THE EFFECTIVENESS OF MONETARY POLICY UNDER FLEXIBLE EXCHANGE RATE REGIME IN NIGERIA.

ABSTRACT

This study investigates the effectiveness of monetary policy under flexible exchange rate regime in Nigeria using Ordinary Least Square approach. Quarterly time series data spanning 1980:1 – 2008:4 are used in this work. The study examines stochastic characteristics of each time series by testing their stationarity using Augumented Dickey Fuller (ADF) test. This is followed by performing co integration test using Augmented Engle-Granger (AEG) technique. The results of the cointegration test indicates that the residuals estimated from our RGDP and CPI equation are not stationary at both 5% and 1% levels of significance implying that the variables used in this regression are not cointegrated. The absence of no co integration means that long run equilibrium relationship does not exist among the non- stationary variables. The result suggests that government should through its monetary policy actions and operations in money market continue to influence   the   exchange   rate   direction   such   that   it   ensures   the competitiveness of the domestic economy.    Thus, the study concludes that under flexible exchange rate regime monetary policy instruments impacted significantly on real output, Consumer price index and balance of payment account in Nigeria.

CHAPTER ONE

INTRODUCTION

1.1     BACKGROUND OF THE STUDY

The Bretton Woods monetary system of fixed exchange rates, which evolved immediately after  the Second World War, worked fairly  well  for nearly thirty years until 1973 when it broke down. U.S. huge current account deficits occasioned by its involvement in the Vietnam War, posed significant challenges to the system. Upon the demise of the Bretton Woods system, a generalized system of floating exchange rates emerged, particularly for the developed countries. The developing countries have had varied experiences with exchange rate regimes, in choosing exchange rate regimes, developing countries need to be fully aware of the circumstances and conditions for their successful adoption. The important factors and criteria in such choices also need to be properly understood. Various forms of exchange rate regimes are open to individual countries. They range from clean floating or flexible exchange rate regime at one extreme to firmly fixed arrangements at the other extreme, with the remaining regimes falling in a continuum in between. These include managed float, pegs, target zones, currency boards, monetary union and dollarization Obadan (2009). In the last few years, a number of developing economies including Nigeria have moved from fixed to flexible exchange rates. This has in most cases led to instability in exchange rates thereby creating an atmosphere of uncertainty which help to aggravate the problem of inflation in the economy.

Monetary policy and exchange rate are key tools in economic management and in macroeconomic stabilization and adjustment process in developing countries like Nigeria, where non-inflationary growth and international competitiveness have become major policy targets. Real exchange rate is one broad measure of international competitiveness, while inflation emanates largely from monetary expansion, currency devaluation and other structural rigidities in the economy. The question of the exchange rate regime that a small open economy should choose has no definite answer, since such a choice depends on the objectives and focus of monetary authorities, as well as on assumptions about the structural characteristics of the economy.  Structural characteristic of the economy in this sense implies openness of capital mobility, wage indexation and the level of economic growth and development (Busari et al, 2008).

Monetary policy formation and implementation thus influence macroeconomic variables, (hence macroeconomic stability) in any economy whether developed or underdeveloped. The critical distinction is the degree to which movement in the exchange rate pass-through to effects domestic macroeconomic variables, most especially consumer prices, output (as a measure  of  Gross  Domestic  Product  GPD)  and  private  consumption.  The choice  of  an  exchange  rate  regime  is  linked  to  some  extent,  to  the achievement of specific targets set by the monetary authorities. Most of the times, these targets are related to internal and external imbalances. Therefore, a correlation between the choices of the exchange rate regime and real output, prices, balance of payments stabilization, and the sources of shocks hitting the economy is expected (Busari et al, 2008).

When the goal is balance of payments stabilization, it is preferable to adopt a flexible exchange rate system to overturn any current or capital account disequlibrium. Here consideration has to be taken on the Marshall- Lerner  conditions,  the  degree  of  capital  mobility  and  foreign  reserve constraint. When the objective is to stabilize domestic price, the financial discipline issue becomes relevant. Many economists believe that the exchange rate can be used as an anchor for financial stability since it is one price of the economy. In this sense, a fixed exchange rate imposes a degree of financial discipline by discouraging recourse to inflationary finance. In contrast to this reasoning, proponents of exchange rate flexibility argue that the announcement of a fixed exchange rate would only cause financial crises followed by continuous devaluation. Finally when the objective is to stabilize real output, the role of exchange rate regime is mainly viewed as a shock absorber. That is, the choice of exchange rate regime is used to spread these effects. Therefore, this choice will depend on the nature of the shocks and the structural characteristics of the economy. Hence, it seems there is a clear trade-off between output/consumption volatility and inflation volatility. With a very high exchange rate pass-through, all monetary rules face a significant trade-off. The nature of the trade-off is also seen between “fixed and flexible” exchange rates (Busari et al, 2008).

