMS) in January and the tight monetary policy stance. In 2013, the year-on-year headline inflation declined from 9.0% in May to 8.4% in June. Also, core inflation declined significantly to 5.5% in June, from 6.2% in May and 6.9% in April, respectively. Notwithstanding the moderation in headline inflation, there are benign risks on the horizon, including the possibility of accelerated fiscal releases in the later part of the year and the effects of the upward review in electricity tariffs. The six-month inflation outlook indicates that inflation would remain within single digit territory due to base effect and tight monetary policy. However, the current state of government finances is likely to generate increased borrowing (CBN, 2013).
On the other hand, the growth of money supply remained modest in the second half of 2012 relative to the benchmark for 2012. By end-June 2012, broad money supply grew by 12.2%, compared to 1.4% recorded at the end of the preceding half year. The development reflected the respective growth rates of 20.9% and 4.8% in net foreign assets and domestic assets of the banking system. In 2013 broad money (M2) grew by 0.71% as at end-June 2013 over the level at end-December 2012. When annualized, M2 grew by 1.42%, compared to the growth of 2.70% in the corresponding period of 2012. Thus, M2 growth was also significant below the growth benchmark of 15.20% for 2013 and 7.60% for second quater of 2013. The CBN’s monetary policy stance is expected to remain tight in the first half of 2013, given the 12.0% inflation (year-on-year) in 2012 (CBN, 2013).
1.2.2 Historical Evolution of the Current Monetary Policy in Nigeria
The CBN’s focus on price stability objective represents a paradigm shift from past practices in which the promotion of rapid and sustainable economic growth and employment were the overriding objectives of monetary policy. Prior to 1986, in order to achieve its objective of sustainable growth and employment, the CBN relied on the use of direct (non-market) monetary policy instruments such as credit ceilings on the Deposit-Money of Banks (DMBs), administered interest and exchange rates, as well as prescription of cash reserves requirements. The most popular instruments of monetary policy were the setting of targets for aggregate credit to the domestic economy and the prescription of low interest rates. With these instruments, the CBN hoped to direct the flow of loanable funds with a view to promoting rapid development through the provision of finance to preferred sectors of the economy (agriculture, manufacturing, and residential housing) (Onafowora and Owoye,
2007).
Notwithstanding the huge oil revenues since 1970’s, government has been reckless in spending. A particular military head of state once exclaimed that the problem of Nigeria is not money, but how to spend it. Thus, the government went into spending spree and invited the whole world for the Festival of Arts and Culture (FESTAC) in 1977. As a result, the economy was plunged into a quackmire of twin deficit. The government resorted to borrowing from the CBN, the International Monetary Fund (IMF), and the World Bank to finance the deficits.
The government also adopted austerity measures in 1982. The austerity measures achieved some success by 1985 as inflation fell to a single digit, the external current account moved from deficit to balanced position, and real GDP grew by 9.5%. However, improvements in the fiscal and external positions in 1985 proved transitory and failed to establish a basis for sustained economic growth (Onafowora and Owoye, 2007). However, as a policy option to put the Nigerian economy back on the path of sustainability, the government adopted the IMF sponsored Comprehensive Structural Adjustment Programme (SAP) in July 1986. The SAP involved both structural and sectoral policy reforms. The main strategies of the SAP were the liberalization of the external trade and payment system, the adoption of a market-based exchange rate in 1985 for the domestic currency (Naira), the elimination of price and interest rate controls, as well as reliance on market forces as the major determinant of economic
activity. The adoption of SAP marked the start of a regime of financial sector reforms characterized by the free entry and free exit of banks and the use of indirect (market-based) monetary control instruments for implementing monetary policy in Nigeria (Nnanna, 2001).
The developments in the Nigerian economy since 1986, and most importantly, the adoption of M2 as an intermediate target for monetary policy by the CBN pose two central questions: Is the real M2 money demand function stable as an intermediate target? Is the CBN justified in its choice of M2 as a target? The recent developments in monetary systems and the increased openness may have caused the money demand function to be unstable. The monetary implications inherent in these questions cannot be over-emphasized. If the money demand function is unstable and experiences substantial shifts over time, then the income velocity of money will be unpredictable, and the quantity of money may not be a good predictor of economic activity. In other words, the choice of M2 as an intermediate target portends serious economic problem for Nigerian monetary authority if M2’s demand function is found to be unstable (Onafowora and Owoye, 2007).
1.3 Statement of the Problem
The Central Bank of Nigeria has over the years sought a predictable and stable money demand function. This is due to the fact that a stable money demand function contributes to broader economic growth and rising standard of living. Thus, the re-examination of the question whether demand for money has remained stable during the financial reforms which started in 2005 in Nigeria is imperative. It is often suggested that financial market reforms could lead to an unstable demand for money and changes in money velocity with attendant consequences for monetary policy implementation. In countries where the central bank targets a money aggregate, for instance using reserve money to implement monetary policy, the effectiveness of monetary policy rests on the stability of the monetary transmission mechanism as well as velocity of money. When this relationship is subjected to unexpected shifts, monetary targets lose their transparency and are less able to accurately signal the appropriate stance of monetary policy. This argument has been used as a reason for moving to inflation targeting, which does not rely on the stability of money demand, but instead uses a broad range of information to assess the monetary policy stance (Dagher and Kovanen,
2011).
