i

Digitally Signed by: Content manager’s Name

DN : CN = Webmaster’s name

O = University of Nigeria, Nsukka

OU = Innovation Centre

Ugboaku, Edith J.

FACULTY OF BUSINESS ADMINISTRATION

DEPARTMENT OF DEPARTMENT OF DEPARTMENT OF DEPARTMENT OF BANKIBANKIBANKIBANKING AND FINANCENG AND FINANCENG AND FINANCENG AND FINANCE

MONETARY POLICY TRANSMISSION MECHANISM AND

THE NIGERIAN ECONOMY

ABDULLAHI, BASHIR MUHAMMED

PG/M.Sc./09/54238

ii

MONETARY POLICY TRANSMISSION MECHANISM AND

THE NIGERIAN ECONOMY

BY

ABDULLAHI, BASHIR MUHAMMED

PG/M.Sc./09/54238

BEING A DISSERTATION PRESENTED TO THE

DEPARTMENT OF BANKING/FINANCE FACULTY OF

BUSINESS ADMINISTRATION UNIVERSITY OF NIGERIA,

ENUGU CAMPUS IN PARTIAL FULFILMENT OF THE

REQUIREMENT FOR THE AWARD OF MASTER OF

SCIENCE (M.Sc.) DEGREE IN BANKING/FINANCE

SUPERVISOR: PROF. J.U.J ONWUMERE

NOVEMBER, 2014

iii

APPROVAL PAGE

This is to certify that this dissertation by Abdullahi Bashir Muhammed with registration

number PG/M.Sc./09/54238 is submitted to the department of Banking and Finance in partial

fulfilment for the award of the Master of Science (M.Sc.) degree of University of Nigeria in

Banking and Finance.

………………………………………… ...........................

PROF. J. U. J ONWUMERE DATE

(SUPERVISOR)

……………………………………........ ............................

ASSOC. PROF. E CHUKE NWUDE DATE

(HEAD OF DEPARTMENT)

iv

DECLARATION

I, Abdullahi Bashir Muhammed, a post-graduate student in the department of Banking

and Finance of the University of Nigeria Enugu Campus, with Registration Number

PG/M.Sc./09/54238 has satisfactorily completed the requirement for research work for

Master of Science degree in Banking and Finance.

This work incorporated in this dissertation is original and has not, to the best of my

knowledge, been submitted in part or in full for any other Diploma or Degree of this or

any other University

………………………………. ...........................

Abdullahi Bashir Muhammed DATE

(PG/M. Sc./09/54238)

v

DEDICATION

To my parents (Prof. O. E. Abdullahi and Mrs H. O. Obajimoh)

vi

ACKNOWLEDGEMENTS

It is my pleasure to use this opportunity to express my profound gratitude to all those who

were instrumental to the successful completion of this work

My gratitude first goes to my supervisor, Dr. J. U. J Onwumere, who gave me all the support

and counsel that has produced this dissertation. His challenge and wilful assistance benefited

me immensely. He is a rear gentle man. Dr. Austin Ujunwa is remembered all for his

benevolence, including his brotherly advice when the going was tough.

My gratitude also goes to all my lecturers in the programme most especially, Prof. Chibuike

C. Uche who made me have and appreciate a better understanding of academic life. Dr. (Mrs)

N. J. Modebe, Mummy, your motherly way of impacting knowledge was really appreciated.

My gratitude also goes to Dr. Chuke Nwude, Dr. E. Onah and Dr. B. E. Chikeleze and all

other members of the Department of Banking and Finance.

Special thanks go to Mrs S. O. Abdullahi (Special Mummy) for the motherly role she has

been playing in my life. This will not be complete without acknowledging the love and

support from my dear wife Asmaau (MPTW) and also my brothers and sisters (Yoonu,

Munira, Nafisa, Raheema, Halima, Abdulmumin and Abdulrasheed). May God All Mighty

continue to guide you all

I will also like to appreciate the efforts of my HOD, Department of Banking and Finance,

University of Abuja and also Malam Abdulmaliq Yekeen towards to completion of my study.

Special thanks also go to my friends; Khalid, Charles, Sly, Ahmad Tijani, Sadiq Daddy,

Dangana (Na-Morocco) and all others that cannot be mentioned.

Finally, to Allah SWT be the glory and thanksgiving for ever. Amen.

vii

ABSTRACT

The effectiveness of monetary transmission mechanism channels in promoting monetary policy objectives has generated serious debate among scholars and practitioners. The controversies centre largely on the complexity of the medium of transmission, the difficulty in quantifying the overall effect of policy change on the economy and the problem of imperfect knowledge about transmission mechanisms which are likely to adversely affect inflation and output volatility and timing of transmission channels. Specifically, it is generally argued that an understanding of transmission process is essential to the appropriate design and implementation of monetary policy. For monetary policy to be successful in achieving its objectives, the monetary authorities must have a reasonable assessment of the effect of their policy on the economy, thus requiring the understanding of the mechanism through which monetary policy affect the economy. It is against this background that this study sought to examine the importance of interest rate channel of monetary policy transmission mechanism on monetary policy target; effectiveness of credit channel of transmission mechanism in achieving the desired combination of monetary policy goals and the effectiveness of exchange rate channel on the monetary policy target. Time series data for 30-years period, 1980-2010, were collated from Central Bank of Nigeria published annual reports and statistical bulletin for the country aggregate data. The Vector Autoregressive model (VAR) was used to estimate the monetary transmission mechanism on the Nigerian economy. Values of Real Gross Domestic Product (RGDP) were used as the exogenous variable while Consumer Price Index (CPI), Monetary Aggregate (M2), Monetary Policy Rate (MPR), Core Credit to the Sector (CCPS), Nominal Exchange Rate (NER) were used as the endogenous variables for the three hypotheses. Descriptive statistics on both the exogenous and endogenous variables were computed and graphed to complement the vector autoregressive estimates. The result revealed that: i.) The interest rate channel of monetary policy transmission mechanism was the most effective channel of monetary policy transmission in Nigeria within the period; ii.) The credit channel is not an efficient monetary policy transmission mechanism in Nigeria and iii.) Exchange rate channel is weak in explaining monetary policy transmission mechanism in Nigeria. The study recommends, among others, that the role of deposit money banks as agents of financial intermediation in the Nigerian economy should not be neglected. Thus, the Central Bank of Nigeria should strive to make these deposit money banks in Nigeria loans transaction more amendable to monetary policy actions or seek a more effective channel of transmitting monetary actions to the economy. Such measures will include sufficient control over the reserves of deposit money banks and the timely application of reserve requirements in monetary policy control. The study also recommends that further studies could be undertaken to establish the suitability of asset price channel, balance sheet channel and expectation channel in cash based economy like Nigeria.

viii

TABLE OF CONTENTS

Title Page. . . . . . . . i

Approval Page . . . . . . . ii

Declaration . . . . . . . iii

Dedication . . . . . . . iv

Acknowledgment . . . . . . . v

Abstract . . . . . . . vi

CHAPTER ONE INTRODUCTION

1.1 Background of the Study. . . . . . . . 1

1.2 Statement of the Problem. . . . . . . . 5

1.3 Objectives of the Study. . . . . . . . 7

1.4 Research Questions. . . . . . . . . 7

1.5 Research Hypotheses. . . . . . . . . 7

1.6 Scope of the Study. . . . . . . . . 8

1.7 Significance of the Study. . . . . . . . 8

1.8 Limitation of the Study. . . . . . . . 9

1.9 Operational Definition of Terms. . . . . . . 9

References. . . . . . . . . . 11

CHAPTER TWO REVIEW OF RELATED LITERATURE

2.1 Theoretical Review. . . . . . . . . . 12

2.1.1 The General Framework of Monetary Policy Transmission Theory. . . 14

2.1.2 The Channels of Monetary Transmission. . . . . . . . . . 20

2.1.3 Financial Crises. . . . . . . 33

2.1.4 The Lending Channel and Consumer Credit . . . . . 35 2.1.5 Monetary Theory of Exchange Rate Determination. . . . . 39

2.1.6 Recent Developments . . . . . . . . 43 2.1.7 International Monetary Policy Regimes . . . . . 50

2.2 Empirical Review. . . . . . . . 68

2.2.1 Interest Rate Channel. . . . . . . . . . 68

2.2.2 The Exchange Rate Channel. . . . . . . . 71

2.2.3 The Asset Price Channel. . . . . . 74

2.2.4 Inflation Expectation Channel. . . . . . . . . . 76

2.3 Review Summary. . . . . . . . 79

References. . . . . . . . . . . 81

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CHAPTER THREE RESEARCH METHODOLOGY

3.1 Research design. . . . . . . . . 89

3.2 Nature and Sources of Data. . . . . . . . 89

3.3 Description of Research Variables. . . . . . . . 89

3.4 Techniques of Analysis. . . . . . . 92

3.5 Model Specification. . . . . . . . 93

References. . . . . . . . . . 96 CHAPTER FOUR PRESENTATION AND ANALYSIS OF DATA

4.1 Presentation of Data. . . . . . . . . 97

4.2 Descriptive Statistics of Aggregate Data. . . . . - 98

4.3 Determination of Research Variable . . . . . 100

4.4 Correlation Matrix . . . . - - - - 104

4.5 Test of hypotheses . . . . . . - - 106

4.6 Robustness Test - - - - - - - - 111

4.7 Discussion of Results - - - - - 111

References - - - - - - - - - 114

CHAPTER FIVE: SUMMARY OF FINDINGS, CONCLUSION AND

RECOMMENDATIONS

5.1 Summary. . . . . . . . . 115

5.2 Conclusion. . . . . . . . . 116

5.3 Recommendations . . . . . . . 117

5.4 Contribution to Knowledge - - - - - - - 117

5.5 Recommended Areas for Further Studies - - - - - 118

Bibliography . . . . . . . . . 119

Appendixes - . . . . . 12

1

CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

The last three decades has seen industrialized countries around the world face multitude of

shocks, which led to the inflationary experience of many countries during the 1970s, to the

exchange rate crises during the early 1990s (Yamin, 2004). The monetary experiences faced

by these countries have also led to numerous questions. These questions rage from what kind

of policy should central bank follow when shocks occur to how should central banks react to

such shock that hits the economy and the welfare effect of such shocks? Any hope of

answering this type of question relies on researchers having a clear idea of the transmission

mechanism of monetary policy. The formulation and implementation of appropriate monetary

policy is one of the major responsibilities of central bank worldwide (Ajayi, 2007).

Monetary policy can be described as the central banks action to influence the availability and

the cost of money and credit as a means of promoting national economic goals (Patrick and

Xavier, 2000). Specifically it can be defined as a combination of measures designed to

regulate the value, supply and cost of credit in an economy in consonance with the expected

level of economic activity (Olekah, 2006). Uchendu (2009) posits that monetary policy is the

use of the instruments at the disposal of the monetary authorities to influence the availability

and cost of credit/money with the ultimate objective of achieving price stability. In the same

vein, Okafor (2009) also argues that monetary policy is a blend of measures and or set of

instruments designed by the central bank to regulate the value, supply and cost of money

consistent with the absorptive capacity of the economy or the expected level of economic

activity without necessarily generating undue pressure on domestic prices and the exchange

rate.

The centrality of these definitions is that monetary policy is a measure designed to influence

the availability, volume and direction of money and credit to achieve the desired economic

objectives. The set objectives are achieved through the use of monetary policy instruments

(Ajayi, 2007). The policy tools under the control of central bank are not however directly

linked to the policy objectives. Consequently, the usual practice is that intermediate target

such as money supply; interest rate and bank credit are employed to achieve monetary policy

objectives. Generally developing a practical understanding of how monetary policy action

transmits to the economy remains a day to day challenge to the central banks.

2

According to Mbutor (2009), the financial repressive policies that preceded the adjustment era

of the late 1980s seem to have made the understanding of the channels of monetary

transmission more difficult due to interest rate volatility. When central bank takes a policy

action, it sets in motion a series of economic events. The consequence of these events start

with the initial influence on the financial market, which in turn slowly work its way through

changes in the current expenditure level, especially, private consumption and investment.

Changes in domestic demand influences the current production levels, wages and employment

and in the process eventually lead to a change in domestic prices (Ajayi, 2007). The chain of

event which link change in the monetary policy with changes in prices and output is known as

the transmission mechanism of monetary policy

In Nigeria, monetary policy formulation is the sole prerogative of the Monetary Policy

Committee (MPC) of the Central Bank of Nigeria (CBN). The MPC which was formally

consolidated in 1999, consisting of the governor of the bank as the chairman, the four deputy

governors of the bank, two members of the board of directors of the bank, three members

appointed by the president and two members appointed by the governor. The MPC has the

responsibility for formulating monetary and credit policies. The traditional function of Central

Bank of Nigeria is to ensure financial stability, favourable macroeconomic environment and

safe guard the external value of Naira.

Since monetary policy covers the monetary aspect of the general economic policy, a high

level of co-ordination is required between monetary policy and its transmission channel so as

to achieve effective monetary policy objectives. Such objectives include price stability (or low

inflation rate), full employment and growth in aggregate income. A successful implementation

of monetary policy requires an accurate assessment of how fast the effects of policy changes

propagate to other part of the economy and how large these effects are (Thorarinn, 2001). This

requires a thorough understanding of the mechanism through which monetary policy affects

economic activity. The priority of price stability over other monetary policy objectives tends

to be potentially accepted in most countries, if not enshrines in the laws governing the central

banks (Norman and Klaus 2002). The channels through which monetary policy actions are

transmitted to the economy are so vast and vary across countries. In the Nigerian, there are

some many channels through which monetary policies transmit to the economy. However,

scholars and practitioners usually identify three major channels which include; interest rate

3

channel, exchange rate channel and credit channel (Mbutor, 2009; Boivin, Kiley, and

Mishkin, 2010; Francisco, 1998).

The Interest rate channel has featured predominantly in literature over several decades as the

key monetary transmission mechanism which was influenced by basic Keynesian model.

Most central banks implement daily liquidity expansions or contractions by charging or

paying an overnight or very short-run interest rate. This rate will influence the whole structure

of interest rate in a variety of ways. Since the overnight rate is views by the market as a bench

mark, arbitrage possibilities will ensure that market interest rate on some 28-day instruments

will tend to equal (1+d), where d is the daily expected central bank interest rate. In turn other

term deposit will react to the changes in one-month so that the one day rate will end up

influencing overall term structure of interest rate. Francisco (1998) posits that another

powerful transmission mechanism is the implicit announcement effects of an interest rate

change. An adjustment of the daily interest rates by the central bank may signal to the market

that the central aims for a tighter or looser stance. Such a change could have an amplified

effect on the level of interest beyond that impact via the arbitrage mechanism described

above.

Exchange rate channel is an important element on the conventional open economy micro

economic model. With the growing internationalization and the advent of flexible exchange

rates, more attention has been paid to monetary policy transmission operating through

exchange rate effects on net exports. Indeed, this transmission mechanism is now a standard

feature in the leading textbooks in macroeconomics and money and banking. This channel

also involves interest rate effects because when domestic real interest rates fall, domestic

dollar deposits become less attractive relative to deposits denominated in foreign currencies,

leading to a fall in the value of dollar deposits relative to other currency deposits, that is, a

depreciation of the dollar (denoted by E↓). The lower value of the domestic currency makes

domestic goods cheaper than foreign goods, thereby causing a rise in net exports (NX↑) and

hence in aggregate output. This exchange rate channel plays an important role in how

monetary policy affects the domestic economy as is evident in research, such as Bryant,

Hooper and Mann (1993) and Taylor (1993).

Credit channel is generally argued to have greater effect on expenditure of smaller firms, since

they are more dependent on bank loans when compared with large firms Taylor (1993). This

is because large firms can access the credit market directly through stock and bond market.

4

Dissatisfaction with the conventional stories about how interest rate effects explain the impact

of monetary policy on expenditure on long-lived assets has led to a new view of the monetary

transmission mechanism that emphasizes asymmetric information in financial markets.

According to Mishkin (1996), there are two basic channels of monetary transmission that arise

as a result of information problems in credit markets: the bank lending channel and the

balance-sheet channel. The bank lending channel is based on the view that banks play a

special role in the financial system because they are especially well suited to solve

asymmetric information problems in credit markets Mishkin (1996). Because of banks' special

role, certain borrowers will not have access to the credit markets unless they borrow from

banks. As long as there is no perfect substitutability of retail bank deposits with other sources

of funds, the bank lending channel of monetary transmission operates as follows.

Expansionary monetary policy, which increases bank reserves and bank deposits, increases

the quality of bank loans available. Given banks' special role as lenders to classes of bank

borrowers, this increase in loans will cause investment (and possible consumer) spending to

rise.

The balance-sheet channel also arises from the presence of asymmetric information problems

in credit markets. The lower the net worth of business firms, the more severe the adverse

selection and moral hazard problems are in lending to these firms. Lower net worth means

that lenders in effect have less collateral for their loans, and so losses from adverse selection

are higher. A decline in net worth, which raises the adverse selection problem, thus leads to

decreased lending to finance investment spending. The lower net worth of business firms also

increases the moral hazard problem, because it means that owners have a lower equity stake in

their firms, giving them more incentive to engage in risky investment projects. Since taking

on riskier investment projects makes it more likely that lenders will not be paid back, a

decrease in business firms' net worth leads to a decrease in lending and hence in investment

spending.

The cash based nature of Nigerian economy and the oil revenue has the ability to distort the

channel of monetary policy transmission mechanisms that is put in place by the Central Bank

of Nigeria. This argument is supported by Nissanke and Aryeetey (1998), when they argue

that in the presence of excess liquidity, it becomes difficult to regulate the money supply

using the required reserve ratio and the money multiplier, so that the use of monetary policy

for stabilization process is undermined. In other words one would expect excess liquidity to

5

weaken the monetary policy transmission mechanism. The transmission mechanisms of

monetary policy work through various channel thus affecting variables and different market

and at various speed and intensities. Identifying these transmission channels is important

because they determine the most effective set of policy instruments, and timing of policy

changes and hence the main restrictions that central banks faces in making their decisions

(Norman and Loayza, 2002).

Given the paramount importance of the transmission mechanism for the understanding of

monetary policy it is surprising that, until very recently, relatively little effort have been

invested in understanding exactly how the transmission mechanisms have been effective in

achieving monetary policy objectives. This study is geared towards filling this important

knowledge gap.

1.2 Statement of Problem

The effectiveness of monetary transmission mechanism channels in promoting monetary

policy objectives has generated serious debate among scholars and practitioners. The

controversies centers on largely on the complexity of the medium of transmission, the

difficulty in quantifying the overall effect of policy change in the economy and the problem of

imperfect knowledge about transmission mechanisms which is likely to adversely affect

inflation and output volatility and, hence, timing of transmission channels (Ajayi, 2007).

According to Mbutor (2009), monetary policy transmission through the monetary policy rate

does not have a contemporaneous effect on the gross domestic product and consumer price

index. However, the heist dip in price as a result of the policy shock is observed, hence

variance decomposition shows that the change in the CPI was mainly caused by GDP and lags

of CPI itself. The inference from the study shows that the lending rate provides the shortest

nexus for the propagation of monetary policy impulse in Nigeria.

Ajayi (2007) also examine the monetary policy transmission mechanism in Nigeria and argue

that, monetary policy transmission mechanism varies in detail between different economies

because it depends partly upon the institutional structures. However, these differences are

small and involve the relative importance of different channels rather than the existence of the

channel itself. He posits that the design and implementation of monetary policy in a given

economy depends on its financial structure and macroeconomic importance. His study

concluded saying that channel of transmission mechanism at one time or the other have been

6

relevant to the Nigerian economy. However recent preliminary study indicates that the

exchange rate channel was very strong in Nigeria between 1980s and 2005 while the interest

rate and the credit channel were week during the period.

Boivin, Kiley, and Mishkin (2009) discussed the evolution in macroeconomics through the

monetary policy transmission mechanism and presented related empirical evidence. They

argued that the core channel of policy transmission i.e. neoclassical link between short term

policy interest rates, other asset prices such as long term interest rate, equity price and the

exchange rates, and the consequent effect on house hold and business demand have remain

steady from early policy oriented model to modern dynamic stochastic general equilibrium

model. In contrast, non neoclassical channels such as credit channels have remain outside the

core models which are responsible for a notable change in the policy behavior and in the

reduced form of correlation policy interest rates with economic activities.

Monetary policy research has centered on some major controversies such as the complexity

of the medium of transmission, the difficulty in quantifying the overall effect of policy change

and the problem of imperfect knowledge about transmission mechanisms. However, none of

these works has looked at the most effective channel of monetary policy transmission. Hence,

this study strived to fill this important research gap by empirically investigating the most

efficient channel of monetary policy transmission in Nigeria.

. Specifically, it is generally argued that an understanding of transmission process is essential

to the appropriate design and implementation of monetary policy. For monetary policy to be

successful in achieving its objectives, the monetary authorities must have a reasonable

assessment of the effect of their policy on the economy, thus requiring the understanding of

the mechanism through which monetary policy affect the economy. Given the inconclusive

findings of the above scholars, need arise to do an empirical work on Nigeria which is the

problem this research work needs to solve.

1.3 Objectives of the Study

The main objective of this study is to examine specifically the dominant channel of monetary

policy transmission mechanism in Nigeria. To achieve this objective, the study strives;

a. To examine the impact of interest rate channel of monetary policy transmission

mechanism on monetary policy target.

7

b. To determine the impact of credit channel of monetary policy transmission

mechanism on monetary policy target.

c. To evaluate the impact of exchange rate channel of monetary policy mechanism on the

monetary policy target.

1.4 Research Questions

This research work was tailored in such a way that provides answers to the following

questions;

a. What is the relationship between interest rate channel of monetary policy transmission

mechanism and monetary policy target?

b. Does credit channel of monetary policy transmission mechanism have impact on

monetary targets?

c. What is the relationship between the exchange rate channels of monetary policy

transmission mechanism on monetary policy targets?

1.5 Research Hypotheses

To achieve the above objectives and provide answers to the research questions, the following

hypotheses were put in place:

a. The interest rate channel of monetary policy transmission mechanism does not have

positive and significant impact on monetary policy target.

b. The credit channel of monetary policy transmission mechanism does not have positive

and significant impact on monetary policy target.

c. The exchange rate channel of monetary policy transmission mechanism does not have

positive and significant impact on monetary policy target.

