ABSTRACT
Results
of monetary policy outcomes suggest that Nigeria does not enjoy ideal
conditions for adopting a monetary policy regime aimed primarily at stabilizing
prices under a freely floating exchange rate. The reasons often advocated is
that Nigeria faces a very volatile macroeconomic environment and a more acute
inflation-output trade-off than other emerging market economies which have
embraced price stabilization programs and thereby abandoning their exchange
rate anchors. Moreover, Nigeria has an intense exchange of goods and services
with the rest of the world which is stronger than other emerging market economies,
thanks to its mainly oil-exporting-oriented economy. This can make Nigeria
particularly exposed to price and quantity-type external shocks, which renders
price stabilization all the more complicated. Open Market Operation is one of
the monetary policy tools of the Central Bank of Nigeria which entails the sale
or purchase of eligible bills or securities in the open market by the Central
Bank of Nigeria for the purpose of influencing deposit money, banks’ reserve
balances, and the level of base money which is effectively aimed at achieving
the price objectives of the Central Bank of Nigeria. Thus, this study sought
to: examine the impact of Open market operation on the maintenance of Exchange
rate price stability in Nigeria and determine the impact of Open market
operation on the maintenance of consumer price stability in Nigeria.
The
research design adopted for this study is the ex post facto research
design. This enabled the researcher make use of secondary data. Annualized data
from 1993 to 2007 of proxies from the Central Bank of Nigeria statistical
bulletin were used. The Linear Regression Model (LRM) estimation technique
using SPSS statistical software was used to evaluate the stated objectives
where rate values of Open Market Operation Rate (OMOR) as proxy for Open Market
Operation (OMO) which is the independent variable while Nominal Effective Naira
Exchange Rate Indices (EXR), Inflation Rate (INFR) and Gross Domestic Product
Growth Rate (GDPGR) as a control variables. The result
revealed that open market operation has a negative non-significant impact on
exchange rate in Nigeria (t = -0.025, coefficient of OMOR = -0.003) and open
market operation has positive non-significant impact on inflation rate in
Nigeria (t = 1.604, coefficient of OMOR = 0.047). As revealed from the findings
in this research the use of open market operation as a monetary policy tool
have actually influence consumer price stability in Nigeria hence the study
recommends among others that an increased use of open market operations as a
tool for achieving price stability in Nigeria and a conscious effort monetary
authorities in bring the informal sector into the main stream of the Nigeria
economy. This will help to expand as well as capture the huge funds in the
informal sector which is presently not captured.
CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND OF THE STUDY
In
general terms, monetary policy refers to a combination of measures designed to
regulate the value, supply and cost of money in an economy, in consonance with
the expected level of economic activity. For most economies, the objectives of
monetary policy include price stability, maintenance of balance of payments
equilibrium, promotion of employment and output growth, and sustainable
development. These objectives are necessary for the attainment of internal and
external balance, and the promotion of long-run economic growth (Nnanna, 2001).
The
importance of price stability is derived from the harmful effects of price
volatility, which undermines the ability of policy makers to achieve other
laudable macroeconomic objectives. There is indeed a general consensus that
domestic price fluctuation undermines the role of money as a store of value,
and frustrates investments and growth. Empirical studies (Ajayi and Ojo, 1981)
on inflation, growth and productivity have confirmed the long-term inverse
relationship between inflation and growth. When decomposed into its components,
that is, growth due to capital accumulation, productivity growth, and the
growth rate of the labour force, the negative association between inflation and
growth has been traced to the strong negative relationships between it and
capital accumulation as well as productivity growth, respectively. The import
of these empirical findings is that stable prices are essential for growth.
The
success of monetary policy depends on the operating economic environment, the
institutional framework adopted, and the choice and mix of the instruments
used. In Nigeria, the design and implementation of monetary policy is the
responsibility of the Central Bank of Nigeria (CBN). The mandates of the CBN as
specified in the CBN Act of 1958 include; issuing of legal tender currency,
maintaining external reserves to safeguard the international value of the currency,
promoting monetary stability and a sound financial system and acting as banker
and financial adviser to the Federal Government.