While inflation rate is often used to track movement in domestic price level, exchange rate is used as policy tool in ensuring external stability and enhancing export performance (Caballero and Corbo, 1989). In addition, exchange rate policy impacts on the outcome of stabilization measures and debt management strategies (Busari and Olayiwola, 1999), especially in developing countries.

Generally, both fiscal and monetary policies seek to achieve relative macroeconomic stability. While the Keynesians argued that fiscal policy is more potent than monetary policy, the monetarists led by Milton Friedman on the other hand believed the other way round.  (Azam,  2001), states that macroeconomic instability can be regarded as a situation of economic malaise, where the economy does not seem to have settled in a steady equilibrium position thereby making it difficult to make predictions and good planning.

Since the rate of interest is the cost of credit, monetary policy includes the control of money supply (through the control of high-powered reserves) and the rate of interest, (Iyoha, 2002). The success of monetary policy however, depends on the operating economic environment, the institutional framework adopted and the choice and mix of the instrument used (Nnanna,

2001) which was why the Central Bank of Nigeria (CBN) deemed it necessary to continuously reassess and evaluate its monetary policy implementation framework to enable it respond to the ever-changing economic and financial environment.

Embedded in these objectives is a separate but highly related role, that is, a financial surveillance (stability) role.  In order to ensure the realization of the goal of monetary and macroeconomic stabilization, the CBN deploys its monetary policy instruments in such a way as to ensure optimality in inflation, exchange rate and growth outcomes.

1.2      STATEMENT OF THE PROBLEM

Since the mid- 1970s, the developing countries have moved to either pegging to a basket of major currencies, away from a single currency peg, or

adopting a more flexible exchange rate regime. In order to reduce the uncertainties arising from the medium – or long-term swings of major currencies which have produced various problems for them, developing countries have had the inclination to adopt intermediate exchange rate regimes rather than the polar regimes of firmly fixed exchange rate and floating exchange rates (Obadan, 2009).

Under the Structural Adjustment Programme, Nigeria’s economy was deregulated in 1986; a market based framework for the determination of exchange rate was adopted. This policy was made a tool for inducing the export promotion goal, coupled with other export targets such as the export incentives and miscellaneous provisions decreases of 1986. In spite of all the policy measures indicated above, the external sector performance has remained  poor  and uninteresting;  the outcome of  exchange rate  policies remained unstable. Consequently, other sectoral policies failed woefully as the target of the other macroeconomic aggregates, which includes: interest rate, inflation rate, unemployment, money supply remained largely unrealized (Ifionu et al, 2007).

Since the early 1990s, two notable developments have conditioned the type of exchange rate regimes adopted by the developing countries; these are the intensification of globalization and emergence of financial crises. No doubt, the deep integration of a number of developing countries into the global economy has promoted trade in goods and services between the developed countries and the developing/emerging market economies. Thus, the choice of exchange rate regime by developing countries is of crucial importance to their self-protection from speculative attacks and currency crisis as well as

achievement of long-term growth. And the choice of exchange rate regime in the developing countries means which regime would be most appropriate not only for preventing massive capital inflows and currency crises but also for better facilitation of trade, FDI and economic growth (Obadan, 2009).

Thus, for the developing country, more access to the global capital market poses a policy dilemma for the choice of exchange rate regime. It seems, therefore, that the choice of an appropriate exchange rate by a developing country is not a straightforward task. Suggestions have been made that an appropriate exchange rate varies depending on the specific circumstances of the country in question and on the circumstances of the time period in question (Frankel, 1999).