1.6 Scope of the Study

The study covers the period, 1980-2012. This time period is necessitated by the desire of the

researcher to examine the dominant channel of monetary policy from the second republic

which started in 1979 to the present democratic dispensation in Nigeria. In line with previous

study along this area, the study focuses on channel of monetary policy transmission

mechanism such as; Exchange rates, Lending rates, Gross Domestic Product (GDP) and

Consumer Price Index (CPI). The study also focuses on the effectiveness of the above

mentioned channels as regards to the achievement of monetary policy targets.

8

1.7 Significance of the Study

A successful implementation of monetary policy requires an accurate assessment of how fast

the effect of policy changes propagate to other parts of the economy and the degree these

effect (Thorarinn, 2001). The process that describes how a change in the monetary policy

propagates to the other parts of the economy is called transmission mechanism of the

monetary policy. The end result of this study will prove to be beneficial and lend more

support to the improvement of monetary policy transmission mechanism in Nigeria. The study

is expected to be significant to key stake holders in the following ways:

a. Policy Makers and Regulators

When the CBN announces the Monetary Policy Rate (MPR) as required by law: It is essential

to signal its intention about the rate of interest and to influence the term structure of interest

rates. The inter-bank call rate has thus become the focal point of attention. The inter-bank call

market and the government securities market since the reforms have been unveiled through

the secondary market transaction have not acquired adequate depth (Mbutor, 2009).

It is against this background, that the CBN has reviled its intention to move from the current

policy framework that is a hybrid of monetary targeting and a loose form of interest rate

targeting to inflation targeting framework. There is, therefore, a more urgent need to

understand as to which of the channels of monetary policy transmission and which of the

others are need to be kept in view in short-to-medium term.

b. General Public

The outcome of this study is expected to educate the general public about the general

objective of monetary policy framework, policy target and its direction, dominant channel of

policy transmission and its effectiveness whose importance in general economic decision

making cannot be overemphasized. This study is expected to provide a platform for further

research on the subject matter.

1.8 Limitation of the Study

This research work is faced with the usual limitation associated with student research works

such limitations include; funds as a limiting factor, insufficient time and other difficulty of

data collection from the CBN such as obeying serious protocols. However, this limitation will

not invalidate the result of the study.

9

1.9 Definition of Terms

Monetary Policy

Monetary policy is a blend of measures and set of instruments designed by the central bank to

regulate the value, supply and cost of money consistent with the absorptive capacity of the

economy or the expected level economic activity without necessarily generating undue

pressure on domestic prizes and exchange rate (Okafor, 2009).

Monetary Policy Objectives

Monetary policy objectives are the set goals and targets that monetary authorities of any

country intends to achieve. In Nigeria, the objectives of monetary policy include;

Achievement of domestic price and exchange rate stability, maintenance of a healthy balance

of payments position, development of a sound financial system, and promotion of rapid and

sustainable rate of economic growth and development.

Monetary Policy Transmission Mechanism

The monetary policy transmission mechanism describes how the policy induce changes in the

nominal monetary stock or short term nominal rate impact on real variables such as aggregate

output and employment.

Monetary Policy Committee (MPC)

The monetary policy committee consolidated in 1999 consists of the governor of the bank as

the chairman, the four deputy governors of the bank, and two members of the board of

directors of the bank. Three members are appointed by the president and while members are

appointed by the governor. The MPC have responsibility within the bank for formulating

monetary and credit policy.

Open Market Operations (OMO)

The market-based tools which specify the proportion of a bank’s total deposit liabilities that

should be kept with the central bank. Open market operation may be undertaken through

outright transactions or through repurchase transaction.

10

References

Ajayi M. (2007), Monetary Policy Transmission Mechanism in Nigeria: Economic and

Financial Review, Abuja: Central Bank of Nigeria. Boivin, J., M.T. Kiley, and F. S. Mushkin (2009), “How Has the Transmission Mechanism

Evolved Over Time” Financial and Economic Discussion Series (FEDS) Humanity Research Council of Canada

Bryant, R., P. Hooper and M. C. Mann (1993), “Evaluating Policy Regimes: New Empirical

Research in Empirical Macroeconomics”, Brookings Institution Washington D.C Chalesn, B.,L. Jens and N. Kalin (2002), Financial Friction and the Monetary Transmission

Mechanism: Theory, Evidence and Policy Implementation, England: ECB Publishers. Freixas, X., A. Martin and D. Skeie, (2009), “Bank liquidity, interbank markets, and monetary

policy” Federal Reserve Bank of New York Staff Reports 371 Keneth, N. K. and C.M Patricia (2002), “Monetary transmission mechanism: Some answers

and further questions”, FRBNY Economic Policy Review New York:. Mbutor, O. M. (2009), “The Dominant Channel of Monetary Policy Transmission in Nigeria:

An Empirical Investigation”, Nigeria Economic and Financial Review, 2(1), 23-34. Modigliani, F. (1971), “Monetary policy and Consumption In consumer Spending and

Monetary Policy: the Linkages”, Federal Reserve Bank of Boston Working Paper Mohanty, M. S. and P. Turner (2008), “Monetary Policy Transmission in Emerging Market

Economies: What Is New?” Bank for International Settlements Papers, 35, 1-59 Mushkin, F.S. (1996), “The Channel of Monetary Transmission: Lessons for Monetary

Policy”, Banquet De France Bulletin Digest Colombian University, 2(3), 103-113. Mushkin, F.S. (2007), Housing and the Monetary Transmission Mechanism, Massachustts,

Cambridge: Prentice Hall Nissanke N. and R. Aryeetey (1998), “Excess Liquidity and Effectiveness of monetary Policy:

Evidence from Sub-Saharan Africa”, IMF Working Paper N0 06/115 Norman, L. and Klaus, S. H. (2002), “Monetary Policy Functions and Transmission

Mechanisms: An Overview”, World Bank working Paper. Olekah, J. K. A. (1995), “Central Bank of Nigeria’s New Monetary Policy Initiatives” a paper

Presented at the 15th, Delegates Conference/Annual General Meeting of the Monetary

Market Association of Nigeria

Okafor P. N. (2009), “Monetary Policy Frame Work in Nigeria: Issues and Challenges.”

Central Bank of Nigeria Bullion, 30(2), 23-35.

11

Ooi, S. K. (2009), “The Monetary Policy Transmission Mechanism in Malaysia: Current Development and Issues” Malaysia Bis Pepers No. 35.

Patrick, B. and Xavier, F. (2006), Coporate Finance and the Monetary Transmission

Mechanism, London: Oxford University Press Peter, N. I. (2008), The new Palgrave Dictionary of Economics, Second Editon,

USA: Macmillan Peter, N. I. (2005), The Monetary Transmission Mechanism, Second Edition: Boston College

and NBER Chestnut Hill, MA. Thorarinn, G. P. (2001), The Transmission Mechanism of Monetary Policy: Analyzing the

Financial Market Pass-through, London: George Allen and Union Ltd. Uchendu A. O. (2009), “Overview of Monetary Policy in Nigeria”, Monetary Policy

Department Central Bank of Nigeria Bullion 30 (2), 107-123. Yamin S. A. (2004), “The Transmission Mechanism Of Monetary Policy” A Dissertation

submitted to the Faculty of the Graduate School of Arts and Sciences of Georgetown

University in partial fulfillment of the requirements for the degree of Doctor of Philosophy in Economics: M.Sc.Washington D.C.

12

CHAPTER TWO

REVIEW OF RELATED LITERATURE

2.1 Theoretical Review

A successful implementation of monetary policy requires an accurate assessment of how fast

the effects of policy changes propagate to other parts of the economy and how large these

effects are. This requires a thorough understanding of the mechanism through which monetary

policy affects economic activity. The process that describes how changes in monetary policy

propagate to other parts of the economy is called the transmission mechanism of monetary

policy. It describes how changes in policy transmit through the financial system, via financial

prices and quantities, to the real economy, affecting aggregate spending decisions of

households and firms, and from there to aggregate demand and inflation. Given the paramount

importance of the transmission mechanism for the understanding of monetary policy it is

surprising that, until very recently, relatively little effort has been invested in understanding

exactly how the transmission mechanism Bernanke and Gertler (1995).

Sims (1986) posits that the transmission mechanism logically involves two stages. The first

stage involves the propagation of changes in monetary policy through the financial system.

This stage of the transmission mechanism explains how changes in the market operations of

central banks transmit through the money market to markets which directly affect spending

decisions of individuals and firms, i.e. the bond market and the bank loan market. This

involves the term structure, through which short term money market rates affect longer-term

bond rates, and the marginal cost of loan funding, through which bank loan rates are affected.

The second stage of the transmission mechanism involves the propagation of monetary policy

shocks from the financial system to the real economy. This explains how monetary policy

shocks affect real production and aggregate prices. It seems obvious that in order to fully

understand the transmission from central bank actions to the real economy, the first stage

needs to be fully understood.

The first stage of the transmission mechanism focuses only on a particular part of the

transmission mechanism, namely the interest rate channel. This implies that other important

transmission channels, such as the exchange rate channel, which should be of great

importance for a small open economy, are not considered. Given the small size and the

considerable weight on exchange rate stabilization in domestic monetary policy, one could

13

expect that world market interest rate shocks would influence interest rate determination.

Given that capital movements were only fully liberalized in 1995, and the fact that it is only in

the last few years that foreign interest rates have started to play a role in monetary policy,

detecting this effect in the data sample used here might be difficult.

The ideal measure of monetary policy would be one that is under direct control of the central

bank and is, in the short run, unaffected by changes in the demand for money. Early studies of

the transmission mechanism, such as Sims (1986), used monetary aggregates, while later

studies have tended to use measures that are under more direct control of the central bank,

such as non-borrowed reserves (Strongin, 1995 and Christiano, Eichenbaum and Evans,

1996), or some short-term interest rate under control of the central bank (Bernanke and

Blinder, 1992 and Sims, 1992).

The choice between these measures of monetary policy obviously depends on the strategy and

operating procedures of the central bank. For banks which conduct monetary policy by

targeting the liquidity of the financial system, measures such as narrow money or reserves

seem appropriate. For central banks which use the interest rate on loans from the central bank

to the financial system as the target variable, the appropriate measure of monetary policy is

this target rate.

2.1.1 THE GENERAL FRAME WORK OF MONETARY POLICY TRANSMISION

THEORY

One way of posing the fundamental question associated with understanding the monetary

transmission mechanism is to ask how seemingly trivial changes in the supply of an outside

asset can create large shifts in the gross quantity of assets that are in zero net supply, how low

is it that small movements in the monetary base translate into large changes in demand

deposits, loans, bonds and other securities, thereby affecting aggregate investment and output?

The various answers no this puzzle can be understood within the framework originally

proposed by Brainard and Tobin (1963). Their paradigm emphasizes the effects of monetary

policy on investor portfolios, and is easy to present using the insights from Fama’s (1980)

seminal paper on the relationship between financial intermediation and central banks. Fama’s

view of financial intermediaries is the limit of the current type of financial innovation,

because it involves the virtual elimination of banks as depository institutions. The setup

focuses on an investor’s portfolio problem in which an individual must choose which assets to

14

hold given the level of real wealth. Labeling the portfolio weight on asset i as w1, and total

wealth as W then the holding of asset, i the asset demand is just X1 = w1W. In general, the

investor is dividing wealth among real assets real estate, equity and bonds and outside money

each asset has stochastic return, ẑ1 with expectation ẑ1 and the vector of asset returns, ẑ1 has a

covariance structure F. Given a utility function, as well as a process for consumption, it is

possible to compute the utility maximizing portfolio weights. These will depend on the mean

and variance of the returns ẑ1 and F, the moments of the consumption process represented as

µc and a vector of taste parameters that is label ф, and assume to be constants. The utility

maximizing asset demands can be expressed as X* = wi*( ẑ1, F, µc, ф) W2 This representation

makes clear than asset demands can change for two reasons. Changes in either the returns

process ẑ1 F or macroeconomic quantities (µc, W) will affect the X*, S3. At the most abstract

level, financial intermediaries exist to carry out two functions. First, they execute instructions

to change portfolio weights. That is, following a change in one or all of the stochastic

processes driving consumption, wealth or returns, the intermediary will adjust investors’

portfolios so that they continue to maximize utility In addition, if one investor wishes to

transfer some wealth to another for some reason, the intermediary will effect the transaction.

For policy to even exist, some government authority, such as a central bank, must be the

monopoly supplier of a nominally denominated asset that is imperfectly substitutable with all

other assets (outside money). In the current environment, it is the monetary base. Reserve

requirements and the use of reserves for certain types of hank clearings are examples.

With this as background, it is now possible to sketch the two major views of the monetary

transmission mechanism. There are a number of excellent surveys of these theories, including

Bernanke (1993a), Gertler and Gilchrist (1993), Kashyap and Stein (l994a) and Hubbard

(1995).

MONEY VIEV

The first theory commonly labeled the money view is based on the notion that reductions in

the quantity of outside money raise real rates of return; this in turn reduces investment

because fewer profitable projects are available at higher required rates of return. This is a

movement along a fixed marginal efficiency of investment schedule. The less substitutable

outside money is for other assets and the larger the interest rate changes. There is no real need

to discuss banks in this context; In fact, there is no reason to distinguish any of the “other”

assets in investors’ portfolios. In terms of the simple portfolio model, the money view implies

15

that the shift in the Wi* s for all of the assets excluding outside money are equal. An

important implication of this traditional model of the transmission mechanism involves the

incidence of the investment decline. Since there are no externalities or market imperfections,

it is only the least socially productive projects that go unfunded. The capital stock is

marginally lower. But, given that a decline is going to occur, the allocation of the decline

across sectors is socially efficient.

This theory actually points to a measure of money that is rarely studied, most empirical

investigations of monetary policy transmission focus on M2, but the logic of the portfolio

view suggests that the monetary base is more appropriate. It is also worth pointing out that

investigators have found it extremely difficult to measure economically significant responses

of either fixed or inventory investment to changes in interest rates that are plausibly the result

of policy shifts, In fact, most of the evidence that is interpreted as supporting the money view

is actually evidence that fails to support the lending view.

THE LENDING VIEW BALANCE SHEET THEORY

The second theory of monetary transmission is the lending view. It has two parts, one that

does not require introduction of assets such as hank loans, and one that does. The first is

sometimes referred to as the broad lending channel, or financial accelerator, and emphasizes

the impact of policy changes on the balance sheets of borrowers. It has substantial similarity

to the mechanism operating in the money view, because it involves the impact of changes in

the real interest rate on investment. According to this view, there are credit market

imperfections that make the calculation of the marginal efficiency of investment schedule

more complex. Due to information asymmetries and moral hazard problems, as well as

bankruptcy laws, the state of a firm’s balance sheet has implications for its ability to obtain

external finance. Policy-induced increases in interest rates (which are both real and nominal)

can cause deterioration in the firm’s net worth, by both reducing expected future sales and

increasing the real value of nominally denominated debt, with lower net worth, the firm is less

creditworthy because it has an increased incentive to misrepresent the riskiness of potential

projects. As a result, potential lenders will increase the risk premium they require when

making a loan. The asymmetry of information makes internal finance of new investment

projects cheaper than external finance.

16

The balance sheet effects imply that the shape of the marginal efficiency of investment curve

is itself a function of the debt-equity ratio in the economy and can be affected by monetary

policy In terms of a simple textbook analysis, policy moves both the IS and the LM curves.

For a given change in the rate of return on outside money (which may be the riskless rate), a

lender is less willing to finance a given investment the more debt a potential borrower has.

This point to two clear distinctions between the money and the lending views; the latter

stresses both the distributional impact of monetary policy and explains how seemingly small

changes in interest rates can have a large impact on investment (the financial accelerator).

Returning to the portfolio choice model, the presence of credit market imperfections means

that policy affects the covariance structure of asset returns. As a result, the Wi*s will shift

differentially in response to monetary tightening as the perceived riskiness of debt issued by

firms with currently high debt-equity ratios will increase relative to that of others. The second

mechanism articulated by proponents of the lending channel can be described by dividing the

“other” assets in investors’ portfolios into at least three categories: outside money, “loans”

and all the others. Next, assume that there are firms for which loans are the only source of

external funds some firms cannot issue securities. Depending on the solution to the portfolio

allocation problem, a policy action may directly change both the interest rate and the quantity

of loans, It is not necessary to have a specific institutional framework in mind to understand

this, Instead, it occurs whenever loans and outside money are complements in investor

portfolios; that is, whenever the portfolio weight on loans is a negative function of the return

on outside money for given means and covariance of other asset returns.

These arguments have two clear parts. First, there are borrowers who cannot finance new

projects except through loans, and second, policy changes have a direct effect on loan supply

Consequently the most important impact of a policy innovation is cross-sectional, as it affects

the quantity of loans to loan-dependent borrowers. Most of the literature on the lending view

focuses on the implications of this mechanism in a world in which banks are the only source

of loans and whose abilities are largely reservable deposits. In this case, a reduction in the

quantity of reserves forces a reduction in the level of deposits, which must be matched by a

fall in loans. The resulting change in the interest rate on outside money will depend on access

to close bank deposit substitutes. But the contraction in bank balance sheets reduces the level

of loans. Lower levels of bank loans will only have an impact on the real economy insofar as

there are firms without an alternative source of investment funds. As a theoretical matter, it is

17

not necessary to focus narrowly on contemporary banks in trying to understand the different

possible ways in which policy actions have real effects. As emphasized, bank responses to

changes in the quantity of reserves are just one mechanism that can lead to a complementarity

between outside money and loans. As pointed out by Romer and Romer (1990), to the extent

that there exist ready substitutes in bank portfolios for reservable deposits such as CDs, this

specific channel could he weak to nonexistent. But it remains a real possibility that the

optimal response of investors to a policy contraction would be to reduce the quantity of loans

in their portfolios. The portfolio choice model also helps to make clear that the manner in

which policy actions translate into loan changes need not be a result of loan rationing,

although it may as Stiglitz and Weiss (1981) originally pointed out, a form of rationing may

arise in equilibrium as a consequence of adverse selection, But the presence of a lending

channel does not require that there be borrowers willing to take on debt at the current price

who are not given loans. It arises when there are firms which do not have equivalent

alternative sources of investment funds and loans are imperfect substitutes in investors’

portfolios. Obviously, the central bank can take explicit actions directed at controlling the

quantity of loans. Again, lowering the level of loans will have a differential impact that

depends on access to financing substitutes. But the mechanism by which explicit credit

controls influence the real economy is a different question.

Distinguishing the two Views; General Consideration

Distinguishing between these two views is difficult because contractionary monetary policy

actions have two consequences, regardless of the relative importance of the money and

lending mechanisms. It both lowers current real wealth and changes the portfolio weights.

Assuming that there are real effects, contractionary actions will reduce future output and

lower current real wealth, reducing the demand for all assets. In the context of standard

discussions of the transmission mechanism, this is the reduction in investment demand that

arises from a cyclical downturn. The second effect of policy is to change the mean and

covariance of expected asset returns, this changes the w1’s. In the simplest case in which there

are two assets, outside money and everything else, the increase in the return on outside money

will reduce the demand for everything else. This is a reduction in real investment. The lending

view implies that the change in portfolio weights is more complex and in an important way

there may be some combination of balance sheet and loan supply effects. This immediately

18

suggests that looking at aggregates for evidence of the right degree of imperfect

substitutability or timing of changes may be very difficult, What seems promising is to focus

on the other distinction between the two views the lending view’s assumption that some firms

are dependent on loans for financing. In addition to differences stemming from the relative

importance of shifts in loan demand and loan supply the lending view also predicts cross-

sectional differences arising from balance sheet considerations; these are also likely to be

testable. In particular, it may be possible to observe whether, given the quality of potential

investment projects, firms with higher net worth are more likely to obtain external funding.

Again, the major implications are cross-sectional.

2.1.2 THE CHANNELS OF MONETARY TRANSMISSION

There are three main types of monetary transmission mechanism models found in the

literature: the interest rate channel, the asset channel and the credit channel (Seyrek and

others, 2004). According to the monetary transmission mechanism, money supply is active

and, in the short term, monetary tools and increased money supply reduce interest rates.

Hence the liquidity effect is only short-term. The drop in interest rates increases credit value.

This situation causes a short-term increase in income. In the long term, the increased price in

money supply increases its general level and the real value of money stock declines.

According to the Monetarist approach, money supply is active during these processes and is

controlled by the Central Bank. According to the Keynesian approach, monetary politics tools

affect the monetary base first, then the money supply. Following this, the changes in money

supply affect interest rates, which in turn affect investments and then revenues. New

Keynesian economics argues that money supply is passive. Rather than the Central Banks’

exported money supply, credit money is determined according to the banks’ credit

preferences. When economic units use credit, deposits created by credit multiply. The passive

money hypothesis presumes that causality moves away from credits towards deposits. Credit

demands are set by the preferences of the credit applicants and creditor. For this reason,

Central Banks do not have control over credits, and therefore, money stocks (Shanmugan and

others, 2003). There are three approaches with regard to passive money stock;

accommodationalist, structuralist and liquidity preference. According to the

accommodationalists (Moree, 1989) credits are the source of money supply and money base,

and that money supply and money revenue (GDP) are co-integrated and interdependent.

According to the structuralists (Palley, 1996, 1998; Pollin 1991) credits are the source of

19

money supply, money base and money multipliers and that money supply and money revenue

(GDP) are co-integrated and interdependent. Finally, according to liquidity preference

theorists (Howells, 1995), credits and money supply are co-integrated and interdependent.

There is a wide argument that monetary policy is a tool promoting economic growth and

stabilizing inflation. However there is a less argument about how policy exactly exacts its

influence. Most of these frequently regard monetary transmission mechanism as a ‘black box’.

In other to make accurate assessment of the magnitude, timing and duration of monetary

policy, the policy maker needs to understand the mechanism through which monetary policy

affects the economy. Mishkin (1995) points out that the monetary transmission mechanism

includes the interest rate channel, the exchange rate channel the asset price channel and the

credit channel.

The Interest Rate Channel

The interest rate channel is the primary monetary transmission mechanism in the

conventional macroeconomic models, such as the IS-LM model. Those models holds that

monetary policy operates through the liability side of the balance sheets: giving some degree

of price stickiness, a change in money is transmitted to the real economy through its impact on

the cost of capital and consumption. In contrast, bank loans, which are one of the bank assets,

are regarded as the instrument in the bond market and then it can conveniently be suppressed

by Walras’ Law. However as pointed out by Bernaken and Gertler (1995), the study have had

a great difficulty in identifying quantitatively important effects of interest policy induced

interest charges is considerable large than that implied by conventional estimate of the interest

elasticity of consumption and investment these observation suggest that mechanism other than

interest rate channel may also work in the transmission of monetary policy.