The velocity of money has been fluctuating in Nigeria. For instance, it was 5.4 in 1970, 2.5 in
1986, 4.6 in 1989, 4.6 in 2006, 2.6 in 2009, and 3.0 in 2011 respectively. This fluctuation in the velocity of money poses big challenge to the Central Bank of Nigeria in its monetary aggregate targeting in particular and monetary policy formulation in general. Again, it can be seen that the velocity of money in 1986 (2.3) and 2009 (2.6) was remarkable. These figures show that there was structural change during the two periods. During the Structural Adjustment Programme in 1986 and the “bailing out” of commercial banks in 2009, lots of money was injected into the economy. This led to a decreased velocity of money and after then increased to 4.6 and 3.0 in 1989 and 2011, respectively. However, some empirical evidence on regime shifts report contradicting results. For example, Kumar, Webber, and Fargher (2010) reported break dates in 1986 and 1992, whereas Chukwu, Agu, and Onah (2010) reported 1994, 1996, and 1997 and Omotor (2011) reported 1981, 1992 and 1994 respectively. Thus, one of the objectives here is to investigate the existence of a long-run broad money demand equilibrium relationship in the presence of structural breaks due to its significance for monetary policy.
If the money demand function is unstable and undergoes substantial instability as Keynes thought, then velocity is unpredictable, and the quantity of money may not be directly linked to aggregate spending, as it is in the modern quantity theory. In recent years, the rapid pace of financial innovations has led to substantial instability of the money demand function and this calls into question whether the theories and empirical analysis are adequate. It also has important implications for the way monetary policy should be conducted, because it casts doubt on the usefulness of the money demand function as a tool to provide guidance to policy makers (Mishkin, 2004). Thus, what is being sought in a stable demand for money function is a set of necessary conditions for money to exert a predictable influence on the economy so that the Central Bank’s control of the money supply can be a useful instrument of economic policy (Tahir, 1995).
Therefore, the difference between the actual and targeted broad money (M2) growth in
Nigeria can be illustrated with figure 1 below:
Figure 1: Trending of targeted and actual broad money (M2)
70
50
40
30
27.43
20 19.8
34.5
22.32
48.07
24.11 24.35
57.88
45
targeted M2
actual M2
14.8
10
16.18
15.6 14.6 15 15
15.43
13.75
0
1991 1994 1996 1998 2000 2003 2005 2008 2011
Source: Researcher’s Computation with data from CBN
From the above figure, the discrepancy between targeted and actual broad money can be clearly seen. For example, in 1991, 1994, 1996, 1998, 2000, 2003, 2005, 2008, and 2011, the targeted and actual broad money growth were 19.8% and 27.43%, 14.8% and 34.5%, 16.8% and 16.18%, 15.6% and 22.32%, 14.6% and 48.07%, 15% and 24.11%, 15% and 24.35%,
45% and 57.88%, 13.75% and 15.43%, respectively. It is likely this mismatch exerts unpredictable influence on the economy and makes it difficult for the Central Bank of Nigeria to control money supply. Thus, the mismatch between targeted money supply (M2) and actual demand for money (M2) in Nigeria may be responsible to either partial knowledge of what constitutes the determinants of demand for money or the recent innovations in the financial sector. Yet, recent studies conducted on Nigerian economy report stable demand for money. The question is, if the demand for money function is truly stable in Nigeria, why is the CBN unable to predict correctly the demand for broad money? It is because none of the previous studies conducted on Nigerian demand for money used all the relevant potential determinants and a few do not employ the appropriate methodology. This is one of the motivations behind this study.
Hence, this study departs from previous studies due to the inclusion of all the relevant determinants such as yield on foreign real assets proxied by US interest rate and own rate of return and employs the most appropriate methodology for this type of study. Including these variables is predicated on the evaluation of macroeconomic situation and developments in the financial system and due to the fact that Nigeria is an open economy and has a high degree of openness as some studies like Nduka (2013); Nduka, Chukwu, Ugbor and Nwakaire (2013) show.
1.4 Research Questions
The following research questions shall be answered:
1. What are the robust determinants of demand for money?
2. What are the number and timing of endogenously determined regime shifts in the cointegrating equation of the demand for money function?
3. Is the demand for money function stable?
1.5 Objective of the Study
The broad objective is to analyze the demand for money function in Nigeria. The specific objectives are:
1. To investigate the robust determinants of the demand for money.
2. To find the number and timing of the endogenously determined regime shifts in the demand for money function.
3. To examine the stability of the demand for money function.
1.6 Research Hypotheses
The study hypotheses are:
Ho1: There are no robust determinants of the demand for money.
Ho2: There are no significant endogenously determined regime shifts in the demand for money function.
Ho3: The demand for money function is not stable.
1.7 Policy Relevance of the Study
The study would be relevant to the Central Bank of Nigeria (CBN), policy makers and researchers. This is because, if the demand for real money balances has a consistent or stable
relationship with its determinants, the changes in money stock would have predictable effects on income and output and the required change in the money stock to restore the equilibrium in the economy. In such a case, the Central Bank of Nigeria (CBN) can bring the desired changes in the economy by using monetary aggregates as a target variable. Thus, if the CBN relies on control of monetary aggregates as policy instruments, it must believe in a known and reliable connection between changes in that aggregate and changes in the arguments of the demand for money function, in order for its policy to have predictable effects. Furthermore, for any Central Bank, the stability issue of the money demand function is one of the most important guiding policy issues that helps decide whether to use monetary targeting strategy or inflation targeting strategy in the monetary policy in bringing the desired changes in the economy. Hence, the focal point for any central bank’s policy relies on whether the demand for money function is stable or not.
1.8 Scope of the Study
The models were estimated using annual (1970-2012) series. The choice of the period is informed by the availability of data which were sourced from CBN and IMF. The variables employed are real demand for broad money, real income, domestic real interest rate, real exchange rate, inflation rate and foreign interest rate.
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