Yet, in recent years, following the currency and financial crises of the

1990s, many developing countries have been advised to shift to the polar exchange rate regimes: flexible or fixed exchange rates with monetary union (or currency board). The feeling is that intermediate regimes between two polar regimes are no longer tenable, considering the trilemma entailed in the principle of the impossible trinity. This trilemma entails the difficulty in attempting   to   pursue   exchange   rate   stability,   capital   mobility,   and independent monetary policy. It is not possible to achieve all three objectives simultaneously; it is possible at most to achieve two of the objectives, making it necessary to sacrifice at least one (Obadan, 2009).

And as the argument further goes, as more countries try to have access to global financial markets, the choice of exchange rate regime is narrowed down to the degree of flexibility in terms of a perfect free floating or hard fixed  exchange  rates  such  as  monetary  union,  currency  board  or  even

dollarisation.  This tends to be in line with the thinking of some analysts that some countries are better suited for a fixed exchange rate regime with monetary union or currency board while others are better off adopting a flexible regime.

Nevertheless, as at date, not much knowledge can be claimed about workable exchange rate regimes.  As Velasco (2000) has observed, during the

1997 – 98 Asian crisis, arrangements that had performed relatively well for years   came   crashing   down   with   almost   no   advance   notice;   other arrangements that once seemed invulnerable almost tumbled down as well. Mid-course corrections and policy changes proved equally troublesome; in every country that abandoned a peg and floated, the exchange rate overshot massively and a period of currency turmoil followed with attendant tremendous real costs. In choosing exchange rate regimes, therefore, developing countries need to be fully aware of the circumstances and conditions for their successful adoption. The important factors and criteria in such choices also need to be properly understood (Obadan, 2009).

Again, a number of empirical studies show that one of the factors that led to variations in inflation in Nigeria is changes in exchange rate (Folawewo and Osinubi, 2006).  Ukwu et al (2003) in their paper, observe that there is a general agreement that a low long-term rate of inflation can be achieved by sufficiently limiting the rate of growth of broad monetary aggregate over a long time dimension. Inflation and exchange rate as at 2005 remained high and volatile. This does not mean well for the economy as it becomes difficult for investors to make good and stable business decisions in such situations. This no doubt represents a major constraint to stabilization opportunities in

monetary policy in Nigeria. Also it is observed that monetary policy stimulates growth better under a flexible rate regime but it is accompanied by severe depreciation, which could destabilize the economy.

Despite these observations, the effectiveness of monetary policy in macroeconomic stabilization under exchange rate regime has been less examined in Nigeria; thereby creating an information gap at the expense of economic expansion. It is against this background that this paper seeks to investigate the interaction between monetary, macroeconomic stabilization and exchange rate regime in Nigeria. The research questions that arise from above are as follows.

a)  What is the effectiveness of monetary policy in stabilizing output growth under flexible exchange rate regime?

b)  Has monetary policy been effective in reducing inflation under flexible exchange rate regime?

c)  How has monetary policy helped to achieve BOP stability under flexible exchange rate?

1.3     OBJECTIVES OF THE STUDY

The broad objective of this research work is to analyze monetary policy and macroeconomic stabilization under alternative exchange rate while the study specifically wants to:

a)  Examine the effectiveness of monetary policy in stabilizing output growth in Nigeria under flexible exchange rate regime.

b)  Determine  the  effectiveness  of  monetary  policy  in  reducing  inflation using  flexible exchange rate in Nigeria.

c)  Examine how monetary policy can achieve BOP stability under flexible exchange rate in Nigeria.

1.4    RESEARCH HYPOTHESES:

Based on the objectives outlined above, this study will be guided by the following hypotheses:-

a)  Monetary policy is not effective in achieving economic growth in Nigeria under flexible exchange rate regime.

b)  Monetary  policy  is  not  effective  in  reducing  inflation  using  flexible exchange rate in Nigeria.

c)  Monetary policy cannot achieve BOP stability under flexible exchange rate in Nigerian economy.

1.5    POLICY RELEVANCE

(i)    This  study  will  be  valuable  to  policy  makers  and  government  in assessing the effectiveness of monetary policy and macroeconomic in stabilizing the        economy using flexible exchange rate regime.

(ii)    The result of this study will give a deeper insight into the relationship between monetary policy and exchange rate in Nigeria.

(iii)  It will add to the existing literature on the topic under discussion and will also serve as a reference for research works in similar studies.

1.6       SCOPE OF THE STUDY

This study is limited to the Nigeria economy for the period 1990 to 2008. The choice of the period is to have adequate observations for time series analysis.

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