Drawing from the various theories on the channels of monetary policy transmission the

Keynesian theory of the channel of monetary policy is prescribed as the framework for

analyzing the transmission channels of monetary policy to real sectorial outputs Mishkin

(2004). In the Keynesian approach, a discretionary change in monetary policy affected the real

economy through the two sides of market forces, the demand and supply sides. From the

aggregate demand side, monetary policy is transmitted either directly through three channels;

the exchange rate, the interest rate and asset channel or indirectly through the bank credit

which is transmitted through two channels: the bank-lending channel and the balance sheet

20

channel. From the supply side, monetary policy impulse affected real variables via changes in

inventory cost (Baksh and Craitgwell, 1997), or indirectly through the bank credit which was

transmitted through two channels: the bank-lending channel and the balance sheet channel.

From the supply side, monetary policy impulse affected real variables via changes in

inventory cost (Baksh and Craitgwell, 1997). While acknowledging the supply side channel,

this study adopted aggregate demand side channels. For two reasons; first, in Keynesian

framework, the aggregate supply was relatively fixed due to stickiness of price at least in the

short run. Second, the Nigerian economy is structurally weak and not well developed to allow

the necessary adjustment to take place if the inventory cost approach is to be relevant. The

economic intuition behind the aggregate demand channels of policy influence on real

variables is usually described by the traditional Keynesian (IS-LM) framework. The

framework focused on the equilibrium position between the demand for and the supply of

money to determine the rate of interest, which influenced investment spending and

consequently output level (Dornbusch et al, 2002). It dichotomized the economy into real and

money sector. The IS curve represented equilibrium in the real sector while the LM curve

represented equilibrium in the money

An important observation with the theoretical exposition above is that interest rate is cardinal

in any channel monetary policy passes through to the real sector. So in recognizing this fact,

the channel that formed the basis for the subsequent analysis was represented schematically

as:

Ms↑→i↓→ PSC↑→Ps↑→Er↓→I↑→Y↑

Ms↑ indicates expansionary monetary policy resulting from government purchases of

securities in the open market, leading to a fall in real interest rate, which in turn: (a) increases

the amount of credit by banks to the private sector; (b) increases in the price of security prices

given the inverse relationship between security prices and interest rate and (c) decreases in

exchange rate; these effects stimulate investment and consequently output.

According to the traditional Keynesian interest rate channel, a policy-induced in the short-

term nominal interest rate leads first to a long-term nominal interest rates. Investors act to

arbitrage away differences I risk-adjusted expected return on debt instrument of various

maturities as described by the expectation hypotheses of the term structure. When nominal

prices are slow to adjust, these movement in nominal interest rest rate translate in to

movement in real interest rate. Firms finding their real cost of borrowing over all horizons has

21

increased, cut back on their investment expenditure. Likewise, house hold facing higher real

borrowing cost scale back on their consumption, thereby reducing the aggregate demand,

output and employment. This interest rate channel lies at the heart of the traditional

Keynesians-LM model, due originally to Hicks (1937). And also appear in more recent new

Keynesian models. The interest rate channel is the key monetary policy transmission

mechanism in the basic Keynesian IS-LM model. It is the traditional mechanism and the one

often regarded as the main channel of monetary policy transmission it can be summarized as

follows: M↑ → ir ↓ → I → Y↑. Where: M = money supply, ir = Real Interest Rate, I =

Investment spending and Y = Output. These shows that the expansionary monetary policy

leads to a fall in real interest rates, which in turn lower the cost of capital causing a rise in

investment spending which then increases aggregate demand and output (Mishkin 1996).

The basic idea is straightforward: given some degree of price stickiness, an increase in

nominal interest rates, for example, translates into an increase in the real rate of interest and

the user cost of capital. These changes in turn lead to a postponement in consumption or a

reduction in investment spending and, hence, the output level and prices. The effectiveness of

monetary policy will depend not only on its ability to affect the real interest rate, but also on

the sensitivity of consumption and investment to changes in the price of inter-temporal

substitution. The elasticity of aggregate demand to the interest rate both absolute and relative

will determine how, when, and to what extent the monetary policy will affect the economy.

This basic model, however, would only be complete if the economy‘s financial portfolio

consisted solely of bonds and money, with no other assets available to agents. If a richer

economic structure is recognized, the economy no longer depends on a single interest rate, so

the direct effect of policy actions on consumption and investment fades.

This is precisely the mechanism embodied in conventional specifications of the IS curve

whether of the Old Keynesian variety, or the forward-looking equations at the heart of the

New Keynesianẑ macro models developed by Rotemberg and Woodford (1997) and Clarida,

Galí, and Gertler (1999), among others. But as Bernanke and Gertler (1995) have pointed out,

the macroeconomic response to policy-induced interest rate changes is considerably larger

than that implied by conventional estimates of the interest elasticity of consumption and

investment. This observation suggests that mechanisms other than the narrow interest rate

channel may also be at work in the transmission of monetary policy.

22

However Arto Kovanen (2011) posits that monetary policy implementation in countries where

financial markets are sufficiently deep and liquid rests on the interest rate channel whereas

monetary aggregates usually are less important for monetary policy. This increased “market

orientation” of monetary policy implementation involves a short-term market interest rate as

the operating target of monetary policy. In this type of framework, for monetary policy to

have a desired impact on the real economy and inflation, which is the ultimate objective of

monetary policy, it is essential that changes in the short-term market interest rate eventually

translate into changes in other interest rates in the economy (that is, interest rate changes are

passed through to retail interest rates for loans and deposits), which then influence the overall

level of economic activity and prices. The interest rate channel is increasingly relevant in

many developing and emerging market countries as well, as countries find it difficult to

achieve their quantitative targets in these countries; monetary policy usually operates through

the targeting of the quantity of reserve money. These countries often have less developed,

shallow financial markets, which itself introduces challenges for monetary policy

implementation and contributes to the weaknesses in the transmission through the interest rate

channel. A good example of such country includes Nigeria and Ghana where monetary policy

is presently implemented in the context of an inflation-targeting framework which Ghana

formally introduced in 2007. This replaced “money targeting” as the operating model for

monetary policy. The Bank of Ghana uses a short-term money market interest rate as its

operating target where changes in the short-term interest rate are expected to influence the

cost of funding for banks and eventually the level of retail deposit and lending interest rates.

The ability to hit the interest rate target consistently plays a critical role in monetary policy

effectiveness. It is also essential for the communication of central bank’s policy stance to the

public Keister (2008). If the market interest rate were to deviate time and again from the

central bank’s announced target, the public might begin to question whether these deviations

represent a glitch in the implementation process or whether they amount to an undisclosed

change in the stance of monetary policy. Such easing or tightening by “stealth”, as one might

call it, would undermine the credibility of monetary policy. An important issue in this respect

is whether central bank’s liquidity forecasting and liquidity management are adequate or

whether short coming in these areas contribute to the rate deviations from the target.

Furthermore, when short-term market interest rates are sensitive to changes in the supply and

demand for liquidity, small errors in central bank’s liquidity forecasts could lead to large

23

swings in the short-term interest rates. In such an environment, the central bank might find it

difficult to an important exception is the European Central Bank, which has assigned a role

for broad money in monetary policy. In the U.S., on the other hand, monetary aggregates are

considered to be of limited importance. The effects of these shocks may be amplified by

illiquid or shallow financial markets.

Goodfriend (1991) posits that the transmission of interest rate changes through the interest

rate channel should ideally take place over a relatively short period of time as a faster

transmission would strengthen the impact of monetary policy on the real economy. Due to a

confluence of factors, however, the short-run interest rate pass-through may be less than

complete in reality and interest rates may also adjust asymmetrically to rising and falling

policy interest rates. The sluggishness of pass-through is evident in the many studies that have

examined the speed of interest rate adjustment. Countries with deep and well developed

financial markets, such as the U.S. and the European common currency area, the speed and

completeness of the interest rate pass-through differs (Kwapil and Scharler (2010) and

Karagiannis et al. (2010)). These differences in part reflect the country-specific features of

financial markets (for instance, in Europe the banking system plays a more significant role in

lending than in the U.S.). In developing countries, due to the underdevelopment and

shallowness of financial markets and the transmission process dominated by bank lending

channel, the structure of financial markets plays an important role in the transmission process

(Mishra, Montiel, and Spilimbergo (2010)). Deficiencies in the financial system and high

concentration among banks reduces competitiveness, while large excess reserves make central

bank’s monetary policy less effective and impairs the interest rate channel. Sander and

Kleimeier (2006) note that in the Southern African Customs Union (SACU) countries the

interest rate channel works differently for deposits and lending rates. While the pass-through

is rather uniform and complete for retail lending interest rates, there is a great deal of

heterogeneity across the national markets and differing degrees of interest rate stickiness and

asymmetry in the adjustment of retail deposit interest rates.

Despite its increasing relevance for monetary policy implementation, the interest rate

transmission process is not extensively studies in most African countries. An exception is

Ghartey (2005) who examines the impact of monetary policy on the term structure of interest

rates in Ghana during 1994-2004 and reports that there is a significant effect from monetary

policy to Treasury bill interest rates.

24

The traditional Keynesian ISLM view of the monetary transmission mechanism can be

characterized by the following schematic showing the effects of a monetary expansion.

M↑→ir↓→ ir↓→Y↑

Where M↑ indicates an expansionary monetary policy leading policy to a fall in real interest

(ir↓), which in turn lowers the cost of capital, causing a rise in investment spending (ir↓),

there by leading to an increase in aggregate demand a rise in output (Y↑). Although Keynes

originally emphasized this channel as operating through businesses’ decision about

investment spending. Thus, the interest rate channel of monetary transmission outlined in the

schematic above applies equally to consumer spending in which I represent residential

housing and consumer durable expenditure. An important feature of the interest transmission

mechanism is its emphases on the real rather than the nominal interest rate as that which

affects consumer and business decisions. In addition, it is often the real long-term interest rate

and not the short-term interest rate that is viewed as having the major impact on spending. It is

that that changes in the short-term nominal interest rate induced by a central bank result in a

corresponding change in the real interest rate on both long and short-term bonds. The key is

sticky prices, so that expansionary monetary policy which lowers the short-term nominal

interest rate and also lowers the short-term real interest rate, and this would still be true even

in a world with rational expectations. The expectation hypotheses of the term structure, which

states that the long interest rate is an average of expected future short-term interest rate,

suggest that lower real short-term interest rate leads to a fall in real long-term interest rate.

These lower real interest rates then leads to rise in business fixed investment, residential

housing investment, consumer durable expenditure and inventory investment, all of which

produce the rise in aggregate output.

The fact that it is the real interest rate that impact on the spending rather than the nominal rate

provides an important mechanism for how monetary policy can stimulate the economy, even

if nominal interest rates hits a floor of zero during a deflationary episode. With nominal

interest rate at a floor of zero, an expansionary in the money supply (M↑) can raise the

expected price level (Pe↑) and hence expected inflation ( ), thereby lowering the real interest

rate (ir↓) even when the nominal interest is fixes at zero, and stimulating spending through the

interest rate channel. That is, M↑→ Pe↑→ ↓→ ir↓→ I↑ Y↑

25

This mechanism thus indicates that monetary policy can still be effective even when nominal

interest rate have already been driven down to zero by the monetary authorities. Indeed, this

mechanism is a key element in monetarist discussion of why the U.S economy was not stuck

in liquidity during the Great depression and why expansionary monetary policy could have

prevented the sharp decline in output during this period.

Taylor (1995) has an excellent survey of the recent research on interest rate channel and he

takes a position that there is strong empirical evidence for substantial interest rate effect on

consumer and investment spending, making the interest rate monetary transmission a stronger

one. His position is highly a controversial one because many researchers, for example

Bernake and Gertler (1995), have an alternative view that empirical studies have had great

difficulty in identifying sufficient effect if interest rate through the cost of capital.

The Credit Channel

According to the credit channel theory of the monetary transmission mechanism, frictions in

credit markets that generate a wedge between the costs of raising funds externally and

internally, the external finance premium, help explain the effect of monetary policy on real

variables. For example, the cost of monitoring in credit markets suggests poorly collateralized

borrowers will pay a higher premium for external funds than larger, more-collateralized

borrowers. The credit channel of monetary policy is a mechanism through which the impact of

monetary policy shocks on the real economy is amplified through its effect on external

finance premiums. In particular, by affecting this wedge counter cyclically, monetary policy

has an additional impact on real variables beyond its standard effect through the cost of

capital.

Bernanke and Gertler (1995), posits that the credit channel mainly operates through two

conduits: the balance sheet channel, in which monetary policy affects borrowers’ net worth

and debt collateral, and the bank lending channel, in which policy impacts the level of

intermediated credit. These channels have been incorporated into general equilibrium models

through costly-state-verification to enhance their empirical relevance. (Bernanke et al., 1999).

A key result from these models is that the strength of both channels and therefore the broader

credit channel increases with the level of financial frictions. Since alternative sources of credit

are very limited or even non-existent customers in developing countries cannot replace lost

bank credit with other types of finance and so are forced to cut back on investment spending.

26

If the credit channel is operational it means monetary policy is likely to have its impact via the

asset side of the balance sheet because a fall in reserves reduces the quantity of loans that can

be made available. According to Ramey (1993) there are two key conditions that must be

satisfied before a lending channel can be made operational. First, banks must not be able to

shield their loan portfolio from changes in monetary policy and, second, borrowers must not

be able to fully insulate their real spending from changes in the availability of bank credit.

Due to the dissatisfaction with the money view prompted an alternative the credit channel

approach. The credit channel comprises two separate channels: a broad lending channel and a

bank-lending channel. The idea of the broad lending channel is that information asymmetries

and moral hazard restrict the ability of firms to obtain external finance to the extent that a

restrictive monetary policy causes deterioration in the firm’s net worth and credit worthiness.

This aspect of the credit channel resembles the money view since it involves the impact on

investment of changes in the real interest rate. To this end the broad lending channel may be

regarded as an enhancement of the money channel. The bank-lending channel is perhaps more

relevant in developing countries because it is based on the premise that investment projects

are primarily financed by bank loans and that the supply of loans is directly influenced by

changes in policy. Since alternative sources of credit are very limited or even non-existent

customers in developing countries cannot replace lost bank credit with other types of finance

and so are forced to cut back on investment spending.

The bank lending channel is based on the view that banks play a special role in the financial

system because they are especially well suited to solve asymmetric information problem in the

credit markets. Fredric S. M (1996). Because of banks special role, certain borrowers will not

have access to the credit markets unless they borrow from banks. As long as there is no

perfect substitutability of retail deposits with other sources of funds, then the bank lending

channel of monetary transmission operates as follows. Expansionary monetary policy, which

increases bank reserves and bank deposits, increases the quantity of bank loan available.

Given the bank’ special role in lending to classes of borrower, the increases in loan cause

investment and possibly consumers spending to rise. Schematically, the monetary policy

effect is M↑→bank deposit↑→bank loan↑→I↑→Y↑.

An important implication of the credit view is that monetary policy will have a greater effect

on expenditure by a small firm that are more dependent on bank loans that it will on large

27

firms that can directly access the credit market through the stock and bond market without

going through banks.

Ewwards and mishkin (1996) posits that some doubt about lending channel have been raised

in some literature which gave reasons to suspect that the bank lending channel in the United

State may not be as powerful as it once was. First is the current U.S regulatory frame work no

longer imposing restrictions on banks hindering the ability to raise funds. Prior to the med

1980s, certificate of deposits (CDs) were subjected to reserve requirement and regulations Q

deposit rate ceilings, which makes it hard for banks to replace deposit that flows out of the

banking system during a monetary contraction. With the regulatory restriction abolished, bank

can more easily respond to a decline in bank reserve and a loss of retail deposits by issuing

CDs at market interest rate that are not required to be backed up by required reserves. Second,

the decline of the traditional bank lending business which is occurring worldwide means the

bank are playing a less important role in credit markets, rendering the bank lending channel

less potent.

Balance Sheet Channel

Even though the bank lending channel may be declining, in importance, it is by no means

clear that this is the case for the other credit channel, the balance sheet channel. The balance

sheet channel also arises from the presence of asymmetric information problems in credit

markets. Meltzer (1995). The lower the net worth of business of business firm, the lower the

net worth means that lenders in the effect have less collateral for their loans, and also loses

from the adverse selection are higher. A decline in net worth, which roses the adverse

selection problem, thus leads to decrease lending to financial investment spending. The lower

the net worth of business firms also increase the moral hazard problem because it means that

owner have a lower equity stake in their firms, giving them more increase in earning on risky

investments projects. Since taking on riskier investment projects makes it more likely that

lenders will not be paid back, a decrease in business firm’s net worth leads to decrease in

lending and hence in investment spending. Monetary policy can affect firms’ balance sheet in

several ways. Expansionary monetary policy (M↑) which causes a rise in equity prices (Pe ↑)

along lines decrease earlier raises the net worth of firms so lead to higher investment spending

(I↑) and aggregate demand (Y↑) because of the decrease in adverse selection and moral

28

hazard problems. This leads to the following for one balance- sheet channel of monetary

transmission:

M↑→ Pe ↑→ adverse selection ↓ & moral hazard ↓→ lending ↑→ I↑→ Y↑

According to Cecchetti (1995), expansionary monetary policy which lowers nominal interest

rate also causes an improvement in firms’ balance sheet because it raises cash flow, thereby

reducing adverse selection and moral hazards problems which lead to the following additional

schematics from the balance channel:

M↑→ i↓→ cash flow↑→ adverse selection ↓ & moral hazard ↓→ lending ↑→ I↑→ Y↑

An important feature of these of this transmission mechanism is that it is nominal interest that

affects cash flow. Thus this interest rate mechanism differs from the traditional interest rate

mechanism discussed earlier in which it is the real rather than the nominal interest rate that

affects investment. Furthermore, the short term interest rate plays a special this transmission

mechanism because it is interest payments on short term rather than debt that typically have

the greatest impact on firm cash flow.

A related mechanism involving adverse section through which expansionary monetary policy

that lowers interest rates can aggregate output involves the credit rationing phenomenon. As

demonstrated by Stigitize and Weisis (1981), credit rationing occurs in cases is because

individuals and firms with the riskiest investment projects are exactly the ones who are

willing to pay the highest interest rates since, if the high-risk investment succeeds, they will

be the primary beneficiaries. Thus, higher interest rates increase the adverse selection problem

and lower interest rates reduce it. When expansionary monetary policy lowers interest rates,

less risk-prone borrowers are a higher fraction of those demanding loans and thus lenders are

more willing to lend, raising both investment and output, alone the lines of parts of the

schematic above.

A third balance-sheet channel operates through monetary policy effects on the general price

level. Because debt payments are contractually fixed in nominal terms, an unanticipated rise

in the price level lowers the value of firms’ liabilities in real terms (decreases the burden of

the debt) but should not lower the real value of the firms’ assets. Monetary expansion that

leads to an unanticipated rise in the price level (P ) therefore raises real net worth, which

lowers advise selection and moral hazard problems, thereby leading to a rise in investment

spending and aggregate output as in the schematic below.

29

M → unanticipated P → adverse selection & moral hazard → lending → = Y

The view that unanticipated movements in the price level have important effects on aggregate

demand has a long tradition in economics: it is the key feature in the debt-deflation view of

the Great Depression espoused by Irving Fisher (1933).

Household Balance-sheet Effects

Although most of the literature on the credit channel focuses on spending by business firms,

the credit channel should apply equally as well to consumer spending, particularly on

consumer durables and housing. Declines in bank lending induced by a monetary contraction

should cause a decline in durables and housing purchases by consumers who do not have

access to other sources of credit. Similarly, increases in interest rates causes a deterioration in

household balance-sheets because consumes’ cash flow is adversely affected.

Another way of looking at how the balance-sheet channel may operate through consumers is

to consider liquidity effect on consumer durable and housing expenditures found to have been

important factors during the Great Depression (Mishkin (1978). In the liquidity effects view,

balance-sheet effects work through their impact on consumers’ desire to spend rather than on

lenders desire to lend. Because of asymmetric information about their quality, consumer

durables and housing are very illiquid assets. If as result of a bad income shock consumers

needed to sell their consumer durables or housing to raise money, they would expect a big loss

because they could not get the full value of these assets in a distress sale (Akerloff 1970) . In

contrast, if consumers held financial assets (such as money in the bank, stocks, or bonds), they

could easily sell them quickly for their full market value and raise the cash. Hence, if

consumers expect a higher likelihood of finding themselves in financial distress, they would

rather be holding fewer illiquid consumer durable or housing assets and more liquid financial

assets.

A consumer’s balance sheet should be an important influence on his or her estimate of the

likelihood of suffering financial distress. Specifically, when consumers have a large amount

of financial assists relative to their debts, their estimate of the probability of financial discreet

is low, and they will be more willing to purchase consumer durables or housing. When stock

prices rise, the of financial assets rises as well; consumer durable expenditure will also rise

because consumers have a more secure financial position and a lower estimate of the

likelihood of suffering financial distress. This leads to another transmission mechanism of the

monetary policy operating through the link between money and equity prices:

30

M → P → financial assets → likelihood of financial distress → consumer durable and

housing expenditure → Y

The illiquidity of consumer durable and housing assets provides another reason why a

monetary contract which raises interest rates and thereby reduces cash flow to consumers

leads to a decline in spending on consumer durables and housing. A decline in consumer cash

flow increases the likelihood of financial distress, which reduces the desire of consumers to

hold durable goods or housing, thus reducing spending on them and hence aggregate output.

The only different between this view of cash-flow effects and that outline in schematic is that

it is not the unwillingness of lenders to lend to consumers that causes expenditure to decline,

but the unwillingness of consumers to spend.

2.1.3 FINANCIAL CRISES

According to Mishkin (1991, 1994), an extreme form of the credit channels described above

provides an important route for monetary policy effects on the economy via a financial crisis.

A financial crisis is a disruption to financial markets that sharply and severely increases

asymmetric information problems of the type described above, so that financial markets are

no longer able to efficiently channel funds to those who have the most productive investment

opportunities. The result is a sharp contract in economic activity. The asymmetric information

theory of financial crises which has been outlined in Bernanke (1983) and Mishkin (1991,

1994) suggests that contractionary monetary policy can play an important role in producing

financial crises. Mishkin (1994) outlines five factors that can promote a financial crisis:

1) Increase in interest rates,

2) Stock market declines,

3) An unanticipated decline in the prices level,

4) Increases in uncertainty, and

5) Bank panics.

