ABSTRACT

Monetary policy is formulated side by side with banking policy and it relies majorly on financial programming which seek to ensure some consistencies among the macroeconomic variables in the Nigeria economy. Usually, the programme attempts to estimate an optimum quantity of money consistent with the assumed targets for Gross Domestic Product (GDP) growth rate, inflation rate and external reserves. With the estimate computed, the optimum level of money is derived, thereby permitting growth target to be determined for some of the intermediate policy variables of money supply and aggregate domestic credit.

The permissible aggregate domestic credit is then allocated between the government and the private sectors. The portion taken- by the government is determined by the size of the budget deficit to be financed by the banking system comprising the Central Bank, commercial bank and merchant banks. The balance is left for the private sector.

CHAPTER ONE

1.0    BACKGROUND OF THE STUDY

It is said that a major responsibility of the modern Central Bank is the monetary management that will ensure a stable internal and external value for the national currency. By monetary policy we meant policy designed to control the supply cost and availability and direction of money and credit to the economy in pursuance of national macro-economic objectives. It is policy designed to ensure that the supply of money is adequate to supply desirable to sustainable economic growth and development without generating Inflationary pressures. It also involves the control of the proportion of the money supply that should be made available to the various sector of the economy.

Therefore, for money to perform it's vital functions as a medium of exchange, store

of value, standard for deferred payments and units of account efficiently, it requires a careful and skillful management being largely dependent on the economic and institutional environment and ingenuity with which the central bank wields the power and resources at its disposal. However, techniques of monetary authorities to

influence the supply, allocation and cost of credit in an economy needed to be adequately applied.

The control is carried out by Central Bank of Nigeria (CBN) in partnership with the Federal Government which has the overall authority over' the system. The Central Bank of Nigeria (CBN) initiate the guiding policy measures and implements them only as approved by the government. In the united state of America, the monetary authority is called the Federal Reserve Bank (FRB), In England it is called bank of England, In Germany It's called bundes bank. The bank's measures to control the monetary and banking system passes through a number of stages which Include the identification of the objectives and target of policy, policy formulation, policy integration into the budget and approval, policy implementation and review as well as extra control measures for banks.

1.1     MONETARY POLICY FORMULATION

It is deal to have an insight into how the monetary policy is formulated in Nigeria for a comprehensive understanding of this study. The statutory power of CBN to formulate monetary and financial policies derived from the Central Bank of Nigeria (CBN) Act of 1959 as amended in decrees 24 and 25 of 1991. The CBN since its inception broadly Interpret its objectives of monetary policy functions to include:

·        The promotion of rapid and adjustable rate of economic growth and development.

·        Maintaining a healthy balance of payment and stable exchange rate

·        The development of a sound financial system and

·        The achievement of relative stability in prices.

Monetary policy Is formulated side by side with banking policy and it relies majorly on financial programming which seek to ensure some consistencies among the macroeconomic variables in the Nigeria economy. Usually, the programme attempts to estimate an optimum quantity of money consistent with the assumed targets for Gross Domestic Product (GDP) growth rate, inflation rate and external reserves. With the estimate computed, the optimum level of money is derived, thereby permitting growth target to be determined for some of the' intermediate policy variables of money supply and aggregate domestic credit.

The permissible aggregate domestic credit is then allocated between the government and the private sectors. The portion taken by, the government is determined by the size of the budget deficit to be financed by the banking system comprising the Central Bank, commercial bank and merchant banks. The balance is left for the private sector.

This process has allowed the Central Bank to influence credit growth either directly under the regime of credit ceiling or indirectly through market based instruments, subject to the size of fiscal deficit financed by the banking system.

In the era of direct monetary control, the major Instruments of policy comprise credit ceiling imposed on banks, administratively fixed interest rate and exchange rates, stipulation of sectoral credit allocation, and the prescription of cash reserve requirements and special deposits. As a result of adverse effects of prolonged use of direct instruments on the effectiveness of monetary policy and the financial sector, a move was made to shift to indirect approach in which reliance is placed on the use of market based instruments such as reserve requirements, the discount rate and open market operation.

