1.1 BACKGROUND TO THE STUDY
The use of economic policy as tool for economic stabilization by governments of different economies of the world cannot be overemphasized. Some of these policy measures may have economic-wide effect (e.g. the budget and inflation) while others may have specific effects such as the consumption tax on consumer good (Killick, 1981 and Black, Calitz, Steenekamp, Ajam, 2000). Policymakers around the world employ various policies, singly or mix, to stabilize the boom-bust cyclical swings of economic activities. In macroeconomic management, the two most commonly employed policies are the fiscal and monetary policies.
The Monetary policy, managed by the Central Bank, is conducted through changes in the money supply and interest rate. While the Fiscal policy, which is managed by the government of that economy, is conducted through changes in government spending and taxes (Liborio, 2011; Hussain, Wijeweera and Hoang, 2012). Despite the fact that monetary and fiscal policies are implemented by two different bodies, these policies are far from independent. In fact, a change in one may influence the effectiveness of the other and thereby the overall impacts of any policy change. Since 1980s, there has been a general consensus among economists in favour of monetary policy as a more effective stabilization tool relative to fiscal policy (Mishkin, 2004; Mankiw, 2005; and Bullard, 2012), however, the recent global financial crisis of 2007 has renewed much interest on fiscal stimulus.
In recent times, policy makers are prompted to employ unconventional actions to stabilize the national economy. Precisely, while monetary policymakers turn to quantitative easing (the purchase of financial assets so as to lower long-term interest rates, thereby increasing the money supply), fiscal policymakers increase government spending and reduce taxes so as to boost employment and output (Liborio, 2011). The global economic meltdown, which persisted until 2009, had significant adverse effects on the real economic activities of many developing countries. For instance the Nigerian real GDP growth rate decline from 7.6 per cent in 2006 to 6.0 per cent at the onset of the crises in 2008. The effect of the global crisis was pervasive and its adverse effect remained noticeable in the areas of agriculture, industry and the wholesale sub-sectors in Nigeria (CBN, 2009). Similar trends were also observed in other countries of the world. To ensure that their economies are insulated or protected from the possible negative effects of such snowballing, many countries especially developing countries had resulted to the use of domestic macroeconomic policy to re-engineer their economy and provide some policy palliative that can assist in stabilizing their economies.
Nigeria in particular had, in response to the global economic crisis, introduced both monetary and fiscal stimuli as proactive measures to prevent the economy from nose-diving into further economic depression. The policy measures adopted by government were mainly on three broad fronts namely: monetary policy, fiscal policy and trade policy. In Nigeria, fiscal and monetary policies (especially the tools of government expenditure, money supply and monetary policy rate (MPR)) have been extensively used by the government and other policy makers to stimulate output.. In order to appreciate the policy-source of these variations in output performance over the years, it is necessary to take a retrospective look at the conduct of fiscal and monetary policy in Nigeria.
Fiscal policy conduct and administration in Nigeria is designed in line with the federal structure (one federal government, 36 state governments and 774 local governments) of the nation’s political system, while its implementation rest on the ministries, departments and agencies (MDAs), the public enterprises and the non-budgetary institutions with stakes in public policy. The primary objective of fiscal policy in Nigeria centres on high, rapid and sustainable economic growth among others, while the policy instruments being employed to achieve this objective include changes in tax rate, government expenditure and public debt operations of financing budgetary gap (Anyanwu, 1993 and 1997).
Prior to 1970, the constituent of government revenue is basically non-oil based (tax, loan, grant and aids etc.). However, since 1970s the government revenue constituent has drastically shifted to oil-based, which has made the nation’s economy to continually swing along the volatile international oil-market. Also, the Nigerian tax policy has been dynamic and decentralized though it is highly limited to the formal sector of the economy, while the informal sector is largely uncovered (Anyanwu, 1993). On the expenditure side, government expenditure profile has been on the rising side, with the recurrent expenditure continually outweighing the capital expenditure within a share range of 30-70% in 1960 to about 80-20% in 2007 (Mordi, Englama and Adebusuyi, 2010). Although, the introduction of Medium-Term Expenditure Framework (MTEF) in 2003 has improved the spending structure of government, much of the government budgetary gap is still being financed through debt (internal and external) as the total federally collected revenue could not meet up with total government expenditure. The Nigeria’s debt profile shows that the debt-GDP ratio (the proportion of the GDP financed by debt) rose from 4.9% in 1960 to 77% in 1990, fell to 28.5% in 1998 and narrowed down to 11.9% in 2006 after the external debt concession/forgiveness granted by the London club and Paris club of creditors. The high profile of the public debt has been attributed mainly to the expanding deficit structure of the fiscal balance.