However, the current
monetary policy framework focuses on the maintenance of price stability while
the promotion of growth and employment are the secondary goals of monetary
policy (see, Nnanna, 2001). In Nigeria, the overriding objective of monetary
policy is price and
exchange rate stability (see, CBN, 2001). The monetary authority’s strategy for
inflation management is based on the view that inflation is essentially a
monetary phenomenon. Because targeting money supply growth is considered as an
appropriate method of targeting inflation in the Nigerian economy, the Central
Bank of Nigeria (CBN) chose a monetary targeting policy framework to achieve
its objective of price stability. With the broad measure of money (M2) as the
intermediate target, and the monetary base as the operating target, the CBN
utilized a mix of indirect (market-determined) instruments to achieve it
monetary objectives. These instruments included reserve requirements, open
market operations on Nigerian Treasury Bills (NTBs), liquid asset ratios and
the discount window (see IMF Country Report No. 03/60, 2003).
Onafowora
(2007 say the CBN’s focus on the price stability objective was a major
departure from past objectives in which the emphasis was on the promotion of
rapid and sustainable economic growth and employment. Prior to 1986, the CBN
relied on the use of direct (non-market) monetary instruments such as credit
ceilings on the deposit money of banks, administered interest and exchange
rates, as well as the prescription of cash reserves requirements in order to
achieve its objective of sustainable growth and employment. During this period,
the most popular instruments of monetary policy involved 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 economic development through the
provision of finance to the preferred sectors of the economy such as the
agricultural sector, manufacturing, and residential housing (see, Onafowora,
2007).
During
the 1970s, the Nigerian economy experienced major structural changes that made
it increasingly difficult to achieve the aims of monetary policy. The dominance
of oil in the country’s export basket began in the 1970s. Furthermore, the
rapid monetization of the increased crude oil receipts resulted in large
injections of liquidity into the economy, induced rapid monetary growth.
Between 1970 and 1973, government spending averaged about 13 percent of gross
domestic product (GDP), and this increased to 25 percent between 1974 and 1980.
This rapid growth in government spending came not from increased tax revenues
but the absorption of oil earnings into the fiscal sector, which moved the
fiscal balance from a surplus to a deficit that averaged about 2.5% of GDP a
year. This new era of deficit spending led the government to borrow from the
banking system in order to finance the domestic
Having
examined the objectives of monetary policy in Nigeria, this study intends to
find out the impact of monetary policy through the use of open market operation
in enhancing economic stability in Nigeria.
1.2 STATEMENT OF THE PROBLEM
Results
of monetary policy outcomes suggest that Nigeria does not often enjoy ideal
conditions to adopting a monetary policy regime aimed primarily at stabilizing
prices under a freely floating exchange rate. There could be possible reasons
for this. The Nigerian macroeconomics environment often do faces a very
volatile macroeconomic environment and a more acute inflation-output trade-off
than other emerging market economies which have embraced price stabilization
programs and thereby abandoned their exchange rate anchors. Moreover, it could
often observed that Nigeria has an intense exchange of goods and services with
the rest of the world, and one that is stronger than other emerging market
economies, thanks to its mainly oil-exporting-oriented economy. This can make
it particularly exposed to price and quantity-type external shocks, which
renders price stabilization all the more complicated. Although Nigerian
consumer price index is not that sensitive to commodity price shocks notably
shocks to the price of oil changes in the Nigerian exchange rate are passed
through sizably and significantly (Batini and Morsink, 2004). Thus, given the
above, the problems associated with the use of open market operation as
monetary policy tools given the objectives of monetary policy in an economy of
maintaining stability are: price instability and exchange rate instability in
Nigeria.
