THE IMPACT OF OPEN MARKET OPERATION ON PRICE STABILITY IN NIGERIA

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THE IMPACT OF OPEN MARKET OPERATION ON PRICE STABILITY IN NIGERIA

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.

TABLE OF CONTENTS

Title Page i

Approval Page ii

Certification Page iii

Dedication iv

Acknowledgements v

Abstract vii

List of Tables x

List of Figures xi

List of Appendixes xii

CHAPTER ONE INTRODUCTION

1.1 Background of the Study . . . . 1

1.2 Statement of Problems. . . . . . . 3

1.3 Objectives of the Study. . . . . . . 6

1.4 Research Questions. . . . . . . . 6

1.5 Research Hypotheses. . . . . . . . 6

1.6 Scope of the Study. . . . . . . . 6

1.7 Significance of the Study. . . . . . . 7

1.8 Definition of Terms. . . . . . . . 8

References. . . . . . . . . 9

CHAPTER TWO REVIEW OF RELATED LITERATURE

2.1 Monetary Policy Framework in Nigerian. . . . 12

2.2 Measuring the Effects of Monetary Policy Innovations in Nigeria. 13

2.3 Nigeria’s Monetary Policy and the Rationale for Adoption. .. 16

2.3.1 The Exchange Rate Targeting Regime (1959-1973). . . 16

2.3.2 Monetary Targeting Regime (1974 to Date). . .. 16

2.3.3 Direct Control (1974-1992). . . . . . . 17

2.3.4 Instruments of Monetary Policy under Indirect Monetary Control Regime 19

2.4 Constraints on Monetary Policy Management in Nigeria. . 21

2.4.1 Fiscal Dominance. . . . . . . . 21

2.4.2 Liquidity Overhang. . . . . . . . 21

2.4.3 Oligopolistic Banking System. . . . . 22

2.4.4 Data. . . . . . . . . . 22

2.4.5 Dualistic Financial and Products Market. . . . 22

2.4.6 Inefficient Payments System. . . . . . 22

2.5 Way Ahead for Monetary Policy in Nigeria. . . . 23

2.6 Maintaining Price Stability in Nigeria. . . . 23

2.7 Monetary Policy and Exchange-Rate Targeting. . . 29

2.8 Brief History of Inflation in Nigeria: 1980–2007. . .. 38

2.9 Monetary Policy and Inflation Targeting. . . . . 40

2.10 The Effectiveness of Anticipated Monetary Policy. . . . 48

2.11 Monetary Policy in the Information Economy. . . . 52

2.12 Monetary Policy Evaluation with Noisy Information. . . 53

2.13 Historical Monetary Policy Analysis and the Taylor Rule. . 56

References. . . . . . . . . 58

CHAPTER THREE RESEARCH METHODOLOGY

3.1 Research Design. . . . . . . . 66

3.2 Sources of Data. . . . . . . . 66

3.3 Explanatory Variables . . . . . . . 66

3.3.1 Independent Variables . . . . . . 66

3.3.2 Dependent Variable. . . . . . . . 67

3.3.3 Control Variable. . . . . . . . 67

3.4 Model Specification. . . . . . . . 67

3.5 Model Justification. . . . . . . . 68

3.6 Techniques of Analysis. . . . . . . 69

References. . . . . . . . . 70

CHAPTER FOUR PRESENTATION AND ANALYSIS OF DATA

4.1 Presentation of Data. . . . . . . . 71

4.2 Test of Hypotheses. . . . . . . . 73

4.2.1 Test of Hypothesis One. . . . . . . 73

4.2.2 Test of Hypothesis Two. . . . . . . 74

CHAPTER FIVE SUMMARY OF FINDINGS, CONCLUSIONS AND RECOMMENDATIONS

5.1 Summary of Findings and Policy Implications. . . 76

5.2 Conclusion. . . . . . . . . 77

5.3 Recommendation. . . . . . . . 77

5.4 Recommended Areas for Further Studies. . . . . 79

References. . . . . . . . . 81

Appendixes. . . . . . . . . 82

Bibliography. . . . . . . . . 85

LIST OF TABLES

Table 4.1 Presentation of Model Proxies from 1993-2007. . 71

Table 4.2 Regression and Correlation Results for hypothesis One 73

Table 4.3 Regression and Correlation Results for hypothesis Two 74

LIST OF FIGURES

Figure 4.1 Graphical Presentations of Table 4.1. . . . 72

LIST OF APPENDIXES

Appendix One Presentation of Model Proxies from 1993-2007. . 82

Appendix Two Hypothesis One. . . . . . 83

Appendix Three Hypothesis Two. . . . . 84

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 deficits. At the same time, the government was saddled with foreign deficits, which had to be financed through massive foreign borrowing and the drawing down of external reserves. To reverse the deteriorating macroeconomic imbalances (declining GDP growth, worsening balance of payment conditions, high inflation, debilitating debt burden, increasing fiscal deficits, rising unemployment rate, and high incidence of poverty), the government embarked on austerity measures in 1982. The austerity measures was successful judging by the fall in inflation rate to a single digit, the significant improvement in the external current account to positions of balance. However, these improvements were transitory because the economy did not establish a strong base for sustained economic growth (see, Onafowora, 2007).

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.

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