Monetary policy formulation and Implementation raised very difficult conceptual as well as practical problem. It may be designed to deal with four broad objectives namely;

·        Price Stability

·        High rate of employment

·        A desirable or sustainable rate of economic-growth and

·        Balance of payment equilibrium

In practice, one finds, more often than not that there are conflict in these objectives.

Thus, the art of monetary management involves difficult trade-off among conflicting

objectives in order to maximize the overall benefits of the society.

The general scope of monetary policy in a country must therefore, be seen in the context of the structure and stage of development of the economy. These factors, together with the characteristics of the general financial system within which monetary operate, exercise a significant influence on the effectiveness of monetary

policy.

The establishment, therefore of a central monetary institution with discretionary power often merely provides only the legal basis for a managed currency and credit

systems, the effectiveness of monetary control.

1.2    THE DEMAND AND SUPPLY OF MONEY

Monetary is the lubricant of industry and commerce's it is like a catalyst in a chemical reaction which makes the reactions go faster and better, but which like the oil in the window's cruse is never used up. Thus, the importance of money in an economic systems cannot be fully realized unless the factors influencing the demand and supply of money are properly understood.

In the classical theory, the role of money has been regulated to the background since it is argued that monetary force do not affect the movement of real variables i.e. output and employment in the economy. In the Keynesian theory however, changes in money supply will change the level of output via changes in interest rates. The classical economist relegated money to the background because prices and wages are assumed flexible in both direction and the economy has the tendency to gravitate towards full employment.

In reality, prices and wages are flexible particularly downwards hence the self-adjustment mechanism of the economymight not be possible there is need for government intervention through monetary measures to stabilize the economy.

The demand for money influences the volume of trade in the economy and stability of the demand for money has important implication for the economy stabilization.

Furthermore, the interest elasticity of the demand for money provides a useful guide to the effectiveness of monetary policy. Empirical work on the demand for money in the Nigeria economy, however, show that the impact of interest rate on the demand for money is minimal. This is because money rather than competing with financial assets competes with physical goods because of the nature of the economy, which is characterized by underdeveloped money market. Thus, the expected rate of inflation takes places of interest rate in until such a time when there are enough financial assets of money market instruments to trade with and interest rates will occupy its normal position of influence.

The supply of money in Nigeria, is an economic variable that is autonomously determined by the monetary authority i.e. CBN, money supply can be defined in different ways. Due to the conclusion or exclusion of components, there are three kinds of money.

·        Narrow money

·        Quasi money

·        Broad money

Narrow money (M1) or base money is the currency in circulation or in the hand of the, public plus all demand deposit held in the commercial banks. Quasi money (M2) is the time deposits plus the savings deposits with the commercial banks. Broad money (M3) is the combination of Ml and M2. The preponderance of the money supply in Nigeria consists of currency outside banks. The higher ratio of currency in circulation is a reflection of the under-developed nature of the banking habits and an evidence of the inadequacy of banking f1acility in Nigeria.

Supply of money is however, determined by the behavior of banks concerning the amount of reserves that they decide to keep at any point in time. This amount given the fact that banks maximize profits in the long-run is influenced by the banker's foresight and their perception of economic activities surrounding them. It is also determined by the behavior of the non-bank public in dividing their money assets between currency and demands deposit, and the larger the marginal-currency ­deposit ratio, the smaller will be the expansion of deposit. Money supply also determined by the monetary authorities decision to change the size of monetary base and also by the right of the authority to set the legal reserve ratio, (Ojo and Ajayi 1981 pp 113).

On the demand side, economic literature provides several theories of the demand for money and the role of money in economic activities. Such theories include the classical the Keynesian, and monetarist theories regarding the role of money. The classical theory of income and employments is usually built around say's law which states "supply creates its own demand" and the economy could never experience either unemployment or under-consumption (Subrata Ghatak 1981, pp 8). This approach is otherwise known as the "quantity theory of money and usually associated with fisher's equation of exchange.