Nigerian consumer prices is so volatile, and more dramatic than in other
emerging market economies countries, this have created problems for the conduct
of a monetary policy aimed at price stability because optimal policy responding
to exchange rate shocks depends on the source and duration of the shock, which
are typically unknown and hard to decipher in an unstable macroeconomic
environment. Judging by the risk premium on dollar-denominated Nigerian
sovereign debt relative to same risk premia of other emerging market economies’
debt, the Nigerian fiscal policy appears extremely vulnerable a reflection of
the fact that the Nigerian central bank is fiscally dominated in the sense of
Masson et al (1997). The size and volatility of the Nigerian risk premium on
government debt means that the Nigerian exchange rate, as well as short- and
long-term rates, may vary endogenously with the debt-to-GDP ratio. Both facts
indicate that it is hard, if not impossible, in the current circumstances to
talk about active monetary policy in Nigeria of whatever kind. As emphasized in
Favero and Giavazzi (2003), large and variable term premia and credit risks
reinforce the possibility that a vicious circle might arise, making the fiscal
constraint on monetary policy more stringent. Given these conditions, it is
reasonable to expect that aiming for and adopting a stable prices/free float
regime in the long run in Nigeria may not lead to successful outcomes. In
addition to not achieving the intended aims, it could be argued that pursuing
unsuccessfully a price stabilization regime may harm the credibility of the
central bank going forward. Sims (2003), for instance, emphasized that when
conditions are such that an inflation targeting commitment has a high
probability of proving unsustainable like when the necessary fiscal backup to
monetary policy is not available embracing nevertheless explicit inflation
targets can be unproductive or lead to an initial success that only amplifies a
later failure.
Exchange
rate target results in the loss of independent monetary policy. With open
capital markets, an exchange-rate target causes domestic interest rates to be
closely linked to those of the anchor country. The targeting country thus loses
the ability to use monetary policy to respond to domestic shocks that are
independent of those hitting the anchor country. Furthermore, an exchange-rate
target means that shocks to the anchor country are directly transmitted to the
targeting country because changes in interest rates in the anchor country lead
to a corresponding change in interest rates in the targeting country (Clarida,
Gali and Gertler (1997). Exchange rate targets have been pointed out forcefully
in Obstfeld and Rogoff (1995), where they say exchange rate targets leave
countries open to speculative attacks on their currencies. An exchange rate
target in emerging market countries that suggests that for them this monetary
policy regime is highly dangerous and is best avoided except in rare circumstances. Exchange rate targeting in emerging market countries is
likely to promote financial fragility and possibly a fully fledged financial
crisis that can be highly destructive to the economy. To see why exchange-rate
targets in an emerging market country make a financial crisis more likely, we
must first understand what a financial crisis is and why it is so damaging to
the economy.
Studies
evaluating the costs of inflation have long established the desirability of
avoiding not only high but even moderate inflation (Fischer and Modigliani,
1978; Fischer, 1981; and more recently Driffill, et., al, 1990 and Fischer,
1994), However, there is still a serious debate on whether the optimal average
rate of inflation is low and positive, zero, or even moderately negative
(Tobin, 1965 and Friedman, 1969). An important issue in this debate concerns
the reduced ability to conduct effective countercyclical monetary policy when
inflation is low. As pointed out by Summers (1991), if the economy is faced
with a recession when inflation is zero, the monetary authority is constrained
in its ability to engineer a negative short-run real interest rate to damp the
output loss. This constraint reflects the fact that the nominal short-term
interest rate cannot be lowered below zero the zero interest rate bound (Hicks,
1937 interpretation of the Keynesian liquidity trap and Hicks, 1967). This
constraint would be of no relevance in the steady state of a non-stochastic
economy. Stabilization of the economy in a stochastic environment, however,
presupposes monetary control which leads to fluctuations in the short-run
nominal interest rate. Under these circumstances, the non-negativity constraint
on nominal interest rates may occasionally be binding and so may influence the
performance of the Economy. Although inflation targeting does appear to be
successful in moderating and controlling inflation, the likely effects of
inflation targeting on the real side of the economy are more ambiguous.
Economic theorizing often suggests that a commitment by a central bank to
reduce and control inflation should improve its credibility and thereby reduce
both inflation expectations and the output losses associated with disinflation.
Experience and econometric evidence (see Almeida and Goodhart, 1998, Laubach
and Posen, 1997, Bernanke, Laubach, Mishkin and Posen, 1998) does not support
this prediction, however. Inflation expectations do not immediately adjust
downward following the adoption of inflation targeting. Furthermore, there
appears to be little if any reduction in the output loss associated with
disinflation, the sacrifice ratio, among countries adopting inflation
targeting......
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