Our earlier discussion shows how contractionary monetary policy can lead to asymmetric

information problems that cause a contraction in the economy as a result of the first three

factors. A monetary contraction which raises interest rates increases adverse selection because

economic agents who are willing to take bigger risks and therefore to pay the higher interest

rates will be the ones most anxious to borrow. In addition, the higher interest rates which

reduce firms’ cash flow hurt their balance sheet position, which increases moral hazard and

31

adverse selection problems, making it less likely that markets will be willing to lend to them.

Monetary contraction also produces a decline in stock prices which lowers the net worth of

firms, again increasing adverse selection and moral hazard problems in credit markets.

Monetary contract can also produce an unanticipated decline in the price level which, because

debt is denominated in normal terms, leads to a debt-deflation scenario (Fisher 1933), in

which the resulting decline in firms’ net worth increases adverse selection and moral hazard

problems. Thus, our analysis of the credit channels above shows how monetary policy can

lead to a financial crisis which is an extreme case of increased asymmetric information

problems, and thereby lead to a sharp economic contraction.

The last two factors promoting financial can also be stimulated by contractionary monetary

policy. A recession, which can result from contractionary money policy, typically result in

increased uncertainty about the payoffs from debt contracts, thus making it hard to screen out

good from bad credit risks. The increase in uncertainty therefore makes information in

financial markets even more asymmetric and the adverse selection problem worse, which

impedes lending and thus cases a decline in economic activity. Monetary contraction can also

promote bank pansies because, as we have seen, it can lead to a deterioration in firms’ balance

sheets that causes bank loans to go sour. Because depositors many not be able to discriminate

between banks that have made good versus bad loans, they rush (run) to the banks to

withdraw their funds. The resulting contraction in deposited and the desire of banks to

increase their reserve relative to deposits to protect themselves from the deposit withdrawals

then leads to a multiple contraction in loans and deposits that prompts other bank failures and

leads to a bank panic (Freidman and Schqartz 1963). As we saw earlier, banks have a special

role in the financial system because they are so well suited to solve asymmetric information

problems in credit markets. The decline in the number of banks and in their sources of funds

to make loans reduces the ability of the financial system to solve adverse selection and moral

hard problems in credit markets, thereby causing a reduction in investment and a decline in

economic activity.

According to Mishkin (1991), most financial crises in the U.S have begun with a sharp rise in

interest rates, a stock market crash, and an increase in uncertainty arising after the start of a

recession, all of which are promoted by contractionary monetary policy. With worsening

business conditions and uncertainty about their banks’ health, depositors then began to

withdraw their funds from the banks, leading to bank panics. In the episodes with the worst

32

financial crises, an unanticipated decline in the price level induced by monetary contraction

would then set in which would lead to debt deflation and cause a further deterioration of

firms’ net worth. We thus see how monetary contract can produce a sequence of events that

lead net worth. We thus see how monetary contraction can produce a sequence of events that

lead to a sharp increase in advises selection and moral hazard problems and a resulting

financial crisis which provides another route for how monetary policy can affect the economy.

2.1.4 THE LENDING CHANNEL AND CONSUMER CREDIT

In the lending channel of the transmission mechanism, contractionary monetary policy can

force constrained commercial banks (constrained on both sides of their balance sheet) to

restrict lending independent of the demand for loans (Bernanke and Gertler 1995). For

borrowers dependent on commercial banks, contractionary monetary policy restricts their

main source of credit and increases the costs of seeking alternative sources (Kashyap and

Stein 1995 and Gertler and Gilchrist 1993, 1994).

As such, the most compelling literature on lending effects focuses on the relationship between

small banks and small borrowers. Kashyap and Stein (1995, 2000), and Gertler and Gilchrist

(1993, 1994) provide a combination of evidence showing that small commercial banks do

contract lending after a negative policy shock while larger banks do not, and small firms are

affected by that contraction (Kishan and Opiela 2000). The “small” commercial bank

assumption is important, because it is assumed that the small borrower relies on a special

relationship with the small bank for its credit, and finds it difficult to obtain credit from larger

banks, or from nonbank alternatives. For households, Gertler and Gilchrist (1994) posits that

consumer loans decline significantly following a monetary policy shock, whereas Ludvigson

(1998) finds evidence of a loan-supply effect through auto loans. With updated data, Den

Haan, Sumner, and Yamashiro (2007) find similar results for consumer loans but they find no

such lending effect for commercial and industrial loans). These lending channel studies

corroborate the assumptions of the lending channel hypothesis that small, liquidity

constrained borrowers suffer when monetary policy forces banks to contract lending. Indeed,

the support for the importance of liquidity constraints motivating a consumer loan-supply

effect is well documented in the consumption literature. As mentioned above, recently, Gross

and Souleles (2002) suggest that credit card borrowing is indicative of the continued relevance

of liquidity constraints. At the same time, households have been traditionally dependent on

33

small, local banks for finance (see Berger et al. 1995). Den Haan, Sumner, and Yamashiro’s

(2007) result, in particular, suggests that consumer lending may be a last viable component of

the lending channel while other studies, including Den Haan, Sumner, and Yamashiro 2007,

have found little-to-weak evidence for a lending channel for firms

However, as compelling as the imagery of the liquidity-constrained household may be in

invigorating lending channel enthusiasts, the lending channel through consumer lending may

have diminished over time. Various strands of economic research suggest that factors such as

deregulation, commercial bank consolidation, and other aspects of structural change in

financial markets have increased consumer lending to all households (Athreya 2002). One

implication is that consumer lending from commercial banks has increased overall and is now

predominantly the province of large, national banks. Credit card lending, for example,

requires the economies of scale best handled by a large organization (Peek and Rosengren

1998). In the least, a glance at consumer credit data suggests that the motivating assumptions

behind the lending channel do not hold.

Exchange Rate Channel

Exchange rate fluctuations induce changes in the relative prices of goods and services, as well

as spending by households firms, especially if a large proportion wealth is held in foreign

currencies. Changes in the exchange rate therefore have implications for spending behavior of

individuals and firms, all of which affect aggregate demand. The strength of the exchange rate

channel, however, depends on the responsiveness of the exchange rate to monetary shocks,

the degree of openness of the economy and the exchange rate, expansionary monetary shocks,

the degree of openness of the economy and the exchange rate arrangement of the country

(Krugman and Obstfeld, 2000). Under a floating exchange rate, expansionary monetary

policies depreciate domestic currencies, and increase the prices of imported goods. However,

adoption of a managed floating regime in some countries resulted in a relatively weak

transmission process in affecting real output and prices. In some cases of managed float, there

is imperfect substitution between domestic and foreign assets; consequently, the exchange rate

channel of monetary policy can influence output and prices.

The Law of one Price

The Law of One Price states that, in competitive markets that have no trade barriers, transport

and other associated costs, the same type of commodity in different countries would sell for

the same price when their prices are expressed in terms of the same currency. This law

34

provides one link between the prices of goods in the domestic economy and the exchange

rates. Formally, if

i

dP = Domestic price of commodity i

i

fP = Foreign price of commodity i

Ed/f = Exchange rate (domestic currency/ Foreign currency)

The law of one price implies that the price of commodity i expressed in the domestic currency

is the same wherever it is sold. This is given as,

i

dP = Ed/f. i

dP (1)

Equivalently, the exchange rate can be expressed as a ratio of domestic price of a commodity i

to foreign price of commodity i.

Ed/f. = i

dP /i

fP (2)

Purchasing Power Parity (PPP)

The purchasing power parity theory states that the exchange rates between the currencies of

the domestic and foreign countries are equal to the ratio of their respective price levels. It

posits that a fall in the domestic currency’s purchasing power (indicated by increase in the

domestic price level) will be associated with proportional currency depreciation in the foreign

exchange market (Krugman and Obstfeld, 2000). The reverse holds as the currency

appreciates with falling domestic prices.

The theory can be represented formally as

Ed/f. = dP / fP (3)

Where

dP = Domestic price level

fP = Foreign price level

Although equations (2) and (3) are similar, the essential difference lies in the fact that while

the law of one price addresses the ratio of the price of a single commodity, the PPP

presupposes the general price level as captured by a representative basket of commodities.

35

Absolute and relative PPP

Absolute PPP describes a relationship between price and exchange rate in levels. This

complicates the concept unless the two countries measure their price levels using exactly the

same basket of commodities. A less complicated concept of relative PPP, however, is the

price that translates the absolute PPP from a statement about price and exchange rate levels

into one about price and exchange rate changes.

This can formally be expressed as:

[ - = - (4)

Where is inflation rate and is expressed as

=[ - Pt -] -1 (5)

Interest parity and the Equilibrium Exchange

The foreign exchange market brings the buyers and sellers of domestic and foreign currencies

together. This market is in equilibrium when deposits of both currencies offer the same

expected rate of returns on deposits of domestic and foreign currencies are equal when

measure in the same currency, say, the domestic currency (Krugman and Obstfeld, 2000). It

relates the expected exchange rate depreciation (appreciation) to changes in the level of

domestic and foreign interest rates. This condition is represented mathematically as,

= +[ - ] / (6)

Where,

= Current rate of return on one-year domestic currency deposits

= Current rate of return on one-year foreign currency deposit

= Expected exchange rate (say, Naira/US Dollar)

= Current exchange rate (Naira/US Dollar)

The left hand side (LHS) of equation (6) represents the rate of return on domestic currency

deposits, while the right hand side (RHS) represents the rate of return on foreign currency

36

deposits plus the expected rate of depreciation (or appreciation) of the domestic against the

foreign currency. The equilibrium exchange currency deposit equals that of foreign currency

deposit plus the expected rate of depreciation (or appreciation) of the domestic currency.

Suppose the exchange rate market is at a point where the return on domestic currency exceeds

that of foreign currency, holders of foreign currency attempt to exchange their holdings for

domestic currency and this action forces the domestic exchange rate to appreciation until

equilibrium is reached. The reverse holds true where the rate of return on foreign currency

deposit is higher than that of domestic currency deposits. As such, given the expected return

on foreign currency deposit, a monetary policy action that raises the domestic interest rates

leads to the appreciation of the domestic currency against the foreign currency. On the other

hand, a monetary policy action which leads to a reduction in domestic interest rates causes the

exchange rate to depreciate.

2.1.5 MONETARY THEORY OF EXCHANGE RATE DETERMINATION

Civcir (2003) posits that the monetary model analysis shows how changes in the demand and

supply of money in the domestic and foreign economies affect the exchange rates. The model

is built on the followings:

1. There is perfect or high capital mobility

2. Purchasing Power Parity holds continuously

3. Interest Parity condition holds

4. Perfect substitutability of domestic and foreign bonds

Following the representation in Civcir (2003), equation (3) was transformed into logarithmic

form and lowercase letters were introduced.

= - ,,tfP +c (7)

Where is a constant and and are logarithms of exchange rate, domestic price level

and foreign price level respectively. When c=o, absolute PPP holds while relative PPP hold

when = o.

37

Furthermore, stable money demand functions were assumed for both domestic and foreign

economics. Equilibrium in the money market is assumed to depend on the logarithm of real

income, , price level, p, and nominal interest rate, i. logarithmic form of the money market

equilibrium is expressed as,

= + -

= + -

and represent domestic and foreign money supply respectively. a2 and a3 are the

income elasticity of demand for money and interest rate semi-elasticity. Rearranging

equations (8) and (9) for price levels and substituting into equation (6) resulted in,

= a1 - a2 - ) + a3 ( - +c+et (10)

Where c+et is the disturbance term.

However, the nominal interest rate, it consists of two components; real interest rate, rt and

expected inflation, n. thus,

+ t ed (11)

+ (12)

Equalizing the real interest rates in both countries gives us.

+ (13)

Given equation (13) we can now rewrite equation (10) as,

= a1 - a2 - ) + a3 ( - +c+ t (14)

This gives us the Flexible price monetary model (FPMM). The model makes the general

prediction that exchange rate is fully determined in the long run by the relative supplies and

demand for money in the two countries, their real income and expected inflation.

Furthermore, it makes some general predictions about the long run interactions of changes in

money supply, interest rates, price and output. If PPP and interest parity conditions hold, a

38

monetary expansion lowers the interest rate which leads to a depreciation in the domestic

currency. All other things being equal, the resultant change in international competitiveness

engendered by the depreciation impacts on the domestic economy as net exports and

aggregate output rise (Akinkunmi, 2006). A reverse monetary policy that contracts the money

supply raises the domestic interest rate and causes an appreciation of the domestic exchange

rate with a negative effect on the current account.

In small, open economies, one of the most important monetary policy channels is the

exchange rate channel. Hamid R. Davoodi et al (2013) posits that the extent to which

monetary policy can affect movements in the exchange rate is largely influenced by the theory

of uncovered interest rate parity (UIP). This simple theoretical relationship suggests that the

expected future changes in the nominal exchange rate are related to the difference between the

domestic and foreign interest rate. In theory, the UIP enables the monetary policy authority to

influence the exchange rate, which in turn affects the relative prices of domestic and foreign

goods, thus affecting net exports and output. For example, a cut in the monetary policy rate

would make domestic deposits less attractive compared to foreign deposits leading to a fall in

the demand for domestic currency. As a result, the domestic currency would depreciate, which

would make domestic goods cheaper compared to foreign goods leading to an increase in net

exports and total output. The effectiveness of the exchange rate channel is determined by the

UIP condition, whose empirical validity has often been subject to criticism. As a result, many

authors suggest that the UIP condition should be augmented with a risk-premium term

implying that foreign investors upon buying domestic financial assets require compensation

not only for expected depreciation, but also for holding domestic assets.

The exchange rate channel is an important element in conventional open-economy

macroeconomic models. The chain of transmission here runs from interest rates to the

exchange rate via the uncovered interest rate parity condition relating interest rate differentials

to expected exchange rate movements. Thus, under floating exchange rates and perfect capital

mobility, arbitrage between domestic and foreign short-term government securities causes

incipient capital flows, which change the equilibrium value of the exchange rate required to

sustain uncovered interest parity. With sticky prices, this change in the nominal exchange rate

is reflected in a real exchange rate depreciation that induces expenditure switching between

domestic and foreign goods. The effectiveness of this channel depends on the central bank‘s

willingness to allow the exchange rate to move, on the degree of capital mobility, on the

39

strength of expenditure switching effects (this depends on the commodity composition of

production and consumption), on the importance of currency mismatches, and on the degree

of exchange rate pass-through. Another channel through which monetary policy can influence

real output and prices is exchange rate channel. The central bank may affect nominal

exchange rate through interest rate and through direct foreign interventions. In the first case

movements in exchange rate is caused by capital inflows or outflows due to changes in

nominal interest rate. Such adjustment of exchange rates to nominal interest rate movements

is explained by uncovered interest rate parity theory. Besides exchange rate has direct effect

on prices through:

(1) Price of imported consumer goods,

(2) Price of imported intermediary goods used in production and aggregate demand through

(a) Trade volumes,

(b) Investment and

(3) Altering international competitiveness of exports.

Surely many literatures that have investigated the pass-through exchange rate to inflation

constitutes majority of the economic papers studying relationships between exchange rates

and other macroeconomic variables. Authors studying transition economies often find

significant exchange rate pass-through. Besimi et al. (2006) analyzing Macedonian data posits

that the depreciation of one percent against the Euro causes the price level to rise by 0.40

percent. The same (0.33 and 0.40 depending on price index used) result was found by

Billmeier and Bonato (2002). Hence two important findings in the literature: First, the

exchange rate pass-through is different for import, producer and consumer price indices.

Second, “exchange rate pass-through is higher for developing countries and that it declines

over time both for industrialized and for developing countries.” There are some papers that

study exchange rate pass-through in Georgia. Gigineishvili (2002), Maliszewski (2003) and

recently Bakradze and Billmeier (2007) have tried to explain the transmission effect of

exchange rate on princes. Despite differences in methodology and data used, they all come to

one conclusion: exchange rate is significant source of inflation in Georgia. Exchange rate in

some countries may have effect on the economic activity through both, aggregate demand and

prices. Aggregate demand may be affected because of high level of foreign asset (cash,

deposits) holding by population in Georgia. In this case, changes in exchange rate will alter

the net wealth of the economic agents, which in turn will have impact on aggregate demand.

40

Second, exchange rate influences price level directly through affecting prices on imported

good. As imports, measured as the percentage of GDP, is significantly high in Georgia, we

would expect significant response of inflation to the exchange rate

2.1.6 RECENT DEVELOPMENTS

Recent theoretical work on the monetary transmission mechanism seeks to understand how

the traditional Keynesian interest rate channel operates within the context of dynamic,

stochastic, general equilibrium models. This recent work builds on early attempts by Fischer

(1977) and Phelps and Taylor (1977) to combine the key assumption of nominal price or wage

rigidity with the assumption that all agents have rational expectations so as to overturn the

policy ineffectiveness result that McCallum (1979) associates with Lucas (1972) and Sargent

and Wallace (1975). This recent work builds on those earlier studies by deriving the key

behavioral equations of the New Keynesian model from more basic descriptions of the

objectives and constraints faced by optimizing households and firms.

More specifically, the basic New Keynesian model consists of three equations involving three

variables: output yt, inflation πt, and the short-term nominal interest rate rt. The first equation,

which Kerr and King (1996) and McCallum and Nelson (1999) dub the expectation IS curve,

links output today to its expected future value and to the ex-ante real interest rate, computed in

the usual way by subtracting the expected rate of inflation from the nominal interest rate:

Overview of Monetary Policy Framework in Nigeria

In Nigeria, the overriding objective of monetary policy is price and exchange rate stability.

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).

41

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.

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. For example, in 1970, the share of oil revenue in

total export value was about 58 percent, and this increased to over 95 percent during the

1980s. The increased revenue from oil to the government led to a rapid increase in Nigeria’s

external reserves 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

42

balance, and the 9.5 percent growth in real GDP in 1985. However, these improvements were

transitory because the economy did not establish a strong base for sustained economic growth.

To put the Nigerian economy back on a sustainable growth path, the government adopted the

comprehensive Structural Adjustment Program (SAP) sponsored by the International

Monetary Fund (IMF) in June 1986. The SAP was a structural and sectoral macroeconomic

policy reform whose main strategies were (a) the liberalization of the external trade and

payment systems, (b) the adoption of a market-based exchange rate for the domestic currency

the Naira, (c) the elimination of price and interest rate controls, and (d) the reliance on market

forces as the major determinants of economic activity.

According Nnanna (2001), the adoption of SAP marked the beginning of reforms in the

financial sector as the banking system witnessed free entry and exit, and the use of indirect but

market-based monetary control instruments for implementing monetary policy in Nigeria. The

CBN reached an important milestone in 1986 when it decided to adopt M2 as an intermediate

target for monetary policy. While this choice raises a key question in terms of why the CBN

considered M2 as the appropriate intermediate target instead of interest rate or nominal GDP

or inflation targeting, however, the more important questions and issues for empirical analyses

are: (1) the commitment of the CBN to its annually announced M2 target growth rates and

whether or not rules apply, (2) was the real M2 money demand function stable to warrant the

choice of M2 money stock as an intermediate target?, (3) what are the macroeconomic

outcomes from the targets in terms of the overall objectives (lower inflation rate and real GDP

growth) of monetary policy?

Given the fact that interest rates and prices were controlled pre-SAP, it is not difficult to see

why the CBN ruled out interest rate targeting or inflation targeting as viable policy options.

Furthermore, the structure of the financial markets in less developed countries renders interest

rate targeting ineffective. As Taylor (2004) pointed out, “if financial markets are weak, the

effectiveness of transmitting policy through interest rates will be limited.” With these controls

and the constraints due to weak financial markets, nominal GDP targeting may not have

succeeded.7 As for the commitment to rules, many countries apply rules because policy rules

may aid in focusing policy discussions in terms of intermediate and operating targets. Over

the past decade, many countries adopted the Taylor rule, which Taylor (1993) developed for

the United States. According to Taylor (2004), these rules can also be part of the monetary

policy strategy in emerging market economies. More recently, Batini (2004) argued that for

43

Taylor rule to be applicable to emerging market economy like Nigeria, modifications have to

be made because of the specific features of the emerging market economies.8 If one examines

the modifications suggested by Batini (2004) and the fact that rules assume that policymakers

seek to stabilize output and prices along paths that are considered to be optimal, then one can

conclude that the CBN’s M2 growth rate target can (and was meant to) influence output and

prices if there is commitment to announced rules. The key issue with the application of Taylor

rule to monetary policy making in Nigeria is commitment to target rules.

The opening up of the Nigerian economy since 1986, which included a significant degree of

trade liberalization as well as financial deepening, suggests that the domestic demand for

money cannot be realistically estimated without considering the impact of foreign monetary

developments. If the residents change their money holdings due to foreign monetary

developments, then the exclusion of foreign effects could lead not only to model

misspecification, but it could lead to a restrictive interpretation of the characteristics of the

money demand function. To capture the effects of foreign factors, some studies of money

demand have considered the impact of foreign interest rates and the expected rate of

depreciation of the domestic currency (see, for example, Arango and Nadiri, 1981; Thomas,

1985; Arize et al., 1990; Bahmani-Oskooee, 1991; Chowdhury, 1997; Ibrahim, 2001;

Bahmani-Oskooee and Shin, 2002; Civcir, 2003). The inclusion of the foreign interest rate in

the money demand function is to capture the effects of capital mobility. Studies suggest that

an increase in the foreign interest rate that increases the return on foreign assets relative to

those on domestic assets may cause agents to decrease their demand for domestic money

holdings (see, McKinnon, 1983).

The expected exchange rate captures the substitution between domestic and foreign

currencies. Its impact on the domestic demand for money is ambiguous because it can be

either positive or negative. In the studies by Arango and Nadiri (1981), Bahmani-Oskooee and

Pourheydarian (1990), and Bahmani- Oskooee and Rhee (1994), they argued that if residents

evaluate their asset portfolio in terms of the domestic currency, a depreciation of the exchange

rate that increases the value of their foreign holdings would enhance wealth. To maintain a

fixed share of the wealth invested in domestic assets, residents will shift parts of their foreign

holdings to domestic assets, including domestic currency. The increase in the share of wealth

held in domestic assets, including domestic currency, suggests a rise in the demand for the

domestic currency. Studies have argued that the depreciation of the domestic currency leads

44

residents to anticipate further depreciation, then as a hedge against the exchange rate risk, they

may adjust their portfolio towards holding more of the foreign currency and less of the riskier

domestic currency. The shift in portfolio away from the domestic currency to foreign

currencies amounts to a decline in the demand for the domestic currency (i.e., the currency

substitution effect).