On the other hand, the conduct and administration monetary policy in Nigeria rest solely on the Central Bank of Nigeria (CBN) through the CBN Establishment Act of 1958 as amended. The objectives of monetary policy in Nigeria have been dynamic, depending on the prevailing monetary regime, but all of them revolve round price stability. During the period 1959 – 1973, exchange rate targeting was adopted as the monetary policy strategy while fixed exchange rate was the anchor. However, monetary policy conduct became difficult due to inflationary pressure on the economy resulting from the oil boom of the 1970’s (Ajayi and Ojo, 2006). To resolve this, the CBN in 1974 adopted monetary targeting as the official monetary policy strategy. Initially, narrow money (M1) was the nominal anchor but the CBN switched to broad money (M2) in 1986 because the latter was found to be more stable and highly correlated to output compared to the former, and it has been in use till date (Mordi, Englama and Adebusuyi, 2010).
Under the monetary targeting framework, two broad policy regimes have been adopted, namely: direct and indirect monetary control. During the period of direct monetary control (1974 – August, 1993), the CBN imposes different credit controls and quantity restrictions on interest rates, while loans and advances were directed to specific sectors of the economy in order of priority. However, under this regime, the CBN lacks instrument autonomy as monetary policy was directed my ministry of finance, hence the possibility of incessant political interference. Meanwhile in September 1993, in line with the Basel Accord, the CBN embarked on indirect monetary control by using market-based instruments to regulate the growth of major monetary aggregates and dismantling all credit ceilings. The main instrument of CBN was the Open Market Operations (OMO) and complemented by cash reserve requirements and discount windows. But the CBN was not granted full instrument autonomy until 1998 (Ajayi and Ojo, 2006; CBN, 2010).
Prior to 2002, the CBN designed its monetary policy alongside fiscal duration of one year. However, due to the incessant problems of time-inconsistency in policy implementation and over-reaction of monetary policy to shocks, the CBN in 2002 commenced a two-year Medium-Term Monetary Framework (MTMF) which is still based on monetary targeting and market-driven instruments. The implementation of MTMF was successful to a great extent as there was significant improvement in output and other policy indicators (Mordi, Englama and Adebusuyi, 2010). With this confidence, the CBN in December 2006 reverts to the one-year duration, but this time, under a new monetary policy framework (NMPF) which has lasted till date. The aim of this new monetary policy framework is to reduce interest rate volatility and prepare the transition to full-fledged inflation targeting. Under this framework, a combination of inter-bank rate and money base are used as the operating targets while the intermediate targets are M2 and Prime Lending Rate (PLR). There was also the introduction of Monetary Policy Rate (MPR) to replace Monetary Rediscount Rate (MRR), interest rate corridor with band for lending and deposit facilities respectively and a Standing Lending Facility (SLF) at a fixed rate above MPR for deposit money banks (DMBs) (Ezema, 2009). More so, recent trend in monetary policy management has witnessed the use of quantitative easing by CBN, including the pegging of MPR at 12% since January 2012 till date, the cashless and cash limits policies. All these are directly or indirectly geared towards influencing aggregate output.
1.3 STATEMENT OF THE PROBLEM
Over the years, fiscal and monetary policies have been choicely employed by policy makers in Nigeria to influence and stabilize the behavior of the aggregate economy, with more focus on the tools of government expenditure, broad money and monetary policy rate (MPR) as the operating instruments. However, neither of these policies individually, could be unanimously said to have effectively stimulated economic performance consistently over time. For instance, evidence from CBN (2012) shows that, for the period 1974-75 (early days of monetary targeting), government expenditure increased by 117%, money supply rose by 80%, interest rate fell by 50 basis points but, surprisingly, output dipped by 5.2% in the same period. Whereas, in 1993-94 period (early days of partial monetary instrument autonomy), government spending fell by 16% while broad money rose by 34.5%, interest rate fell by 12500 basis points and output rose by a paltry rate of 0.1% for that period. Meanwhile in 2004-05 fiscal year (under the medium-term fiscal framework), government expenditure climbed 28% while broad money grew by 24%, interestingly, interest rate dipped 200 basis points and output increased by 5.4%. Surprisingly in 2010-11 fiscal period (under the new monetary policy framework), when government expenditure grew insignificantly by 2.5% but with significant growth in broad money by 15.4%, interest rate rose by more than 300 basis but still, output increased by 6.7% in the same period.
