The Roles of the Central Bank in Stabilizing Economy
CHAPTER ONE
Objectives of the Study
The General objective of the study is to find out the extent to which monetary policy (captured by MPR) could bring about Price Stability (stability in inflation, interest and exchange rates) in Nigeria. Consequently, the following is the specific objective of the study:
To investigate how interest rate, exchange rate and inflation respond to shocks in CBN monetary policy rate (MPR).
CHAPTER TWO
LITERATURE REVIEW
Introduction
This chapter is divided into three, the conceptual, theoretical and empirical literature; the conceptual literature break down in piece meals the key words in the study (monetary policy, inflation, interest and exchange rates) in addition to other important terminologies used in the research, the empirical literature reviews various researches that are considered germane to the research work. On the other hand, the theoretical literature, for the economy of time and space concentrates only on those economic theories that are deemed most appropriate for the study.
Conceptual Literature;
Overview of inflation
Inflation could be defined as an economic situation in which the increase in money supply is “faster” than the new production of goods and services in the economy (Hamilton, 2001). More often than not economists draw a line of difference between inflation and an economic condition of a onetime increase in price or when there are price increases in a narrow group of economic goods and services (Piano, 2001). Consequently, inflation signifies a general and persistent increase in the prices of goods and services in an economy (Ojo, 2000; Melberg, 1992).
Usually, the rate of Inflation is measured by the percentage change in the price index, which may be wholesale price index, producer price index, retail price index, or consumer price index. In Nigeria, inflation is measured as the percentage change in the consumer price index, which aggregates the price of a representative basket of goods and services purchased by the average consumer, and obtained through periodic survey of consumer prices (CBN, 2005; Essien, 2002).
The National Bureau of Statistics has the statutory responsibility for compiling inflation statistics in Nigeria. Different weights are assigned to the goods in the representative consumer basket. As a result of these weights, changes in the prices of some goods in the basket exert varying effects on measured inflation. However, in this research work we used the headlines inflation used by CBN as against the consumer price index.
The year-on-year headline inflation was preferred because of the following disadvantages associated with the consumer price index (CPI) as a measure of the price levels; first it does not reflect goods and services bought by firms or government, such as machinery. Second, it does not reflect the changes in the quality of goods which might have occurred over time. Third, changes in the price of substitutable goods are not captured. Lastly, CPI basket usually does not change often. Inflation could also be measured by GDP deflator, though it is sparingly used because CPI represents the cost of living and is therefore more appropriate for measuring the welfare of the people.
As regards the causes of inflation; three school of thought stand out; the neo- Classical/monetarist, neo-Keynesian and structuralist. The neo-Classical/monetarists opine that inflation is driven mainly by growth in the quantum of money supply. However, practical experiences of the Federal Reserve in the United State (US) have shown that this may not be entirely correct. To buttress this, the US money supply growth rates increase faster than the price itself (Hamilton, 2001; Colander, 1995). This has been traced to the increased demand for the US dollar as a global trade currency (Mordi, C et al, 2007).
CHAPTER THREE
METHODOLOGY
Introduction
Monetary policy actions are transmitted through a series of connections among macroeconomic variables. For this reason VAR models have been a popular framework for the study of monetary policy in recent years, as they are able to embody the interaction between the conduct of monetary policy and the economy without ascribing to a particular theoretical model (Mies and Tapia, 2003). VAR effectively captures linkages among macroeconomic variables since it is a dynamic system that permits simultaneity of activities among included variables. In other words, the variables in the system express themselves freely at the same time and the impulse response function serves to trace out the actions due to each variable in the entire system (Mbutor: 2009). To be specific, we strictly, implored Structural Autoregressive (SVAR) model to achieve the objective of the study. The choice of SVAR was informed by its ability to allow modeling non-recursive structures of the economy with a parsimonious set of variables and above all it facilitates the interpretation of the contemporaneous correlations among disturbances (Joao and Andrew, 2006)
CHAPTER FOUR
ANALYSIS OF THE RESULTS
Introduction
This Chapter presents the results of the various estimation techniques used to achieve the specific objective of the study. Unit root test was conducted to determine the order of stationarity, Granger causality to find the direction of influence among the variables, Impulse Response to identify the response of interest rate, exchange rate and inflation to shocks in MPR while Variance Decompositions helped in the establishment of the contributions of MPR to these variables.