According to Handa’s (2000), the domestic rate of interest and the expected exchange rate

depreciation are two important variables to include in the modified long-run real money

demand function, and the failure to include foreign interest rate “would make it difficult to

capture the substitution between domestic currency and foreign bonds, which is an element of

capital mobility rather than of the substitution of the liquidity services of the foreign currency

for the domestic one”. Furthermore, it is important to point out that it is not unusual to include

inflation rate as an explanatory variable in the money demand function. Some studies use

current inflation rate and others use expected inflation rate as explanatory variable. This is so

because the inflation generating process is not universal, but more importantly, the

expectations of inflation vary across developed and developing countries. With respect to

developing countries, monetary and non-monetary factors contribute to the inflation process.

For example, in a study of money demand and the inflation process in Brazil. Calomiris and

Domowitz (1989) argued that expected inflation is determined simultaneously with

equilibrium real balances and real government debt. In addition, Calomiris and Domowitz

(1989) found that changes in money do not predict changes in the price level whereas changes

in the price level do predict changes in money. In many other developing countries, studies

show that one of the dominant predictors of inflation is the growth of money (see Owoye,

1997). In the case of Nigeria, monetary factors and macromonetary policy announcements are

major determinants of the inflation generating process. With every policy announcements,

economic agents form their expectations about prices accordingly. In other words, in

economies such as Nigeria where prices adjust almost instantaneously due to policy

announcements, one can therefore assume that there is no difference between current inflation

and expected inflation.

The Central Bank of Nigeria (CBN) is mandated by the CBN act of 1958 to promote and

maintain monetary stability and a sound financial system in Nigeria. Just like other central

banks, the CBN has the “end” of achieving price stability and sustainable economic growth

through the “means” of monetary policy. Embedded in this twin objectives are (1) the

45

attainment of full employment, (2) maintaining stability in the long-term interest rates and (3)

pursuing optimal exchange rate targets. To achieve these multiplex objectives, the CBN

operates through a system of targets. These are; the operational targets, the intermediate

targets and the ultimate target (Ibeabuchi, 2007). The Central Bank uses its operational target

(unborrowed reserves), over which it has deterministic control to influence the intermediate

target (broad money) which eventually affects the ultimate targets (inflation and output). In

setting its targets, the CBN considers an information set that is feed into by contemporaneous

and lagged values of real Gross Domestic Product (GDP), real investment prices, real wages,

labour productivity, fiscal operations and balance of payments performance, among others.

Depending on the relative importance attached to the various information elements, the CBN

sets its target parameters for its quantity-based nominal anchor and its price-based anchors.

The bank generally implements its monetary policy programmes using the market-based and

rule-based techniques. When implementing monetary policy using the rule-based technique,

the CBN uses direct instruments like selective credit controls, direct regulation of interest

rates and moral suasion. While indirect instruments like the Open Market Operation (OMO),

discount rate and the reserve requirements are used when implementing monetary policy

programmes using the market-based approach. Since its inception, the CBN has implemented

monetary policy using various combinations of these two techniques with more or less

emphasis on the one. Depending on the emphasis that is placed on either of the techniques, the

evolution of monetary policy in Nigeria can be classified into two phases: (1) the era of direct

controls (1959-1986) and (2) the era of market-based controls (1986-date). The era of direct

controls was a remarkable period in monetary policy management in Nigeria, because it

coincided with several structural changes in the economy; including the shift in the economic

base from agriculture to petroleum, the execution of the civil war, the oil boom and crash of

the 1970s and early 1980s respectively and the introduction of the Structural Adjustment

Programme (SAP). During this period CBNẑs monetary policies focused on fixing and

controlling interest rates and exchange rates, selective sectoral credit allocation, manipulation

of the discount rate and involving in moral suasion. Reviewing this period, Omotor (2007)

observe that monetary policy was ineffective particularly because the CBN lacked instrument

autonomy and goal determination, being heavily influenced by the political considerations

conveyed through the Ministry of Finance.

46

Progressively, the implementation of the SAP programme which commenced in 1986 ushered

in a new era of monetary policy implementation with market-friendly techniques in Nigeria.

The capacity of the CBN to carry out monetary policy using market friendly techniques was

letter reinforced by the amendments made to the CBN Act in 1991 which specifically granted

the CBN full instrument and goal autonomy. Using this technique, the CBN indirectly

influences economic parameters through its Open Market Operations (OMO). These

operations are conducted wholly on Nigerian Treasury Bills (TBs) and Repurchase

Agreements (REPOs), and are being complimented with the use of reserve requirements, the

Cash Reserve Ratio (CRR) and the Liquidity Ratio (LR). These set of instruments are used to

influence the quantity-based nominal anchor (monetary aggregates) used for monetary

programming. On the other hand, the Minimum Rediscount Rate (MRR) is being used as the

price-based nominal anchor to influence the direction of the cost of funds in the economy.

Changes in this rate give indication about the monetary disposition of the Bank, whether it is

pursuing a concessionary or expansionary monetary policy. This rate has generally been kept

within the range of 26 and 8 percent since 1986. As a companion to the use of the MRR, the

CBN latter introduced the Monetary Policy Rate (MPR) in 2006 which establishes an interest

rate corridor of plus or minus two percentage points of the prevailing MPR. Since 2007, this

rate has been held within the band of 10.25 and 6 percent. Despite the empirical evidence

found for the efficacy of monetary policy with market-based techniques, the effectiveness or

otherwise of monetary policy during this era is still an issue in debate. Though we take a

position on this issue at the conclusion of the work, we recognize that monetary policy in

Nigeria is confronted with several challenges. Some of them include; fiscal dominance and

non-synchronization of fiscal and monetary policies, the existence of a large informal sector,

debt and liquidity overhang, data inconsistencies and lateness, and the cash-in-hand nature of

the economy. These peculiar characteristics of the economy place a special emphasis on the

dynamism of monetary policy in Nigeria.

2.1.7 INTERNATIONAL MONETARY POLICY REGIMES

Mishkin (1998) say in recent years a growing consensus has emerged for price stability as the

overriding, long run goal of monetary policy. However, despite this consensus, the following

question still remains: how should monetary policy be conducted to achieve the price stability

goal? A central feature of all of the monetary regimes discussed here is the use of a nominal

anchor in some form, so first we will examine what role a nominal anchor plays in promoting

47

price stability. Then we will examine two basic types of monetary policy regimes: 1)

exchange-rate targeting, and 2) inflation targeting.

Exchange-rate Targeting

Targeting the exchange rate is a monetary policy regime with a long history. It can take the

form of fixing the value of the domestic currency to a commodity such as gold, the key

feature of the gold standard. More recently, fixed exchange-rate regimes have involved fixing

the value of the domestic currency to that of a large, low-inflation country. As another

alternative, instead of fixing the value of the currency to that of the low-inflation anchor

country, which implies that the inflation rate will eventually gravitate to that of the anchor

country, some countries adopt a crawling target or peg in which its currency is allowed to

depreciate at a steady rate so that its inflation can be higher than that of the anchor country

(Mishkin, 1998).

Exchange-rate targeting has several advantages. First, the nominal anchor of an exchange rate

target fixes the inflation rate for internationally traded goods, and thus directly contributes to

keeping inflation under control. Second, if the exchange-rate target is credible, it anchors

inflation expectations to the inflation rate in the anchor country to whose currency it is

pegged. Third, an exchange-rate target provides an automatic rule for the conduct of monetary

policy that avoids the time-inconsistency problem. It forces a tightening of monetary policy

when there is a tendency for the domestic currency to depreciate or a loosening of policy

when there is a tendency for the domestic currency to appreciate. Monetary policy no longer

has the discretion that can result in the pursuit of expansionary policy to obtain employment

gains which lead to time-inconsistency. Fourth, an exchange-rate target has the advantage of

simplicity and clarity, which make it easily understood by the public. A "sound currency" is

an easy-to-understand rallying cry for monetary policy. This has been important in France, for

example, where an appeal to the "franc fort" is often used to justify tight monetary policy.

Given its advantages, it is not surprising that exchange-rate targeting has been used

successfully to control inflation in industrialized countries. Both France and the United

Kingdom, for example, successfully used exchange-rate targeting to lower inflation by tying

the value of their currencies to the German mark. In 1987, when France first pegged their

exchange rate to the mark, its inflation rate was 3%, two percentage points above the German

inflation rate. By 1992 its inflation rate had fallen to 2%, a level that can be argued is

consistent with price stability, and was even below that in Germany. By 1996, the French and

48

German inflation rates had converged, to a number slightly below 2%. Similarly, after

pegging to the German mark in 1990, the United Kingdom was able to lower its inflation rate

from 10% to 3% by 1992, when it was forced to abandon the Exchange Rate Mechanism

(ERM) (See, Mishkin, 1998).

Exchange-rate targeting has also been an effective means of reducing inflation quickly in

emerging market countries. An important recent example has been Argentina, which in 1990

passed established a currency board arrangement, requiring the central bank to exchange U.S.

dollars for new pesos at a fixed exchange rate of 1 to 1. The currency board is an especially

strong and transparent commitment to an exchange-rate target because it requires that the

note-issuing authority, whether the central bank or the government, stands ready to exchange

the domestic currency for foreign currency at the specified fixed exchange rate whenever the

public requests it. In order to credibly meet these requests, a currency board typically has

more than 100% foreign reserves backing the domestic currency and allows the monetary

authorities absolutely no discretion. The early years of Argentina's currency board looked

stunningly successful. Inflation which had been running at over a one-thousand percent annual

rate in 1989 and 1990 fell to under 5% by the end of 1994, and economic growth was rapid,

averaging almost 8% at an annual rate from 1991 to 1994.

Despite the inherent advantages of exchange-rate targeting, it is not without its serious

problems, as the international experience demonstrates. There are several serious criticisms of

exchange-rate targeting. First is that an exchange-rate target results in the loss of independent

monetary policy.1 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.

A striking example of these problems occurred when Germany reunified in 1990. Concerns

about inflationary pressures arising from reunification and the massive fiscal expansion

required to rebuild East Germany led to rises in German long-term interest rates until

February 1991 and to rises in short-term rates until December 1991. This shock to the anchor

country in the Exchange Rate Mechanism (ERM) was transmitted directly to the other

49

countries in the ERM whose currencies were pegged to the mark because their interest rates

now rose in tandem with those in Germany. As pointed out in Clarida, Gali and Gertler

(1997), monetary policy in countries such as France and the United Kingdom was far tighter

than would have been the case if monetary policy in these countries was focused on domestic

considerations. The result was that continuing adherence to the exchange rate target produced

a significant slowing of economic growth and rising unemployment, which is exactly what

France experienced when it remained in the ERM and adhered to the exchange-rate peg.

A second problem with exchange-rate targets has been pointed out forcefully in Obstfeld and

Rogoff (1995): exchange-rate targets leave countries open to speculative attacks on their

currencies. Indeed, one aftermath of German reunification was the foreign exchange crisis of

September 1992. As we have seen, the tight monetary policy in Germany resulting from

German reunification meant that the countries in the ERM were subjected to a negative

demand shock that led to a decline in economic growth and a rise in unemployment. It was

certainly feasible for the governments of these countries to keep their exchange rates fixed

relative to the mark in these circumstances, but speculators began to question whether these

countries' commitment to the exchange rate peg would weaken because these countries would

not tolerate the rise in unemployment that would result from keeping interest rates sufficiently

high to fend off speculative attacks on their currencies.

At this stage, speculators were in effect presented with a one-way bet: the exchange rates for

currencies such as the French franc, the Spanish peseta, the Swedish krona, the Italian lira and

the British pound could only go in one direction, depreciate against the mark. Selling these

currencies thus presented speculators with an attractive profit opportunity with potentially

high expected returns and yet little risk. The result was that in September 1992, a speculative

attack on the French franc, the Spanish peseta, the Swedish krona, the Italian lira and the

British pound began in earnest. Only in France was the commitment to the fixed exchange

rate strong enough, so that France did not devalue. The governments in Britain, Spain, Italy

and Sweden were unwilling to defend their currencies at all costs and so allowed their

currencies to fall in value.

The attempted defense of these currencies did not come cheaply. By the time the crisis was

over, the British, French, Italian, Spanish and Swedish central banks had intervened to the

tune of an estimated $100 billion, and the Bundesbank alone had laid out an estimated $50

billion for foreign exchange intervention. It is further estimated that these central banks lost

50

$4 to $6 billion as a result of their exchange-rate intervention in the crisis, an amount that was

in effect paid by taxpayers in these countries. The different response of France and the United

Kingdom after the September 1992 exchange rate crisis illustrates the potential cost of an

exchange-rate target. France, which continued to peg to the mark and thereby was unable to

use monetary policy to respond to domestic conditions, found that economic growth remained

slow after 1992 and unemployment increased. The United Kingdom, on the other hand, which

dropped out of the ERM exchange-rate peg and adopted inflation targeting (discussed later),

had much better economic performance: economic growth was higher, the unemployment rate

fell, and yet inflation performance was not much worse than France's (Seem Mishkin, 1998).

The aftermath of German reunification and the September 1992 exchange rate crisis

dramatically illustrate two points: 1) an exchange-rate target does not guarantee that the

commitment to the exchange-rate based, monetary policy rule is sufficiently strong to

maintain the target, and 2) the cost to economic growth from an exchange-rate regime with its

loss of independent monetary can be high. For emerging market countries, it is far less clear

that these countries lose much by giving up an independent monetary policy when they target

exchange rates. Because many emerging market countries have not developed the political or

monetary institutions that result in the ability to use discretionary monetary policy

successfully, they may have little to gain from an independent monetary policy, but a lot to

lose. Thus, they would be better off by, in effect, adopting the monetary policy of a country

like the United States through targeting exchange rates than in pursuing their own independent

policy. Indeed, this is one of the reasons that so many emerging market countries have

adopted exchange-rate targeting (See, Mishkin, 1998).

Nonetheless, as is emphasized in Mishkin (1997, 1998), there is an additional disadvantage

from 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 full-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.

In recent years, an asymmetric information theory of financial crises has been developed

which provides a definition of a financial crisis (Bernanke, 1983; Calomiris and Gorton, 1991

51

and Mishkin, 1991; 1994; 1996). A financial crisis is a nonlinear disruption to financial

markets in which asymmetric information problems (adverse selection and moral hazard)

become much worse, so that financial markets are unable to efficiently channel funds to

economic agents who have the most productive investment opportunities. A financial crisis

thus prevents the efficient functioning of financial markets, which therefore leads to a sharp

contraction in economic activity.

Because of uncertainty about the future value of the domestic currency, many nonfinancial

firms, banks and governments in emerging market countries find it much easier to issue debt

if the debt is denominated in foreign currencies. This tendency can be further encouraged by

an exchange rate targeting regime which may encourage domestic firms and financial

institutions to issue foreign denominated debt. The substantial issuance of foreign

denominated debt was a prominent feature of the institutional structure in the Chilean

financial markets before the financial crisis in 1982, in Mexico before its financial crisis in

1994 and in East Asian countries before their recent crisis.

With an exchange-rate target regime, depreciation of the currency when it occurs is a highly

nonlinear event because it involves devaluation. In most developed countries devaluation has

little direct effect on the balance sheets of households, firms and banks because their debts are

denominated in domestic currency. This is not true, however, in emerging market countries

with their very different institutional structure. In these countries, but not in developed

countries, a foreign exchange crisis can trigger a full-scale financial crisis in which financial

markets are no longer able to move funds to those with productive investment opportunities,

thereby causing a severe economic contraction (See, Mishkin, 1998).

With debt contracts denominated in foreign currency as in emerging market countries, when

there is a devaluation of the domestic currency, the debt burden of domestic firms increases.

On the other hand, since assets are typically denominated in domestic currency, there is no

simultaneous increase in the value of firms' assets. The result is a that a devaluation leads to a

substantial deterioration in firms' balance sheets and a decline in net worth, which, in turn,

means that effective collateral has shrunk, thereby providing less protection to lenders.

Furthermore, the decline in net worth increases moral hazard incentives for firms to take on

greater risk because they have less to lose if the loans go sour. Because lenders are now

subject to much higher risks of losses, there is now a decline in lending and hence a decline in

investment and economic activity. The damage to balance sheets from devaluation in the

52

aftermath of the foreign exchange crisis was a major source of the contraction of the

economies of Chile in 1982, Mexico in 1994 and 1995 and East Asia in 1997-98 (Mishkin,

1998).

In addition, the depreciation of the domestic currency can lead to deterioration in the balance

sheets of the banking sector. In emerging market countries, banks typically have many short-

term liabilities denominated in foreign currency which increase sharply in value when

depreciation occurs. On the other hand, the problems of firms and households mean that they

are unable to pay off their debts, also resulting in loan losses on the assets side of the banks'

balance sheets. Once there is deterioration in bank balance sheets, with the substantial loss of

bank capital, banks have two choices: either 1) they can cut back on their lending in order to

shrink their asset base and thereby restore their capital ratios, or 2) they can try to raise new

capital. However, when banks experience deterioration in their balance sheets, it is very hard

for them to raise new capital at a reasonable cost. Thus, the typical response of banks with

weakened balance sheets is a contraction in their lending, which slows economic activity. In

the extreme case in which the deterioration of bank balance sheets leads to a banking crisis

which forces many banks to close their door, thereby directly limiting the ability of the

banking sector to make loans, the effect on the economy is even more severe (Mishkin, 1998).

An additional danger from using an exchange-rate target in emerging market countries is that

although the exchange-rate target is initially successful in bringing inflation down for

example, Mexican inflation fell from over a 100% annual rate before it adopted exchange-rate

targets in 1988 to inflation rates in the single digits by 1994 a successful speculative attack

can lead to a resurgence of inflation. Because many emerging market countries have

previously experienced both high and variable inflation, their central banks are unlikely to

have deep-rooted credibility as inflation fighters. Thus, a sharp depreciation of the currency

after a speculative attack that leads to immediate upward pressure on prices can lead to a

dramatic rise in both actual and expected inflation. Indeed Mexican inflation surged to 50% in

1995 after the foreign exchange crisis in 1994 and recent forecasts for Indonesia suggest that

it too might experience inflation rates near the 50% level in the aftermath of the crisis

(Mishkin, 1998).

A rise in expected inflation after a successful speculative attack against the currency of an

emerging market country is another factor exacerbating the financial crisis because it leads to

a sharp rise in interest rates as occurred in Mexico and the East Asian crisis countries. The

53

interaction of the short duration of debt contracts and the rise in interest rates leads to huge

increases in interest payments by firms, thereby weakening firms' cash flow position and

further weakening their balance sheets. Then, as we have seen, both lending and economic

activity are likely to undergo a sharp decline. Another potential danger from an exchange-rate

target is that by providing a more stable value of the currency, it might lower risk for foreign

investors and thus encourage capital inflows. Although these capital inflows might be

channeled into productive investments and thus stimulate growth, they might promote

excessive lending, manifested by a lending boom, because domestic financial intermediaries

such as banks play a key role in intermediating these capital inflows (Calvo, Leiderman and

Reinhart, 1994). Indeed, Folkerts-Landau, et. al (1995) found that emerging market countries

in the Asian-Pacific region with the large net private capital inflows also experienced large

increases in their banking sectors. Furthermore, if the bank supervisory process is weak, as it

often is in emerging market countries, so that the government safety net for banking

institutions creates incentives for them to take on risk, the likelihood that a capital inflow will

produce a lending boom is that much greater. With inadequate bank supervision, the likely

outcome of a lending boom is substantial loan losses and a deterioration of bank balance

sheets.

The deterioration in bank balance sheets can damage the economy in two ways. First, the

deterioration in the balance sheets of banking firms leads them to restrict their lending in order

to improve their capital ratios or can even lead to a full-scale banking crisis which forces

many banks into insolvency, thereby directly removing the ability of the banking sector to

make loans. Second, the deterioration in bank balance sheets can promote a foreign exchange

crisis because it becomes very difficult for the central bank to defend its currency against a

speculative attack. Any rise in interest rates to keep the domestic currency from depreciating

has the additional effect of weakening the banking system further because the rise in interest

rates hurts banks' balance sheets. This negative effect of a rise in interest rates on banks'

balance sheets occurs because of their maturity mismatch and their exposure to increased

credit risk when the economy deteriorates. Thus, when a speculative attack on the currency

occurs in an emerging market country, if the central bank raises interest rates sufficiently to

defend the currency, the banking system may collapse. Once investors recognize that a

country's weak banking system makes it less likely that the central bank will take the steps to

successfully defend the domestic currency, they have even greater incentives to attack the

54

currency because expected profits from selling the currency have now risen. The outcome is a

successful attack on the currency, and the resulting foreign exchange crisis causes a collapse

of the economy for the reasons already discussed (See, Mishkin, 1998).

The recent events in Southeast Asia and Mexico, in which the weakness of the banking sector

and speculative attack on the currency tipped their economies into full-scale financial crises,

illustrate how dangerous exchange-rate targeting can be for emerging market countries.

Indeed, the fact that an exchange-rate target in these countries leaves them more prone to

financial fragility and financial crises, with potentially catastrophic costs to their economies,

suggests that exchange-rate targeting is not a strategy to be recommended for emerging

market countries. An additional disadvantage of an exchange-rate target is that it can weaken

the accountability of policymakers, particularly in emerging market countries, because it

eliminates an important signal that can help keep monetary policy from becoming too

expansionary. In industrialized countries, and particularly in the United States, the bond

market provides an important signal about the stance of monetary policy. Overly expansionary

monetary policy or strong political pressure to engage in overly expansionary monetary policy

produces an inflation scare of the type described by Goodfriend (1993) in which long-term

bond prices tank and long-term rates spike upwards. In many countries, particularly emerging

market countries, the long-term bond market is essentially nonexistent. In these countries, the

daily fluctuations of the exchange rate can, like the bond market in the United States, provide

an early warning signal that monetary policy is overly expansionary. Thus, like the bond

market, the foreign exchange market can constrain policy from being too expansionary. Just

as the fear of a visible inflation scare constrains central bankers from pursuing overly

expansionary monetary policy and also constrains politicians from putting pressure on the

central bank to engage in overly expansionary monetary policy, fear of exchange rate

depreciations can make overly expansionary monetary policy less likely.

An exchange-rate target has the important disadvantage that it removes the signal that the

foreign exchange market provides about the stance of monetary policy on a daily basis. Under

an exchange-rate-target regime, central banks often pursue overly expansionary policies that

are not discovered until too late, when a successful speculative attack has gotten underway.