However, it is pretty difficult for policy makers to ascertain which of the fiscal and monetary actions is actually responsible for driving the economy at a specific point in time, and how the interaction between them have enhanced or inhibited output performance in Nigeria. In an attempt to unravel the uncertainty around fiscal and monetary policy effectiveness and interactions, various studies have been conducted, with different approaches. In fact, country-specific evidences on Nigeria have shown diverse results with two main strands; some in favour of monetary policy effectiveness (e.g. Ajayi, 1974; Asogu, 1998; Adefeso and Mobolaji, 2010; Okpara and Nwaoha, 2010; Iyeli, Enang and Emmanuel, 2012) while a few of them favours fiscal policy effectiveness (Aigbokhan, 1985; Egwaikhide, Enoma and Saheed, 2012).
The pro-monetary effectiveness studies argue that the effectiveness of the government fiscal policy in a country like Nigeria is very doubtful. Their argument is premised on the fact that: first, for many years, government has been practicing budget of incremental which has had little correlations with obtained economic performance. Even with the implementation of the Medium-Term Fiscal Framework (MTFF) since 2010, budget performance still remains abysmal. Secondly, the Nigerian economy comprises of a very huge informal sector which is largely untaxed and unaffected by the various tax reforms of the government over the years, thereby making the reforms less effective (Ogbuabor, 2013). More so, the rising trend of government spending over the years seems to have little correlation with growth. Evidence from research has shown that, many a times, large chunk of government expenditure for a proposed project is lost to corruption and individual’s subjective utility maximization of the bureaucrats while a little proportion of it actually trickles down for grassroots development, thereby making government spending to have a very weak link, or at best erratic effect, on output performance which is contrary to some theoretical postulations (Ajisafe and Folorunso, 2002; Abata, Kehinde and Bolarinwa, 2012).
In a similar way, the pro-fiscal effectiveness studies argue that, in a developing country like Nigeria, where the financial system is at best rudimentary while government plays a significant role in major sectors of the economy, monetary policy conduct is most likely difficult with very few chances of influencing the aggregate economy significantly. They premised their argument on the fact that: first, due to the weak structure of the economy’s financial system, the CBN policy rate (MRR/MPR) which is the primary signal of the money market seems to be weak in channeling financial resources from surplus spending units to deficit spending units. This implies that interest rate may not be the stimulating/deciding factor in saving and investment decisions in the Nigerian economy (CBN, 2010). Corollary to this is the weak link between interest rates and aggregate output performance of the economy. For instance there were some periods where the policy rate (MRR/MPR) was constant (e.g. 1970-74, 1984-86, 1994-97, 2012-13Q1), however, the economy posted significant growth differentials for same periods, which is contrary to economic theory (CBN, 2012).
Furthermore, recent evidence reveals that, due to the structural imbalance in the real (productive) sector of the Nigerian economy, growth in money aggregates translates into inflation rather than output/productivity growth, thereby leaving monetary policy conduct with much questions than results (Egwaikhide, Enoma and Saheed, 2012). Despite the plausibility of various arguments portrayed by these strands of studies on Nigeria, most of them did not consider any form of interaction between fiscal and monetary policy, and a need for policy-mix in their analysis of policy management, which might have affected their outcomes. Whereas, recent evidences on macroeconomic policy management have shown that for effective performance of both fiscal and monetary policy, individual policy transmission is not sufficient, rather, there is a need for policy-mix or interaction as well as a mutual coordination between fiscal and monetary authorities (Leith and Thadden, 2006; Raj, Khundrakpam and Das, 2011). And it is expected that the nature of this interaction, complementarily or confliction, between these policies may have severe consequences on their ability to effectively stabilize the economy or dampen business cycles (Okafor, 2013).