CHAPTER FIVE
SUMMARY, CONCLUSION AND RECOMMENDATIONS
SUMMARY
The study theoretically and empirically investigated the roles of the central bank in stabilizing economy. This was done by investigating how inflation, interest and exchange rate respond to shocks in CBN monetary policy (captured by MPR). The research work used monthly data, beginning from December, 2006 (when the MPR was introduced) through February, 2012. The Structural VAR was employed to estimate the model, where the impulse response revealed how the inflation, interest and exchange rates responded to shocks in MPR and the variance decomposition brought to the limelight the impact of MPR on these Macroeconomic variables. The Granger Causality was equally used to disclose the causal direction among the variables, while Augmented Dickey Fuller (ADF) was conducted on all the variables before the estimations to establish the absence of stochastic process.
OUTLINES OF MAJOR FINDINGS
Inflation responds to shocks in MPR only in a volatile manner (a pattern that is almost unpredictable); in the first four periods, positive shocks in MPR could not bring down inflation but thereafter, any further increase in MPR produced gradually declining but positive interest rate.
Exchange rate responds to shocks in MPR in a relatively downward fashion and quickly assumes upward trend from the second period lasting throughout the periods.
Interest rate responds quickly and positively to shocks in MPR from the first thorough the last period. Therefore, MPR has its greatest influence on interest rate (prime lending rate).
Of all the three macroeconomic variables, inflation is the most difficult to deal with and cannot always be successfully conquered with the manipulation of MPR alone.
CONCLUSION
The study concludes that both interest (prime lending rate) and exchange rates respond quickly and almost in a predictable way to shocks in MPR. However, changes in MPR do not automatically and consistently produce changes in inflation and above all inflation responds to shocks in MPR only in a volatile manner (a pattern that is almost unpredictable). Hence of all the three variables, inflation is the most difficult to deal with (stability of which could leads to stability in the remaining two) and could not be totally addressed by mere manipulations of MPR. Hence low and stable inflation is a necessary condition for the achievement of low and stable interest and exchange rate. We also conclude that MPR is also responsive to Monetary Policy Committee (MPC) meetings.
RECOMMENDATIONS
Other monetary policy instruments particularly Cash Reserve Requirements (CRR) and especially, OMO should be prudently used to compliment MPR in achieving Price Stability.
The current monetary tightening stance of the CBN is a step in the right direction but should be used with caution. Considering the dual objective of CBN, the monetary policy should be tailored to promote real sector lending while trying to achieve low and stable inflation.
There is the need for policy harmonization between the monetary and fiscal authorities. Budget deficit should be avoided and more fund be appropriated for capital as against the recurrent expenditures.
CBN should license more banks to operate non-interest banking so as to boost financial deepening and inclusion. The large informal sector in the country that cripples the transmission mechanism of monetary policy and constraints the ability of CBN to control money supply was to some extent caused by cultural and religious belief that interest is unlawful; this could be avoided by introducing more non-interest banks.
The “cashless policy” of CBN should be maintained, made more efficient and user friendly. Researches have shown that a system that is cash based is inefficient and distorts transmission mechanism. More efficient point of sale (POS) terminals, multifunctional ATMs as well as mobile payment compatible system should be put in place.
There is the need for proper enlightenment of the public about any new CBN policy initiatives (e.g. non-interest banking & cash-lite policy). The communication strategy should be clear and concise.
The physical and social infrastructures of the economy should be improved to reduce the cost of doing business and by extension the interest charged by the banks.
The three tiers of Government should exercise fiscal prudence and fiscal responsibility act be fully implemented. More so, Banks and Other Financial Institutions should improve their operational efficiency by cutting down overhead and any other unnecessary expenses.
The CBN should reduce or strike out any unnecessary stringent documentation requirement for the purchase of forex in the official market. This would kill patronage and by extension the life of parallel market/street trading.
To ensure policy continuity and consistency, the rate of turnover of CBN Governors should be checked and the frequency of MPC meetings be reduced to at most quarterly unless in case of emergencies.
REFERENCES
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