The problem of lack of accountability of the central bank under an exchange-rate-target

regime is particularly acute in emerging market countries where the balance sheets of the

central banks are not as transparent as in developed countries, thus making it harder to

55

ascertain the central bank's policy actions. Although, an exchange-rate peg appears to provide

rules for central bank behavior that eliminates the time-inconsistency problem, it can actually

make the time-inconsistency problem more severe because it may actually make central bank

actions less transparent and less accountable.

One solution to this problem is to strengthen the transparency and commitment to the

exchange-rate target by adopting a currency board as has been done in Argentina. Although

the stronger commitment to a fixed exchange rate may mean that a currency board is better

able to stave off a speculative attack against the domestic currency than an exchange-rate peg,

it is not without its problems. In the aftermath of the Mexican peso crisis, concern about the

health of the Argentine economy resulted in the public pulling their money out of the banks

(deposits fell by 18%) and exchanging their pesos for dollars, thus causing a contraction of the

Argentine money supply. The result was a sharp contraction in Argentine economic activity

with real GDP dropping over 5% in 1995 and the unemployment rate jumping to above 15%.

Only in 1996, with financial assistance from international agencies such as the IMF, the

World Bank and the Inter-American Development Bank, which lent Argentina over $5 billion

to help shore up its banking system, did the economy begin to recover, and in recent years

Argentina's economy has been performing quite well. Because the central bank of Argentina

had no control over monetary policy under the currency board system, it was relatively

helpless to counteract the contractionary monetary policy stemming from the public's

behavior. Furthermore, because the currency board does not allow the central bank to create

money and lend to the banks, it limits the capability of the central bank to act as a lender of

last resort, and other means must be used to cope with potential banking crises (Mishkin,

1998).

Although a currency board is highly problematic, it may be the only way to break a country's

inflationary psychology and alter the political process so that it no longer leads to continuing

bouts of high inflation. This indeed was the rationale for putting a currency board into place in

Argentina, where past experience had suggested that stabilization programs with weaker

commitment mechanisms would not work. Thus, implementing a currency board might be a

necessary step to control inflation in countries that require a very strong disciplinary device.

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Inflation Targeting

Given the breakdown of the relationship between monetary aggregates and goal variables

such as inflation, many countries have recently adopted inflation targeting as their monetary

policy regime. New Zealand was the first country to formally adopt inflation targeting in

1990, with Canada following in 1991, the United Kingdom in 1992, Sweden in 1993, Finland

in 1993, Australia in 1994 and Spain in 1994. Israel and Chile have also adopted a form of

inflation targeting. Inflation targeting involves several elements: 1) public announcement of

medium-term numerical targets for inflation; 2) an institutional commitment to price stability

as the primary, long run goal of monetary policy and to achievement of the inflation goal; 3)

an information inclusive strategy, with a reduced role for intermediate targets such as money

growth; 4) increased transparency of the monetary policy strategy through communication

with the public and the markets about the plans and objectives of monetary policymakers; and

5) increased accountability of the central bank for attaining its inflation objectives (See,

Mishkin, 1998).

Inflation targeting has several important advantages. In contrast to exchange-rate targeting,

but like monetary targeting, inflation targeting enables monetary policy to focus on domestic

considerations and to respond to shocks to the domestic economy. Inflation targeting also has

the advantage that velocity shocks are largely irrelevant because the monetary policy strategy

no longer relies on a stable money-inflation relationship. Indeed, an inflation target allows the

monetary authorities to use all available information, and not just one variable, to determine

the best settings for monetary policy. Inflation targeting, like exchange-rate targeting, also has

the key advantage that it is readily understood by the public and is thus highly transparent.

Monetary targets are less likely to be easily understood by the public than inflation targets,

and if the relationship between monetary aggregates and the inflation goal variable is subject

to unpredictable shifts, as has occurred in many countries including a long-standing monetary

targeter such as Switzerland, then monetary targets lose their transparency because they are no

longer able to accurately signal the stance of monetary policy. Because an explicit numerical

inflation target increases the accountability of the central bank, inflation targeting also has the

potential to make it more likely that the central bank will avoid falling into the time-

inconsistency trap in which it tries to expand output and employment by pursuing overly

expansionary monetary policy. But since time-inconsistency is more likely to come from

political pressures on the central bank to engage in overly expansionary monetary policy, a

57

key advantage of inflation targeting is that it can help focus the political debate on what a

central bank can do in the long-run that is, control inflation rather than what it cannot do raise

economic growth and the number of jobs permanently through expansionary monetary policy.

Thus inflation targeting has the potential to reduce political pressures on the central bank to

pursue inflationary monetary policy and thereby reduce the likelihood of time-inconsistent

policymaking.

Despite the rhetoric about pursuing "price stability", in practice all the inflation-targeting

countries have chosen to target the inflation rate rather than the level of prices per se. In

addition, all the inflation targeters have chosen midpoints for their inflation target to be

substantially above zero, and above reasonable estimates of possible upward measurement

bias in the inflation rates calculated from consumer price indices. For example, currently New

Zealand has the lowest midpoint for an inflation target, 1.5%, while Canada and Sweden set

the midpoint of their inflation target at 2%; the United Kingdom, Australia and Spain

currently have their midpoints at 2.5%, while Israel is at 8.5%. It is important to note that even

Germany, considered to be one of the most resolute opponents of inflation in the world, sets

its long-run inflation goal at 2% for many years (changed to 1.5 to 2% in December 1996),

right in the middle of the pack for inflation targeters (see, Mishkin, 1998).

The decision by inflation targeters (and hybrid targeters like Germany) to choose inflation

targets well above zero and not price level targets reflects monetary policymakers concerns

that too low inflation, or particularly low inflation, can have substantial negative effects on

real economic activity.8 There are particularly valid reasons for fearing deflation, including

the possibility that it might promote financial instability and precipitate a severe economic

contraction (see Mishkin, 1991 and 1997). Indeed, deflation has been associated with deep

recessions or even depressions, as in the 1930s, and the recent deflation in Japan has been one

factor that has weakened the financial system and the economy. Targeting inflation rates of

above zero makes periods of deflation less likely. The evidence on inflation expectations from

surveys and interest rate levels (Almeida and Goodhart, 1998, Laubach and Posen (1997) and

Bernanke, Laubach, Posen and Mishkin, 1998) suggest that maintaining a target for inflation

above zero (but not too far above) for an extended period does not lead to instability in

inflation expectations or to a decline in the central bank's credibility.

Another key feature of inflation-targeting regimes is that they do not ignore traditional

stabilization goals. Central bankers responsible in inflation-targeting countries continue to

58

express their concern about fluctuations in output and employment, and the ability to

accommodate short-run stabilization goals to some degree is built into all inflation-targeting

regimes. All inflation-targeting countries have been willing to take a gradualist approach to

disinflation in order to minimize output declines by lowering medium-term inflation targets

towards the long-run goal slowly over time.

In addition, many inflation targeters, particularly the Bank of Canada, have emphasized that

the floor of the target range should be emphasized every bit as much as the ceiling, thus

helping to stabilize the real economy when there are negative aggregate demand shocks.

Indeed, inflation targets can increase the flexibility of the central bank to respond to declines

in aggregate spending because declines in aggregate demand that cause the inflation rate to

fall below the floor of the target range will automatically stimulate the central bank to loosen

monetary policy without fearing that its action will trigger a rise in inflation expectations.

Another element of flexibility in inflation-targeting regimes is that deviations from inflation

targets are routinely allowed in response to supply shocks. First, the price index on which the

official inflation targets are based is often defined to exclude or moderate the effects of

"supply shocks;" for example, the officially targeted price index may exclude some

combination of food and energy prices, indirect tax changes, terms-of-trade shocks, and the

direct effects of interest rate changes on the index (for example, through imputed rental costs).

Second, following (or in anticipation) of a supply shock, such as a rise in the value-added tax,

the normal procedure is for the central bank first to deviate from its planned policies as

needed and then to explain the reasons for its action to the public. New Zealand, on the other

hand, has an explicit escape clause in its targeting regime which the central bank uses to

justify such actions, although it has also permitted target deviations on a more ad hoc basis

(see, Mishkin, 1998).

Inflation-targeting regimes also put great stress making policy transparent -- policy that is

clear, simple, and understandable -- and on regular communication with the public. The

central banks have frequent communications with the government, some mandated by law and

some in response to informal inquiries, and their officials take every opportunity to make

public speeches on their monetary policy strategy. These channels are also commonly used in

countries that have not adopted inflation targeting, Germany and the United States being

prominent examples, but inflation targeting central banks have taken public outreach a step

further: not only have they engaged in extended public information campaigns, even engaging

59

in the distribution of glossy brochures, but they have engaged in publication of Inflation

Report type documents (originated by the Bank of England).

The publication of Inflation Reports is particularly noteworthy because these documents

depart from the usual, dull-looking, formal reports of central banks to take on the best

elements of textbook writing (fancy graphics, use of boxes) in order to better communicate

with the public. An excellent description of the shift in emphasis in these reports is reflected

in the following quote from the Bank of Canada. The new Monetary Policy Report will be

designed to bring increased transparency and accountability to monetary policy. It will

measure our performance in terms of the Bank's targets for controlling inflation and will

examine how current economic circumstances and monetary conditions in Canada are likely

to affect future inflation. (Bank of Canada, 1995) The above channels of communication are

used by central banks in inflation-targeting countries to explain the following to the general

public, financial market participants and the politicians: 1) the goals and limitations of

monetary policy, including the rationale for inflation targets; 2) the numerical values of the

inflation targets and how they were determined, 3) how the inflation targets are to be

achieved, given current economic conditions; and 4) reasons for any deviations from targets.

These communication efforts have improved private-sector planning by reducing uncertainty

about monetary policy, interest rates and inflation; they have promoted public debate of

monetary policy, in part by educating the public about what a central bank can and cannot

achieve; and they have helped clarify the responsibilities of the central bank and of politicians

in the conduct of monetary policy.

Another key feature of inflation-targeting regimes is the tendency toward increased

accountability of the central bank. Indeed, transparency and communication go hand in hand

with increased accountability. The strongest case of accountability of a central bank in an

inflation targeting regime is in New Zealand, where the government has the right to dismiss

the Reserve Bank's governor if the inflation targets are breached, even for one quarter. In

other inflation targeting countries, the central bank's accountability is less formalized.

Nevertheless, the transparency of policy associated with inflation targeting has tended to make

the central bank highly accountable to both the public and the government. Sustained success

in the conduct of monetary policy as measured against a pre-announced and well-defined

inflation target can be instrumental in building public support for a central bank's

independence and for its policies. This building of public support and accountability occurs

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even in the absence of a rigidly defined and legalistic standard of performance evaluation and

punishment (see, Mishkin, 1998).

Two remarkable examples illustrate the benefits of transparency and accountability in the

inflation-targeting framework. The first occurred in Canada in 1996, when the president of

the Canadian Economic Association made a speech criticizing the Bank of Canada for

pursuing monetary policy that he claimed was too contractionary. His speech sparked off a

widespread public debate. In countries not pursuing inflation targeting, such debates often

degenerate into calls for the immediate expansion of monetary policy with little reference to

the long-run consequences of such a policy change. In this case, however, the very existence

inflation targeting channeled the debate into a substantive discussion over what should be the

appropriate target for inflation, with both the Bank and its critics obliged to make explicit

their assumptions and estimates of the costs and benefits of different levels of inflation.

Indeed, the debate and the Bank of Canada's record and responsiveness led to increased

support for the Bank of Canada, with the result that criticism of the Bank and its conduct of

monetary policy was not a major issue in the 1997 elections as it had been before the 1993

elections.

The second example occurred upon the granting of operational independence to the Bank of

England on May 6, 1997. Prior to that date, it was the government, as represented by the

Chancellor of the Exchequer (equivalent to the finance minister or the secretary of the

treasury), that controlled the decision to set monetary policy instruments, while the Bank of

England was relegated to acting as the government's counter inflationary conscience. On May

6, the new Chancellor of the Exchequer, Gordon Brown, announced that the Bank of England

would henceforth have the responsibility for setting both the base interest rate and short-term

exchange-rate interventions. Two factors were cited by Chancellor Brown that justify the

government's decision: first was the Bank's successful performance over time as measured

against an announced clear target; second was the increased accountability that an

independent central bank is exposed to under an inflation-targeting framework, making the

Bank more responsive to political oversight. The granting of operational independence to the

Bank of England occurred because it would now be operating under a monetary policy regime

that ensures that monetary policy goals cannot diverge from the interests of society for

extended periods of time, yet monetary policy can be insulated from short-run political

considerations. An important benefit of an inflation-targeting regime is therefore that it makes

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it more palatable to have an independent central bank which focuses on long-run objectives,

but which is consistent with a democratic society because it is accountable.

The performance of inflation-targeting regimes has been quite good. Inflation-targeting

countries seem to have significantly reduced both the rate of inflation and inflation

expectations beyond that which would likely have occurred in the absence of inflation targets.

Furthermore, once inflation is down, it has stayed down; following disinflations, the inflation

rate in targeting countries has not bounced back up during subsequent cyclical expansions of

the economy.

Also inflation targeting seems to ameliorate the effects of inflationary shocks. For example,

shortly after adopting inflation targets in February 1991, the Bank of Canada was faced with a

new goods and services tax (GST) -- an indirect tax similar to a value-added tax an adverse

supply shock that in earlier periods might have led to a ratcheting up in inflation. Instead the

tax increase led to only a one-time increase in the price level; it did not generate second- and

third-round rises in wages in prices that would led to a persistent rise in the inflation rate.

Another example is the experience of the United Kingdom and Sweden following their

departures from the ERM exchange rate pegs in 1992. In both cases, devaluation would

normally have stimulated inflation because of the direct effects on higher export and import

prices and the subsequent effects on wage demands and price-setting behavior. Again it seems

reasonable to attribute the lack of inflationary response in these episodes to adoption of

inflation targeting, which short-circuited the second- and later-round effects and helped to

focus public attention on the temporary nature of the devaluation shocks. Indeed, one reason

why inflation targets were adopted in both countries was to achieve exactly this result.

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 (e.g., 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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A common concern raised about inflation targeting is that it will lead to low and unstable

growth in output and employment. Although inflation reduction is associated with below-

normal output during disinflationary phases in inflation-targeting regimes, once low inflation

levels have been achieved, output and employment return to levels at least as high as they

were previously. A conservative conclusion is that, once, low inflation is achieved; inflation

targeting is not harmful to the real economy. Given the strong economic growth after

disinflation was achieved in many countries that have adopted inflation targets, New Zealand

being one outstanding example, a case can even be made that inflation targeting promotes real

economic growth in addition to controlling inflation.

Some economists, such as Friedman and Kuttner (1996), have criticized inflation targeting

because they believe that it imposes a rigid rule on monetary policymakers that does not allow

them enough discretion to respond to unforeseen circumstances. This criticism is one that has

featured prominently in the rules-versus-discretion debate. For example, policymakers in

countries that adopted monetary targeting did not foresee the breakdown of the relationship

between these aggregates and goal variables such as nominal spending or inflation. With rigid

adherence to a monetary rule, the breakdown in their relationship could have been disastrous.

However, the interpretation of inflation targeting as a rule is incorrect and stems from a

confusion that has been created by the rules-versus-discretion debate. In my view, the

traditional dichotomy between rules and discretion can be highly misleading. Useful policy

strategies exist that are "rule-like" in that they involve forward-looking behavior which

constrains policymakers from systematically engaging in policies with undesirable long-run

consequences, thereby avoiding the time-inconsistency problem.

These policies would best be described as "constrained discretion." Indeed, inflation targeting

can be described exactly in this way. As emphasized above, inflation targeting as actually

practiced is very far from a rigid rule. First, inflation targeting does not provide simple and

mechanical instructions as to how the central bank should conduct monetary policy. Rather,

inflation targeting requires that the central bank use all available information to determine the

appropriate policy actions to achieve the inflation target. Unlike simple policy rules, inflation

targeting never requires the central bank to ignore information and focus solely on one key

variable. Second, inflation targeting as practiced contains a substantial degree of policy

discretion. As we have seen, inflation targets have been modified depending on economic

circumstances. Furthermore, central banks under inflation-targeting regimes have left

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themselves considerable scope to respond to output growth and fluctuations through several

devices.

However, despite its flexibility, inflation targeting is not an exercise in policy discretion

subject to the time-inconsistency problem. The strategy of hitting an inflation target, by its

very nature, forces policymakers to be forward looking rather than narrowly focused on

current economic conditions. Further, through its transparency, an inflation-targeting regime

increases the central bank's accountability, which constrains discretion so that the time-

inconsistency problem is ameliorated.

2.2 EMPIRICAL REVIEW

2.2.1 INTEREST RATE CHANNEL

Most conventional models of the interest rate channel indicate that a change in the policy rate

affects banks’ lending and deposit rates, which in turn directly affect households and business

spending decisions. This is partly due to the fact that changes in policy rate impact

immediately on the money market by affecting treasury bills and interbank rates, including

deposit money banks’ short-term instruments.

Various studies have shown the role of the interest rate channel in the transmission of

monetary policy. Taylor (1995) in his survey of the interest rate channel concluded that there

is a strong empirical evidence for substantial interest rate effects on consumer and investment

spending. The European Central Bank (ECB) (2002) observed that in industrial countries, the

interest rate channel plays an important role in the transmission of monetary shocks.

According to the initiation, direct and indirect effects of interest rate changes (including

wealth and exchange rate effects) on investment explain about 80 percent of the total response

of output to monetary shocks after a lag of three years. Similarly, Loayza and Schmidt-Hibbel

(2002) posited that the interest rate channel plays a dominant role in the transmission process

in a developed financial system.

Mohanty and Turner (2008) summarised central banks’ views about the relative strength of

the pass-through of policy rates. Their findings show that most central banks see interest rates

as the dominant channel of transmission. For example, interest rates explain a large part of the

short-and long-term variation in output and inflation in Mexico. In Hong Kong and Thailand

after the crisis of 1997 – 1998, the interest rate channel dominated all other channels, while in

64

the Philippines, the central bank borrowing rate dominates the transmission channel. Bems

(2001) study on Estania, Latvia, and Lithuania found that the interest rate channel was visible

in all three countries, although the impact of the ECB rates was weak in Lithuania. However,

Bernanke and Gertler (1995) study on interest rate channel of monetary policy transmission

had difficulties in identifying significant effects of interest rate pass-through to the coast of

capital.

In general, competition and innovations in the banking sector have effect on the pass-through

of monetary policy changes to retail rates. Cottarelli and Kourelis (1994) found that the pass-

through is not the same across countries and structural parameters such as competitive

structure on the market (costs of switching bank), individual bank policies in relation to

market share, deposit structure, business cycle, credit risk and interest rate volatility make the

pass-through incomplete. They found that interest rates are quite sticky in the short run and

possibly also in the long run. For example they explain deposit interest rate stickiness as a

consequence of an economy’s competitive structure. Banks’ deposit rate will not respond to

the changes in official rates if the market is very competitive because the marginally better

interest rate does not compensate for the high switching costs.

In less competitive markets, banks might act in a conclusive manner and, therefore, reach a

new equilibrium, after a change in market rates. In addition, the degree of competition in the

banking system affects the level of competition and, therefore, the pass-through (Hannan and

Berger, 1991; Neumark and Sharpe, 1992; Angbazo, 1997; Hannan, 1997; and Corvoisier and

Gropp, 2002). Banks will also try to exploit consumer inertia and consumers’ own perception

of switching costs which they deem inaccurately too high (Klemperer, 1987).

The banks might also want to avoid high sunk costs, which would be incurred every time a

change in rate has to be administered and advertised to new and existing customers; the banks

might only pass-through rate changes when the revenues from changing the rate are greater

than the costs of changing and/or when changes are considered more permanent (Lowe and

Rohling, 1992, and Nabar et al, 1993).

Increase in competition narrows banks’ lending margins and makes the more responsive to

market rates which should increase the speed and the degree of the pass-through. Financial

innovation, especially in the funding side such as securitization should also make retail

lending more responsive to market rates (Ryding, 1990). Kolari, Fraser and Anari, 1998), and

Pais (2005). Alternatively, a depository institution which is mainly funded with core deposits

65

(less responsive to market passing interest rates) is less exposed to market rates and can delay

passing increases in market rates to borrowers i.e. the depository lender is in a better position

to offer risk sharing opportunities to their borrowers, which is typical of traditional bank

lending.

An empirical aspect that has been almost completely disregarded is the relation between

financial structure and the speed of the monetary policy transmission process. Cottarelli and

Kourelis (1994) tested the degree of lending rate stickiness in 31 industrial and developing

countries, which focused on how the financial structure affects the degree of stickiness of

bank lending rates i.e. the speed at which bank lending rates adjust to their long-run

equilibrium value after a “shock” affecting money market rates. The results indicate that, by

“signalling” monetary policy changes, movements in administered discount rates can speed up

the adjustments of lending rates. It is shown that the discount rate is more important in

countries where the response of lending rates to money market rates is lower. They further

argue that this phenomenon is due to a form of “discount rate addiction” of the banking

system. In countries where the discount rate has systematically been used as a signalling

device by the central bank, banks tend to postpone their reaction to changes to money market

rates until the discount rate changes.

Economic literature has recently re-examined the importance of bank credit markets for the

transmission mechanism of monetary policy (Bernanke and Blinder, 1988), Bernanke and

Gertler (1989), Bernanke (1993)). This literature stresses that banks are not neutral

“conveyors” of monetary policy impulses. For instance, a tightening of monetary policy is

reflected in an increase in money market rates. Such a tightening may fail to contain aggregate

demand or exchange rate pressures if financial intermediaries do not promptly adjust their

lending rates. The reaction of financial intermediaries is, of course, more important in

developing countries where the direct financial channels between primary lenders and

borrowers are limited, but almost irrelevant in industrial countries.

2.2.2 THE EXCHANGE RATE CHANNEL

Several studies that have investigated the exchange rate channel or monetary policy

established the importance of the exchange rate channel in the transmission of monetary

policy to the real economy. Arnostova and Hurnik (2004) employed the vector autoregressive

(VAR) model to analyse the transmission mechanism in the Czech Republic. They used two

samples (1993:1-2003:4 and 1998:1-2003:4) to investigate the presence of structural break

66

due to regime switch from fixed exchange rate to inflation targeting in 1997. The results

confirmed among others, that the exchange rate channel was significant during this period.

Although the result confirmed that an exchange rate shock led to an initial increase in prices

and output, a later stage fall in output helped to return prices to their initial levels.

Furthermore, they observed the “exchange rate puzzle” when an increase in interest rate led to

the depreciation of the domestic currency rather than an appreciation, a phenomenon common

to countries that have undergone exchange rate crisis during the relevant period.