In his equation of exchange, fisher related the circulation of the stock of money to the amount of money spent in the economy during a given period of time. The classical economists show that it is the demand for money that allows people to carry out transaction and this in turn bears a constant relationship to the level of national income.

Keynes analyzed the motives for holding money much more rigorously than did classical economists. He asserted that the level of transaction by individuals and indeed by the whole economy will bear a stable relationship to the level of income. In the Keynesians theory, an individual is assumed to hold all of his wealth in bonds or in money. While money is a financial assets with no rates of interest or returns, bond on the other hand carries with it the promise to pay the owner a certain income per annum. The price of a bound varies inversely with the rate of interest (yield) and this inverse relationship makes it possible for bond holders to earn capital gains or losses. In a two asset worlds of Keynes, bond offer the attraction of income plus the possibility of capital gains when the interest is expected to full (Ojo and Ajayi 1981 pp 100).

The implication of Keynes theory is that the classical mechanism might fail to guarantee full employment equilibrium because if the speculative demand for money is infinitely elastic with respect to change in the interest rate (i.e. liquidity trap), then extra investment would be forth coming from a further rise in savings and economy will end up in an unemployment equilibrium. Hence, there will be needs for monetary policy to achieve a desired level of employment.

The monetarist theory as postulated by Milton friedman state that a change in money supply will change the price level as long as the demand for money is stable, as such a change will as affects the real value of national income and economic activity only in short run. It is believed that as long as the demand for money is stable it is possible to predict the effect of change of money supply on total expenditure and income. Monetarists agree that If the economy operates at less than full employment level, then an increase In money supply will lead to a rise in output and employment because of a rise in expenditure though this is only in the short run. After a time, the economy will return to less than full employment situation which must be caused by other real factors. Monetarists therefore believe that changes in money supply will affects real variables in the long run.

1.3    JUSTIFICATION OF THE STUDY

We know that as inflation rate escalates, unemployment increases, the balance of payment position worsened, adverse conditions happen to the economy. We also know that monetary policies are put in place in order to check the undesirable development by the monetary authority. Thus the reasons for under-going this study. Moreover, as we have conflict of, views and suggestion with different policies and models being experimented over the years all in the bid to stabilize the economy.

1.4    SCOPE OF THE STUDY

The scope of our study covers the period (1983 - 2009) that is twenty-seven years.  We have chosen only monetary policy tools that can be quantified for the empirical analysis.

1.5    RESEARCH HYPOTHESES

The hypothesis to be tested in the model are being stated as below.

Ho:    Money supply does not affect GDP in Nigeria

Hi:     Money supply does affect GDP in Nigeria

Ho:    Consumer price index does not affect GDP in Nigeria

Hi:     Consumer price index does affect GOP in Nigeria

Ho:    Unemployment does not affect GDP in Nigeria

Hi:     Unemployment does affect GDP in Nigeria

1.7     RESEARCH QUESTION

This research work is aimed at establishing the effectiveness of monetary policy in Nigeria. Based on this we came up with the research questions below:

·        Is monetary policy effective at all in controlling the Nigeria economy?

·        If it is effective what are the major variables that it works upon as a target in controlling the economy?

·        Lastly, which type of relationship exist between these targets and GDP in the economy?

1.8    LIMITATION OF THE STUDY

This research work is limited' by shortage of resources which includes time and finance, which constitute major hindrance on this work. Data sources also form part of the limitation. As we all know, in Nigeria means of data collection is weak and may not be accurate.

1.9    PLAN OF STUDY

This project will come in five chapters. The introduction note will be the first chapter. Chapter two will provide the literature review while chapter three will reveal the research undertaken, so to discover new facts about the effectiveness of monetary policy in Nigeria context. The fourth chapter will contain theoretical frame work that will feature error correction model to purge out unit-root from the Nigeria data and also the methodology.

However, chapter five will be the analysis of data and the interpretation of error correction model (ECM) result Including the summary, conclusions as well as recommendations.

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