In the light of the above analysis, one may wonder how fiscal and monetary policies interact with each other in Nigeria; the nature of interaction between them – whether these policies conflict (substitute) rather than complement each other or whether any of the policies dominates the other in the process of transmission; how these policies have influenced economic performance, both singly and interactively; why these policies have continually missed their economic targets and how they can be used to mitigate external shocks in a different exchange regime despite the special attention given to them and the cost of running them; and what institutional framework need to be put in place in order to harness the potency of these policies, singly and interactively. It is therefore necessary to investigate the level to which this interaction can transmit in to an effective output performance (effective demand management policy) and guide against external shocks. Guided by the Killick’s (1981) criteria for assessing policy efficiency, this study therefore, seeks to answer the following questions:
- What is the nature of interaction between fiscal and monetary policy in Nigeria over time?
- How does fiscal and monetary actions transmit to output response in Nigeria?
- Can this policy mix mitigate the degree of openness in Nigeria?
1.4 OBJECTIVE OF THE STUDY
The broad objective of this study is to analyze the role of policy interaction in the assessment of the relative effectiveness of fiscal and monetary policy on output response in Nigeria. The Specific objectives are to examine the:
- nature of interaction between fiscal and monetary policy in Nigeria over time
- transmission mechanism of fiscal and monetary policy on output
- analyze the impact of policy mix on the degree of openness in Nigeria
1.5 RESEARCH HYPOTHESES
In line with the specific objectives of this study, this research shall be guided by the following hypotheses:
Ho1: There is no interaction between fiscal and monetary policy mix in Nigeria.
Ho2: Fiscal and monetary policy mix does not transmit to output response.
Ho3: the degree of openness does not have impact on the Nigerian economy
1.6 SIGNIFICANCE OF THE STUDY
This study belongs to the area of Macroeconomic Public Policy (MPP) which deals with policy simulation, evaluation and analysis within a macroeconomic framework. By analyzing the interaction between various fiscal and monetary instruments, this study shall improve the understanding of the policymakers on the nature, extent and effect of policy interaction on macroeconomics targets, like output, in Nigeria. And the examination of the nature of policy interaction under different policy regimes in the country shall guide the fiscal policymakers and monetary authority on the optimal policy-mix for a specific target under a similar scenario of a particular policy regime in the future. This study shall guide policy makers of the policy mix that can mitigate the impact of external shock on domestic economy. Also, the outcome of this study shall help the government and the monetary authority to discover some areas of weakness in the choice and usage of specific policy instruments and how to improve on them for effective stabilization. Moreover, the study shall help both fiscal and monetary policymakers to design better policies, as well as make good economic forecasts based on the chosen policy instruments.
Furthermore, the study shall add to the existing literature on the interaction of fiscal and monetary policy, especially for developing counties, like Nigeria, where the government has been playing a prominent role while the financial system is at best rudimentary. Finally, the study shall lend a voice to the ongoing advocacy for a cordial and mutual relationship between the fiscal (government) and monetary (CBN) authorities, especially in the area of policy management and macroeconomic stabilization.
1.7 SCOPE/DELIMITATION OF THE STUDY
This research is a country-specific study concentrating on the Nigerian economy. For relevance and in-depth analysis, the study span through the period 1960-2012, the study considered annual data instead of quarterly data, as is common in much of the literature. The main advantage of using annual data is that the economic interpretation of external shocks identified with quarterly data may be more problematic, as (substantial) economic reversions do not usually take place at that high frequency. Although there are many instruments of fiscal and monetary policy that have been employed in empirical research, for the purpose of this study, fiscal balance and interest rate shall be employed as proxies for the respective policies, while output performance shall be captured with GDP gap.
1.8 ORGANIZATION OF THE STUDY
This empirical study is divided into five chapters and, each of which is further sub-divided. The first chapter is introduction. These include: the introduction, background of the study, statement of the problem, objective of the study, hypothesis of the study, significance of the study, scope and delimitations of the study and organization of the study.
In the second chapter, relevant theoretical and empirical literatures are reviewed.
Chapter three is the methodology. The researcher’s model is stated. The sources of the data and their description, the estimation procedure are all stated. Chapter four shows the presentation, analysis and interpretation of results. The fifth chapter is the concluding part of the work, under which the researcher states the summary of findings, policy recommendation and conclusion.
This material content is developed to serve as a GUIDE for students to conduct academic research
FISCAL-MONETARY POLICY MIX AND OUTPUT RESPONSE IN NIGERIA (1960-2012)>
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