Elchenbaum and Evans (1995) investigated the relationship between monetary policy shock

and exchange rate for the US using VAR model and found that monetary policy contraction

led to persistent and significant nominal and real exchange rate appreciation and interest rate

parity deviation. In the case of Armenia, the exchange rate channel plays a significant role for

the transmission of monetary policy (Dabla-Norris and Floerkemeier, 2006). Using the VAR

analysis and monthly data spanning 2005:5 to 2005:12. The authors observed that a positive

shock to the monetary policy, led to the appreciation in the nominal effective exchange rate

(NEER). Consequently, a rapid exchange rate pass-through to prices was observed as the

appreciation in the NEER led to an almost immediate decline in prices. These findings were

consistent with evidences established for most other transition economies.

To test the proposal that the depreciation of the Yen could rekindle Japan’s growth and move

the economy out of the liquidity trap, Nagayasu (2005) employed he vector error correction

model (VECM) and a quarterly sample of datasets which included exchange rate, money and

output for the period 1970:1 to 2003:1 to investigate the significance of the exchange rate as a

channel for monetary policy transmission to real economy. The results confirmed that though

monetary expansion had led to the depreciation of the Yen as suggested by theory, there was

no evidence, however, that Yen depreciation leads to improvement in output. Specifically, the

results from the VECM implied the absence of long-run causality from the exchange rate to

output. This led to the conclusion that Yen depreciation could not facilitate sustainable

economic growth and was not a significant channel for the transmission of monetary policy to

the real economy.

Siswanto, et al (2002) employed a structural vector autoregressive (SVAR) model to test the

importance of the exchange rate channel of monetary policy in Indonesia. They broke their

sample into “pre-crisis (1990:101997:7)” and “during crisis” periods. The result of the pre-

crisis period showed that although monetary tightening raised the Bank of Indonesia (BI) rate

67

and created interest rate differentials that attracted foreign capital, the Ruphiah exchange rate

did not appreciate because the monetary authorities intervened under the managed floating

regime to maintain the exchange rate within a band in order to preserve international

competitiveness. Similarly, the exchange rate did not witness any significant appreciation as a

result of monetary tightening during the period because of the crisis of confidence that

followed. Other non-quantitative determinants of foreign capital inflow became much more

influential. The study concluded that exchange rate did not work well as a channel of

monetary policy transmission during the per-crisis period because of the managed floating

regime even though it led to huge inflow of foreign capital. The period that followed was that

of instability in domestic socio-political environment and high country risk and as such, even

though the exchange rate regime changed to flexible, not much improvement was recorded

over the pre-crisis period. However, in terms of exchange rate pass-through to prices, the post

crisis, free-floating exchange rate regime established strong evidences of the significance of

exchange rate in the transmission of monetary policy to prices.

In the case of Nigeria, Nwafor (2006) had employed co-integration and error correction

methodology to test the validity of the monetary model of exchange rate determination in

explaining the relationship between the Naira/US dollar exchange rate and macroeconomic

fundamentals. The results established the existence of a long-run relationship between the

exchange rate and the other macroeconomic variables. As such, he concluded that the FPMM

holds for Nigeria. The result is important for the transmission mechanism of monetary policy

through the exchange rate channel in Nigeria. A monetary policy-induced change in money

supply influences the exchange rate which in turn affects the current account, prices and

output.

Adebiyi (2006) conducted a stuffy to analyse the effect of the financial sector reforms on the

transmission mechanism of monetary policy in Nigeria. He used the VAR methodology on

two samples categorized as “pre-reform” and “post-reform” periods. Using the forecast error

variance decomposition (VD) and impulse response (IR) analyses, his findings showed that

the exchange rate channel, among others, did not play any significant role in influencing

output and prices during the pre-reform period. However, its importance improved after the

financial sector reforms. Specifically, exchange rate became more important for long run

output developments in the post-reform period, explaining about a quarter of the variations in

output by the second quarter of the third year. In terms of prices, a positive exchange rate

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shock led to rising inflation in the long run, a result generally consistent with most empirical

findings in the literature.

A preliminary analysis of transmission mechanism of monetary policy in Nigeria was carried

out by the Research Department of the Central Bank of Nigeria (2008). To investigate the

exchange rate channel, a four-variable (output, price, exchange rate and money supply) VAR

was estimated and the result indicated that a positive shock to the real exchange rate (real

appreciation) led to a decline in output while an equally positive shock to the money supply

failed to elicit any significant response exchange from the real effective exchange rate

(REER). Furthermore, analysis of VD showed that the REER was not an important source of

variation in both output and the price level as it accounted for at most 12.4 and 5.9 percent of

the variation, respectively. The shock in REER was accounted for mainly by its own shock. In

conclusion, the effectiveness of the exchange rate channel was largely limited by the rigid

exchange rate regime that allowed the nominal exchange rate to fluctuate only within a narrow

band.

2.2.3 THE ASSET PRICE CHANNEL

Over the last three decades, there has been a surge in empirical research on the role of asset

prices as a channel of monetary policy transmission. A study on the impact of housing wealth

on consumption using German data, suggested the existence of a significant link between

consumption and housing wealth (Hordahi and Packer, 2007). Elchengreen and Tong (2003)

also confirmed the link between fluctuations in asset prices and changes in monetary policy

regimes. Seminally, Kannan (2006) tested the predictive power of equity prices for inflation

rate and economic activity in India and discovered that stock prices seemed to be a leading

indicator of inflation, though they appeared to lack predictive power for the output gap.

Sexton (2003) noted that asset prices could mirror price bubbles since such movements

influenced and help to predict general price inflation. In this regard, if equity prices fall, the

incentive to buy stock or use it as a source of financing investment weakens. For real estate,

price affects aggregate demand through its direct effect on housing expenditure and increase

in housing wealth. This would in turn lower the cost of financing housing investment while

increasing the prices of real estate. He, therefore, concluded that asset prices should be

included in a broader and more comprehensive measure of the general price level which could

be factored into the formulation of monetary policy by central banks. Studies by Al-Mashat

69

and Billmeier (2007), on asset price channel in Egypt concluded that the rapid development in

the Egyptian stock market index between March 2003 and February 2006 could have

contributed to the impact that the monetary policy stance had on real activities and prices.

McCarthy et al (2002) in a study of residential investment focused on the effects of

securitisation on the monetary policy transmission mechanism by examining how regulatory

changes and other innovations in housing finance had impacted on the transmission of policy

shocks to housing investment. They discovered that interest rates as opposed to quantity

constraints have taken on a larger role, since the dismantling of regulation and the shift from

thrift-based intermediation to a more market-oriented system of housing finance. Perhaps as a

consequence of these changes, mortgage interest rates responded swiftly to monetary policy

than they did prior to 1986. However, residential houses responded more slowly and

fluctuated more or less concurrently with the overall level of economic activity.

Thygesen (2002) noted that the transmission mechanism through changes in asset price to the

real economy was well understood through difficult to quantify empirically. Thus, the three

main transmission channels through which this could occur are the wealth effect, the Tobin’s

Q effect and changes in credit through the balance sheet of financial intermediaries.

Ehrmann and Fratscher (2004) examined the reaction of equity markets to the US monetary

policy in the period 1994 to 2003. They explained that a high degree of market volatility,

changes in the direction of monetary policy, and unanticipated changes in the federal funds

rate cause stronger effect on stock prices. The effect is stronger in industries that are cyclical

and capital-intensive. Using a structural VAR model, Bjornland and Leitemo (2005) examined

the relationship between monetary policy and the stock market. The authors found that a

shock on either sector had significant and direct impact on the other sector.

Thorbecke (1997) found that an expansionary monetary policy increased ex-post stock

returns. With a low interest rate, firms’ economic activity increased, leading to larger cash

flows and higher returns. Similarly, Cooley and Quadrini (1999) developed a value-weighted

index and employed a general equilibrium model with heterogeneous, old firms where

financial factors played an important role in production and investment decisions, to examine

the response of stock market index to monetary policy shocks. They found that small firms

responded more to monetary shocks than big firms and as a result of the financial decisions of

firms, monetary shocks had impact on output. Furthermore, monetary shocks led to

70

considerable volatility in the stock market such that a 1.0 percent monetary shock led to about

0.2 percent decline in stock market index.

2.2.4 INFLATION EXPECTATION CHANNEL

Cerisola and Gelos (2005) empirically studied the drivers of inflation expectations in Brazil.

They based their work on the understanding of inflation dynamics by examining the role of

fundamental determinants of inflation expectations from a survey-based estimation. The study

focused on the period Brazil adopted IT and revealed that inflation expectations were well

anchored in the monetary policy transmission mechanism. This resulted in a decline in the

dispersion of expectation in the results. The outcome also showed that the monetary policy

framework has become more credible with sustained implementation of prudent

macroeconomic policy and the ease of anchoring inflation expectations. The study established

the insignificance of past inflations (the adaptive model) in the determination of expectations

in Brazil. To further improve on the IT process, the authors suggested a forward-looking

frame which will give impetus to the credibility of the monetary policy process.

Blanchflower (2008) revealed that inflation expectations were strongly influence by past

experiences, while evidences of future path of prices were highly correlated with an

individual’s evaluation of current inflation. Using the Bank of England/NOP expectations

survey for the United Kingdom, Blanchflower’s findings were intriguing as a significant

number of individuals do not know what inflation rate was or how it might affect model

expectation he cautioned that market-based measures could further complicate the

interpretation of expectations since market conditions reflect risk premia with built-in

uncertainly about future inflation and liquidity position. These, he opined, could be influenced

by institutional factors.

Mellow and Moccero (2006) studied the effect of inflation targeting and exchange rate

regimes on inflation expectations in Brazil, Chile, Columbia and Mexico. They used time-

series and multiple co-Integration analysis to investigate the relationship between interest rate,

inflation target and inflation expectations. The paper tested for the existence of volatility

spillover effects between monetary policy stance and inflation expectations. Their findings

established a long-run relationship among the three variables in Brazil, Chile and Mexico.

This was evidence in the countries’ monetary policy regime (inflation targeting) which was

forward-looking and anchored inflation expectations. Using the M-GARCH model, they

71

further established the possibility of volatility spillover effects in Brazil and Columbia but

none for chile. Orphanides and Williams (2002) examined the effects of a relatively modest

deviation from rational expectation by building in learning equation of economic agents with

imperfect knowledge as key to the model on inflation expectations. Thus, the presence of

imperfect knowledge in the formation of expectations made the transmission of monetary

policy through his channel problematic. Using a simple linear model, they revealed that

although inflation expectations were far from being efficient under an imperfect knowledge

conditions, the uncertainties would aggravate inflation and distort the trade-off between

inflation and output growth in monetary policy target. Goelton (2008) in his study on the

transmission mechanisms of monetary policy in Indonesia showed that expected inflation is

determined predominantly by the exchange rate, past inflation, and the interest rate. The

market expects inflation to increase as the interest rate increases. Wuryandani, et. al. (2001)

investigated the inflation expectations channel using VAR analysis and confirmed the

existence of his channel. The expected inflation was determined by inertia as well as interest

and exchange rates. Expected inflation played a role in inflation formation, though not as

strong as past inflation. The credibility of the monetary authority was also important. All these

determined the effectiveness of inflation targeting. The study also noted that the market would

expect inflation to increase as interest rate increased. Mishkin and Schmidt – Hebbel (2001)

and the IMF (2006) confirmed that inflation targeting would adequately anchor inflation

expectations. Empirical evidence by Gurkaynak et al (2007) in a study of the United States,

Canada and Chile revealed that inflation expectations were well anchored in the last two

countries. Specifically, the study showed that the Bank of Chile used the difference between

the yields of nominal and inflation-linked bonds, known as inflation compensation to measure

market expectations of inflation. These were key variables to inflations-targeting framework

in Chile which guided monetary policy actions and formed the means of evaluating the

markets’ perception of the central Bank’s commitment to achieving its inflation target and its

credibility. A similar model by the Bank of Canada (see (Deguay and Longworth, 1998)

linked expectations to the credibility of the Bank as perceived by the responses of economic

agents to the announcement of the policy rate and thus focused on the behavioral equation of

these agents. The model considered three critical variables, namely: past actual inflation and

the difference between recent forecasts and recently observed inflation; policy actions and the

state of the economy reflecting the performance of the real sector. The model employed a mix

72

of the backward (adaptive) and forward-looking (rational) approaches and presented its

specifications thus:

�Explnfit = bo + Σ k B ij Inflat,\. Lagged ty + B2 Recent forecast difference t-1 + B3 Bank

ratet + B4 Exch ratet + B5 Spreadt + B6 Slopet + B7 Unemployment t-1 + Ao Announcement

• Inflation lagged represents the recent known of the inflation process.

• Recent forecast Difference t-1 is the difference between the most recent average

forecast and the most recently observed actual rate inflation.

• Bank rate is the average known nominal bank rate over the previous 12 months

and defines the effect of the current stance of monetary policy on expected

inflation.

• Exchange rate is the most recent known 12-months exchange rate change.

• Spread is the average difference between Canadian and American interest rate over

the previous 12 months.

• Slope is the average slope of the term structure over the last 12 months. Expressed

as long rates minus short rates. The interest rate and exchange rates variables may

also measure the anticipated effects of the current stance of monetary policy on the

real economy in the future and thus on expected inflation.

• Unemployment refers to the known change in the average unemployment rate

between the last 12 months and the previous 12 months; the variable, was included

in the regressions to take into account the knowledge of forecasters concerning the

state of real economy as well as the effects of past monetary policy.

• The effect of the policy announcement is measured by the coefficient “Ao” on the

dummy variable announcement.

The recent convergence of private sector inflation expectation surround the central bank’s

inflation target in many countries such as Czeh Republic, Colombia, Mexico and south Africa

and, thus, has given importance to the expectation channel. Mahanty and Turner (2008)

observed that most central banks agree that the growing role of the expectation channel has

implications for the magnitude of their interest rate response. For example, in Colombia, the

volatility of the policy rate had fallen since 2000 following improved credibility of monetary

policy. Similarly, in Israel, more stable nominal wage expectations had allowed the central

bank to moderate interest rate movements. Mayes (2004) in his study on the monetary policy

transmission mechanism in the Baltic States found that monetary policy actions exerted

73

effects on the economy through their impact on the confidence and expectations of economic

agents about the future outlook of the economy. In particular, expectation effects might

improve monetary policy transmission through the other channels by shortening reactions

lags.

2.3 REVIEW SUMMARY

From most of the theoretical and empirical review of monetary policy transmission

mechanism above, it can be summarized that developments in financial markets can affect

both banks’ ability and willingness to lend and companies’ ability to raise funds in the capital

market, these in turn, will affect the consumption and investment decisions of households and

businesses. Endogenous changes in creditworthiness may increase the persistence and

amplitude of business cycles (the financial accelerator) and strengthen the influence of

monetary policy transmission mechanism (the credit channel).The different channels of the

monetary transmission mechanism are not mutually exclusive and the economy’s overall

response to monetary policy will incorporate the impact of a variety of channels. But

monetary policy appears to have less of an impact on real activity than it once had although

the causes of that change remain an open issue.

The literature survey above has also quoted some evidence for the existence and importance

of credit channel. A number of studies have shown that the credit effects are particularly

important for small firm during the period of monetary tightening. These results are appealing

from a theoretical pint of view since small firm are more likely to be facing severe

information problem, and consequently credit constraint, moreover, there are clear link

between banks’ lending behavior and bank balance sheet liquidity, which suggests that the

bank lending may turn out to be very significant source of monetary transmission when the

banking system is relatively illiquid.

However, the recent literature on investment equations has cast some doubt on where the

significant of cash flow in Tobin’s can be interpreted as evidence for credit constraints. It is

possible that the significant of cash flow in investment equation may simply proxy for

unobserved future profit opportunities. Never the less, Taylor (1995) concluded that there is a

strong empirical evidence for substantial interest rate effects on consumer and investment

spending, which showed the role of the interest rate channel in the transmission of monetary

policy.

74

As Mohanty and Turner (2008) summarized central banks’ views about the relative strength

of the pass-through of monetary policy transmission channel. Their findings show that most

central banks see interest rates as the dominant channel of transmission. For example, interest

rates explain a large part of the short-and long-term variation in output and inflation in

Mexico.

75

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CHAPTER THREE

RESEARCH METHODOLOGY

3.1 Research design

The research design adopted in this study is the ex post facto research design. The adoption of

this research design is based on two reasons. First, the ex post facto research design according

to Onwumere (2005) is adopted when the researcher does not intend to control the variables

and as such those variables must have been in existence and had already existed in published

form. Secondly, the ex post facto research design is adopted according to Kerlinger (1973)

when the researcher is investigating a cause-effect relationship. The study main construct is

determining the dominant channel of monetary policy transmission mechanism hence

determining the channel that have the most impact in monetary policy target.

3.2 Nature and sources of data

The nature of data that used in this study is secondary and the data were sourced from

secondary sources. Data to be use is obtained from the published sources, such as the

publications of the Central Bank of Nigeria. The central bank of Nigeria statistical bulletin

forms the main sources of data in this study.

3.3 Description of Research Variables

In this section, the variables used were presented in line with the adopted models and the

justifications for the adopted variables were also presented.

3.3.1 Explanatory Variable

Monetary Policy Target (Growth of GDP)

Monetary policy target measure the ability of monetary to achieve certain pre-determined

level of interest rate, monetary base, discount windows reserve requirements. (CBN, 2009).

However, consistent with extant literature, the growth of GDP is mostly used in empirical

literature. Cerisola and Gelos (2005) argue that the preference for the GDP growth is based on

the fact that GDP captures the market value of all goods and services produce in a country,

which in the main, is the major objective of monetary policy (price stability). Gross domestic

product also refers to the market value of all officially recognized final goods and services

produced within a country in a given period. This study adopts the growth rate of GDP as a

proxy for monetary policy target. This is the most robust measure of monetary policy since,

monetary transmission policies of the government must and should enhance the growth in

83

gross domestic product which is a barometer for measuring the performance of the entire

economy.

3.3.2 Independent Variables

Credit to the Private Sector

The private sector represents the productive sector of the economy. This sector must and

should be fueled with sufficient funds as to enhance the growth of that sector. Therefore, in

this study we will adopt the total credit granted to the core sector of the Nigerian Economy as

a measure through which monetary policies in Nigeria affects the growth of the economy.

Corvoisier and Kourelis (2002) posits that the credit to core private sector which provide

credits to private sector adequately captures the credit channel of monetary policy

transmission mechanism

Monetary Policy Rate

According to Bjornland (2005), business runs on credit such credit determine the volume of

transaction within an economy. Banks borrow too on a daily basis from each other or their

central bank. The latter sets the baseline interest rates every other interest rate adds on to.

Therefore monetary policy rate is the rate that controls the amount of money in circulation at

any given time. Raise them and the money supply shrinks; lower them and it expands. "Tight"

money slows economic activity down; "loose" money speeds it up. The decision to do either

comes after careful deliberation about what monetary policy a central bank should pursue

given prevailing economic conditions. This study will adopt this proxies as means through

which monetary policy have an impact on the economy.

Nominal Exchange Rate

This measures the numerical exchange value. In a floating rate regime, an increase in the

value of domestic currency is known as appreciation which increases the rate of growth in real

GDP The nominal exchange rate indicates the number of naira one receives for a dollar or

other currencies (or vice versa), it does not show the purchasing power of the naira versus any

other currency. Bernanke (1995) posits that there are two types of exchange rate viz; nominal

and real exchange rate. While the Nominal exchange rates are established on currency

financial markets called "forex markets", which are similar to stock exchange markets. These

rates are usually established in continuous quotation, with newspaper reporting daily

quotation (as average or finishing quotation in the trade day on a specific market). Central

84

bank may also fix the nominal exchange rate. The Real exchange rates are nominal rate

corrected somehow by inflation measures. In fact, higher prices mean an appreciation of the

real exchange rate, other things equal. In this study we will adopt the official quote which is

the nominal exchange rate as a proxy for determining the dominant channel of monetary

policy transmission.

3.3.3 Control Variables

Consumer Price Index

This is a measure that examines the weighted average of prices of a basket of consumer goods

and services, such as transportation, food and medical care. The CPI is calculated by taking

price changes for each item in the predetermined basket of goods and averaging them; the

goods are weighted according to their importance. Changes in CPI are used to assess price

changes associated with the cost of living. CPI is one of the most frequently used statistics for

identifying periods of inflation or deflation. This is because large rises in CPI during a short

period of time typically denote periods of inflation and large drops in CPI during a short

period of time usually mark periods of deflation. In line with the works of Duguay and

Longworth (1998), this study adopted CPI as control variable. This is because, CPI, being

inflation could undermine or promote the achievement of monetary targets. Thus, not

controlling for its effects will bias our result. As such, this study controls for CPI

Money Supply

Money supply or money stock is the total amount of money available in an economy at a

specific time. Andres (2001) posits that there are several ways to define "money," but standard

measures usually include currency in circulation and demand deposit (depositors' easily

accessed assets on the books of financial institutions). Nigeria uses M2 as a measure of money

supply and M2 Represents money and close substitutes for money. M2 is a broader

classification of money than M1. Economists use M2 when looking to quantify the amount of

money in circulation and trying to explain different economic monetary conditions. M2 is a

key economic indicator used to forecast inflation.. Hence, this measure will also be extracted

from the CBN Statistical bulletin as a proxy to determine the dominant channel of monetary

policy.

85

3.4 Techniques of Analysis

This study will adopt the Structural Vector Auto Regressive (SVAR) model. The appeal for

this model rests on its simplicity and high predictive power. Using this model to determine the

monetary policy transmission mechanism allows the imposition of restrictions (if any) on how

stocks from monetary policy actions affect the rest of the economy. Also this approach

recognizes the dependence of monetary policy on other variable that is, the policy reaction

function (Podder et al, 2006).

Furthermore, the impulse response and variance decomposition generated in the VAR would

enable us to trace the response of any variable to shocks from other variables:

The general SVAR representation is as follows:

Yt = ay t- 1 + bXt + Vt………………………………………………. (ix)

Where Yt is the vector of endogenous variable, Xt is the vector of exogenous variable and Vt

is the residual vector. In addition, a is a matrix that includes all the coefficients describing the

relationships among the endogenous variables and b is a matrix that includes all the

coefficients describing the relationships among the endogenous and exogenous variables. The

use of the vector of exogenous variables helps to solve the price puzzle that is often

observable in VAR results.

A typical reduced-form VAR, as proposed by Sims (1980), is a system of equations that can

be written in the form:

Yt = A (L) Yt-1 + ẑt …………………………………………........(x)

Where Yt is the column vector of observations at time (t) on all variables and is known as the

vector of endogenous variables. A(L) is the matrix of coefficients to be estimated and the

symbol ẑt represent the column vector of random disturbances values called innovations that

may be contemporaneously correlate with each other and assumed to be non auto-correlated

over time.

A more explicit representation of equation (x) can be expressed as:

Yt = A1Yt-1 + A2Yt-2 + A3Yt-3 +… + AkYt-p + ẑt ………………………….. (xi)

86

In a VAR, each variable is regressed on its own lags and the lags of each of the other variables

in the model. The VAR provides a better insight into the dynamics of the system and thus,

allows a feedback among the endogenous variables in the model (See, Littleman, 1986).

3.5 Model Specification

A model, according to Onwumere (2005) can be a mathematical representation of reality. In

writing the model for this study, the following were used to represent their respective

variables. There are:

Rgdp = Vector of exogenous variable. [GDP Growth as proxy for monetary policy target]

CPI = Consumer price Index M2 = Money Supply MPR = Monetary Policy Rate CCPS = Credit to the Core private sector NER = Nominal Exchange Rate

In adopting this model, a baseline model that incorporates real output (Rgdpt), prices (CPIt),

money supply (M2t), is stated to capture the dynamics of the transmission mechanism. The

deviation from this baseline model will be used in this study to estimate the channel which is

more dominant. The baseline model is represented according to CBN (2010) as;

(MPT) = f(MPRt ,CCPSt, NERt CPIt, M2t)………………………………………… (i) Where, MPT is the monetary policy target and proxied by GDP growth. The matrix form of the model is given as

= V (L ) ………… (ii)

where, ẑCPl and ẑM2 are structural disturbances on monetary policy target (MPT). The first

row in equation (i) represents monetary policy rate MPR, which is the endogenous factor of

the model. The second row represent credit to the core private sector CCPS, and the third row

represent net exchange rate NER, also an endogenous factor of the model. The forth row

represent the consumer price index CPI, which is also an endogenous factor of the model and

87

is allowed to respond to shocks on output alone by assuming non-zero a43. The fifth row is the

money supply function which depends on output and price. The basic model is modified with

various policy variables that will served as a measure of the dominant monetary policy

channel in this study.

Thus, for the first hypothesis which states that the interest rate channel of monetary policy

transmission mechanism is not the most effective channel of monetary policy transmission in

Nigeria, it will be represented as;

MPT = f(MPRt, CPIt, M2t,)………………………………… (iii) The matrix form of the above is represented as;

= V (L) …………………(iv)

Where, ẑCPl, ẑM2, and ẑMPR are structural disturbances on the respective variables. The first

row in equation (ii) represents MPR, which is the endogenous factor of the model. The second

row is the consumer price index function and is allowed to respond to shocks on output along

by assuming non-zero a21. The third row is the money supply function, which depends on

output and price.

For the second hypothesis which states that the credit channel is not the most efficient

monetary policy transmission mechanism in Nigeria, it is represented as;

MPT = f(CCPSt, CPlt, M2t)……………………………………………...(v)

The matrix form is represented as:

= V (L) ……………(vi)

The credit channel of monetary policy transmission attempts to situate the roles which deposit

money banks (DMBs) play in the transmission of monetary policy impulses to output and

88

prices. It extends the standard 1S-LM constructs by including quantum of loans advanced by

DMBs to ascertain DMBs reaction to changes in policy rates.

Lastly for the third hypothesis which states that, the exchange rate channel is not the most

efficient monetary policy transmission mechanism in Nigeria. It will be represented as;

MPT = f (NERt CPlt, M2t)……………………………………………... (vii)

The matrix form of the above is represented as:

= V (L) ……………….. (viii)

Where, ẑMER, ẑCPl, ẑM2 and are structural disturbances on the respective variables, the

variables are ordered with the impact assumption that the speed with which they respond to

shocks differs.

89

References

CBN (2010), Monetary Policy Transmission Mechanism in Nigeria, Abuja: Central Bank of Nigeria

Kerlinger, F.N. (1973), Foundations of Behavioural Research Techniques In Business and

Economics Eleventh Edition, Boston; McGraw Hill Irwin

Littleman, R.B. (1986), “Forecasting with Bayesian Vector Autoregressive-Five Years of

Experience” Journal of Business and Statistics, 4(1) 25-38 Onwumere, J.U.J (2005), Business and Economic Research Method, Lagos; Don-Vinton

Limited Podder, T. et al, (2006), The Monetary Transmission Mechanism in Jordan, IMF Working

Paper, WP/06/48 Sims, C.A (1980), “Macroeconomics and Reality” Econometrica, 48(1) 1-48

90

CHAPTER FOUR

PRESENTATION AND ANALYSIS OF DATA

4.1 Presentation of Data

In this section the relevant data for analysis were presented.

Table 4.1 shows Aggregate values of model data

Table 4.1 Aggregate Values of Model Data

Year Rgdp Cpi M2 MPR CCPS NER

1980 31546.8 0.88 15100 6 7457.8 106.3

1981 205222.1 1.03 16161.7 6 8570.05 110.39

1982 199685.3 1.1 18093.6 8 10668.34 109.86

1983 185598.1 1.53 20879.1 8 11668.04 109.84 1984 183563 1.87 23370 10 12462.93 113.2

1985 201036.3 1.89 26277.6 10 13070.34 99.9

1986 205971.4 2.15 27389.8 10 15247.45 51.89

1987 204,806.50 2.36 33667.4 12.75 21082.99 14.72

1988 219,875.60 3.8 45446.9 12.75 27326.42 12.97

1989 236,729.60 5.5 47055 18.5 30403.22 8.88 1990 267,550.00 5.7 68662.5 18.5 33547.7 7.72

1991 265,379.10 7 87499.8 14.5 41352.46 6.34

1992 271,365.50 10.42 129085.5 17.5 58122.95 3.74

1993 274,833.30 16.8 198479.2 26 127117.7 2.97

1994 275,450.60 29.7 266944.9 13.5 143424.2 2.96

1995 281,407.40 45.03 318763.5 13.5 180004.8 0.74

1996 293,745.40 51.47 370333.5 13.5 238595.6 30.17 1997 302,022.50 56.73 429731.3 13.5 316207.1 28.83

1998 310,890.10 63.49 525637.8 14.31 351956.2 28.32

1999 312,183.50 63.63 699733.7 18 431168.4 73.91

2000 329,178.70 72.87 1036080 13.5 530373.3 77.21

2001 356,994.30 84.9 1315869 14.31 567961.5 81.3

2002 433,203.50 95.2 1599495 19 930493.9 88.95

2003 477,533.00 117.9 1985192 15.75 1096536 100.63

2004 527,576.00 129.7 2263588 15 1421664 107.07

2005 561,931.40 144.7 2814846 13 1838390 106.58

2006 595,821.60 157.1 4027902 12.25 2290618 105.02

2007 634,251.10 167.4 5809827 8.75 3680090 106.41

2008 674,889.00 192 9167068 9.81 6941383 79.01

2009 718,977.33 102.2 10780627 7.44 9147417 95.73

2010 775,525.70 114.2 11525530 6.13 10157021 96.57

2011 834,000.80 128.1 13303500 9.19 1066607.0 101.17

2012 888,893.00 141.2 15483800 12.00 1464928.0 98.94

Source: CBN Statistical Bulletin (Various Years)

91

Note:

Rgdp = Real Gross Domestic Product; CPI = Consumer Price Index; M2 = Aggregate Money Supply; MPR = Monetary Policy Rate; CCPS = Core Credit to the Private Sector; NER = Nominal Exchange Rate 4.2 Descriptive Statistics

Table 4.2 Descriptive Statistics of Aggregate Data

RGDP CPI M2 MPR CCPS NER

Mean 348862.7 56.5 1796591.0 12.9 1312303.0 63.5

Median 281407.4 45.0 318763.5 13.5 180004.8 79.0

Maximum 775525.7 192.0 11525530.0 26.0 10157021.0 113.2

Minimum 31546.8 0.9 15100.0 6.0 7457.8 0.7

Std. Dev. 182759.4 59.1 3197406.0 4.5 2639727.0 43.7

Skewness 0.9 0.7 2.1 0.6 2.4 -0.3

Kurtosis 2.8 2.3 6.2 3.6 7.8 1.4

Jarque-Bera 3.9 3.5 36.3 2.2 60.5 4.0

Probability 0.1 0.2 0.0 0.3 0.0 0.1

Observations 31.0 31.0 31.0 31.0 31.0 31.0

Source: Researcher’s E-view Result Note: Rgdp = Real Gross Domestic Product; CPI = Consumer Price Index; M2 = Aggregate Money Supply; MPR = Monetary Policy Rate; CCPS = Core Credit to the Private Sector; NER = Nominal Exchange Rate. In this section, the descriptive statistics results were presented. Table 4.2 contains the descriptive statistics of aggregate data.

As indicated from tables 4.2, the mean value of aggregate real gross domestic product from

1980 to 2010 was N348, 862.70million. The median value of the real gross domestic product

was N281, 407.4million. The year with the highest growth in the Nigeria was in 2010 when

the gross domestic product was N775, 525.70million while the least was in 1980 when the

gross domestic product was N31, 546.8million. Overall the gross domestic product of Nigeria

consistently increases over the period of the study. As revealed from table 4.2, there was a

positive skewness of gross domestic product (0.9) indicating that the degree of departure from

symmetry of a distribution was positive. Also Kurtosis of 2.8 < 3 which is the normal value

revealed that the degrees of peakedness of gross domestic product within the period of this

study were not normally distributed as it tends to move to the right as further buttressed by the

positive skewness.

The consumer price index as revealed from tables 4.2 shows that the mean was 56.5 percent

while the median was 45.0 percent. In 2008, the highest inflation rate was observed in Nigeria

92

within the period under study as indicated by the consumer price index (192 %) while the

least was observed in 1980 (0.88) approximated to 0.9. Overall, the consumer price index

showed fluctuations within the period of the study. Again as revealed from table 4.2, there

was a positive skewness of consumer price index (0.7) indicating that the degree of departure

from mean of the distribution was positive. Also, Kurtosis of 2.3 < 3 which is the normal

value revealed that the degrees of peakedness of consumer price index within the period of

this study were not normally distributed as it tends to move to the right as further buttressed

by the positive skewness.

As revealed from tables 4.2. The mean value of aggregate real money supply (M2) from 1980

to 2010 was N1, 796, 591.0million. The median value was N318, 763.5million. The year with

the highest quantum of money in circulation in Nigeria within the period under review was in

2010 when the aggregate money supply was N11, 525, 530.0million while the least was in

1980 when the total quantum of money in circulation was N15, 100.0million. Overall, the

quantum of money in circulation of Nigeria consistently increased over the period of the

study. There was a positive skewness of M2 (2.1) indicating that the degree of departure from

the mean of the distribution was positive. Also Kurtosis, of 6.2 > 3 which is the normal value

revealed that the degrees of peakedness of money supply within the period of this study were

normally distributed as it tends to hover around the mean.

The monetary policy rate as revealed from tables 4.2 shows that the mean was 12.9 percent

while the median was 13.5percent. In 1993, the highest monetary policy rate was observed in

Nigeria within the period under study as indicated by the monetary policy rate of (26.0%)

while the least was observed in 1980 and 1981 when the monetary policy rate was 6.0 percent.

Overall, the monetary policy rate showed fluctuations within the period of the study. Again, as

revealed from table 4.2, there was a positive skewness of monetary policy rate (0.6) indicating

that the degree of departure from mean of the distribution was positive. Also Kurtosis of 3.6 >

3 which is the normal value revealed that the degrees of peakedness of the monetary policy

rate within the period of this study were normally distributed as it tends to hover around the

mean.

From tablesa 4.2, the mean value of aggregate core credit to the private sector from 1980 to

2010 was N13, 123, 303million. The median value was N180, 004.8million. The year with the

highest quantum of credit to the private sector was in Nigeria within the period under review

93

was in 2010 when the aggregate core credit to the private sector was N10, 157, 021.0million

while the least was in 1980 when the total core credit to the private sector was N7,

457.8million. Overall the total core credit to the private sector consistently increased over the

period of the study. There was a positive skewness of CCPS (2.4) indicating that the degree of

departure from the mean of the distribution was positive. Also, Kurtosis of 7.8 > 3 which is

the normal value revealed that the degrees of peakedness of core credit to the private sector

within the period of this study were normally distributed as it tends to hover around the mean.

The nominal exchange rate as revealed from tables 4.2 shows that the mean was 63.5 percent

while the median was 79.0percent. In 1984, the highest nominal exchange rate was observed

in Nigeria within the period of this study (113.2%) while the least was observed in 1995 when

the nominal exchange rate was 0.7 percent. Overall, the nominal exchange rate showed

fluctuations within the period of the study. Again as revealed from table 4.2, there was a

negative skewness of nominal exchange rate (-0.3) indicating that the degree of departure

from mean of the distribution was negative. Also, Kurtosis of 1.4 < 3 which is the normal

value revealed that the degrees of peakedness of the nominal exchange rate within the period

of this study were not normally distributed as it tends to move away from the mean.

Table 4.3 revealed the ratio values of the model proxies. Again tables 4.3 and 4.4 are interpreted together.

4.3 Determination of Research Variables

In this section, the data presented in section 4.1 were transformed in testable forms. This is to

mitigate the problem associated with heteroskedasticity, and also conform with the

assumption of linearity which posits that all data must be in the same state (homoscedasticity)

(see Gujarati and Porter, 2009)

Table 4.3 Ratio Values of Model Data

Years GDPGROWTH LOGCPI LOGM2 LOGMPR LOGCCPS LOGNER

1980 0.053386 -0.05552 4.178977 0.778151 3.872611 2.026533

1981 5.505322 0.012837 4.208487 0.778151 3.932983 2.04293

1982 -0.02698 0.041393 4.257525 0.90309 4.028097 2.04084

1983 -0.07055 0.184691 4.319712 0.90309 4.066998 2.040761

1984 -0.01097 0.271842 4.368659 1 4.09562 2.053846

1985 0.09519 0.276462 4.419586 1 4.116287 1.999565

1986 0.024548 0.332438 4.437589 1 4.183197 1.715084

1987 -0.00566 0.372912 4.52721 1.10551 4.323932 1.167908

1988 0.073577 0.579784 4.657504 1.10551 4.436583 1.11294

1989 0.076652 0.740363 4.672606 1.267172 4.48292 0.948413

94

1990 0.130192 0.755875 4.83672 1.267172 4.525663 0.887617

1991 -0.00811 0.845098 4.942007 1.161368 4.616501 0.802089

1992 0.022558 1.017868 5.110877 1.243038 4.764348 0.572872

1993 0.012779 1.225309 5.297715 1.414973 5.104206 0.472756

1994 0.002246 1.472756 5.426422 1.130334 5.156622 0.471292

1995 0.021626 1.653502 5.503469 1.130334 5.255284 -0.13077

1996 0.043844 1.711554 5.568593 1.130334 5.377662 1.479575

1997 0.028178 1.753813 5.633197 1.130334 5.499972 1.459845

1998 0.029361 1.802705 5.720687 1.15564 5.546489 1.452093

1999 0.00416 1.803662 5.844933 1.255273 5.634647 1.868703

2000 0.05444 1.862549 6.015393 1.130334 5.724582 1.887674

2001 0.0845 1.928908 6.119213 1.15564 5.754319 1.910091

2002 0.213475 1.978637 6.203983 1.278754 5.968714 1.949146

2003 0.10233 2.071514 6.297802 1.197281 6.040023 2.002727

2004 0.104795 2.11294 6.354797 1.176091 6.152797 2.029668

2005 0.065119 2.160469 6.449455 1.113943 6.264438 2.027676

2006 0.06031 2.196176 6.605079 1.088136 6.359953 2.021272

2007 0.064498 2.223755 6.764163 0.942008 6.565858 2.026982

2008 0.064072 2.283301 6.96223 0.991669 6.841446 1.897682

2009 0.065327 2.009451 7.032644 0.871573 6.961298 1.981048

2010 0.078651 2.057666 7.061661 0.78746 7.006766 1.984842

2011 0.0701139 1.448700 7.123900 0.963300 5.029800 2.005100

2012 0.0617534 2.152900 7.189900 1.079200 6.165800 1.995400

Source: CBN Statistical Bulletin (Various Years) Note: Rgdp = Real Gross Domestic Product; CPI = Consumer Price Index; M2 = Aggregate Money Supply; MPR = Monetary Policy Rate; CCPS = Core Credit to the Private Sector; NER = Nominal Exchange Rate

Table 4.3 shows ratio values of model data.

95

Table 4.4 Descriptive Statistics of Ratio Data

RGDP CPI M2 MPR CCPS NER

Mean 22.45 56.46 3.08 12.90 2.16 63.49

Median 5.44 45.03 1.13 13.50 0.64 79.01

Maximum 550.53 192.00 14.99 26.00 13.10 113.20

Minimum -7.05 0.88 0.08 6.00 0.04 0.74

Std. Dev. 98.15 59.13 4.39 4.51 3.57 43.69

Skewness 5.27 0.74 1.77 0.58 2.20 -0.32

Kurtosis 28.86 2.31 5.02 3.60 6.69 1.36

Jarque-Bera 1007.54 3.46 21.39 2.19 42.54 3.98

Probability 0.00 0.18 0.00 0.33 0.00 0.14

Observations 31.00 31.00 31.00 31.00 31.00 31.00

Source: Researcher’s E-view Result Note: Rgdp = Real Gross Domestic Product; CPI = Consumer Price Index; M2 = Aggregate Money Supply; MPR = Monetary Policy Rate; CCPS = Core Credit to the Private Sector; NER = Nominal Exchange Rate

Table 4.4 shows descriptive statistics of ratio data. As indicated from tables 4.4. The mean value of real gross domestic product growth rate from

1980 to 2010 was 22.45 per cent. The median value of the real gross domestic product growth

rate was 5.44 per cent. The year with the highest growth rate gross domestic product was in

1981 when the gross domestic product grew by 550.53 per cent while the least growth in real

gross domestic product was in 1983 when the gross domestic product fell by 7.05 per cent

from the previous year rate. Overall the growth rate of Nigeria’s gross domestic product

showed consistent increase over the period of the study. As revealed from table 4.2, there was

a positive skewness of gross domestic product (28.86) indicating that the degree of departure

from symmetry of a distribution was positive. Also Kurtosis of 5.7 > 3 which is the normal

value revealed that the degrees of peakedness of gross domestic product within the period of

this study were normally distributed as it tends to hover around the mean.

The consumer price index as revealed from tables 4.4 shows that the mean was 56.5 percent

while the median was 45.0 percent. In 2008, the highest inflation rate was observed in Nigeria

within the period under study as indicated by the consumer price index (192 %) while the

least was observed in 1980 (0.88) approximated to 0.9. Overall the consumer price index

showed fluctuations within the period of the study. Again as revealed from table 4.2, there

was a positive skewness of consumer price index (0.7) indicating that the degree of departure

from mean of the distribution was positive. Also Kurtosis of 2.3 < 3 which is the normal value

96

revealed that the degrees of peakedness of consumer price index within the period of this

study were not normally distributed as it tends to move to the right as further buttressed by the

positive skewness.

From tables 4.4, the mean value of financial deepening measured by (M2/GDP) from 1980 to

2010 was 3.08 per cent while the median was1.13 percent. The year with the highest financial

deepening in Nigeria within the period under review was in 2009 when M2/GDP was 14.99

per cent while the least was in 1981 when the rate of financial deepening was 0.078

(approximated to 0.08). Overall, the rate of financial deepening in Nigeria showed a

consistent increase over the period of the study. There was a positive skewness of financial

depeening (1.77) indicating that the degree of departure from the mean of the distribution was

positive. Kurtosis of 2.31 < 3 which is the normal value revealed that the degrees of

peakedness of money supply within the period of this study were not normally distributed as it

tends to move away from the mean.

The monetary policy rate as revealed from tables 4.4 shows that the mean was 12.9 percent

while the median was 13.5percent. In 1993, the highest monetary policy rate was observed in

Nigeria within the period under study as indicated by the monetary policy rate of (26.0%)

while the least was observed in 1980 and 1981 when the monetary policy rate was 6.0 percent.

Overall the monetary policy rate showed fluctuations within the period of the study. Again as

revealed from table 4.2, there was a positive skewness of monetary policy rate (0.6) indicating

that the degree of departure from mean of the distribution was positive. Also Kurtosis of 3.6 >

3 which is the normal value revealed that the degrees of peakedness of the monetary policy

rate within the period of this study were normally distributed as it tends to hover around the

mean.

From tables 4.4, the mean value of penetration of core credit granted to the private sector

which is put into productive use into the Nigerian economy from 1980 to 2010 was 2.16

percent. The median value was 0.64 percent. The year with the highest penetration of credit

granted to the private sector into the Nigerian economy within the period under review was in

2010 when the penetration level was 13.10percent while the least was in 1981 when the

penetration level was 0.04 percent. Overall the level of penetration level of credit to the

private sector into the Nigerian economy consistently increased over the period of the study.

There was a positive skewness of ratio of core credit to the private sector to gross domestic

97

product (2.2) indicating that the degree of departure from the mean of the distribution was

positive. Also Kurtosis of 6.69 > 3 which is the normal value revealed that the degrees of

peakedness of ratio of credit to the private sector to gross domestic product within the period

of this study were normally distributed as it tends to hover around the mean.

The nominal exchange rate as revealed from tables 4.4 shows that the mean was 63.5 percent

while the median was 79.0percent. In 1984, the highest nominal exchange rate was observed

in Nigeria within the period of this study (113.2%) while the least was observed in 1995 when

the nominal exchange rate was 0.7 percent. Overall the nominal exchange rate showed

fluctuations within the period of the study. Again as revealed from table 4.2, there was a

negative skewness of nominal exchange rate (-0.3) indicating that the degree of departure

from mean of the distribution was negative. Also Kurtosis of 1.4 < 3 which is the normal

value revealed that the degrees of peakedness of the nominal exchange rate within the period

of this study were not normally distributed as it tends to move away from the mean.

4.4 Correlation Matrix

This section presents the pair-wise correlation matrix for the transformed data.

Correlation Matrix

Table 4.5 Correlation Matrix

RGDPGR CPI M2 MPR CCPS NER

RGDPGR 1

CPI -0.1513 1

M2 -0.1102 0.7966 1

MPR -0.2713 -0.0655 -0.3198 1

CCPS -0.0956 0.7015 0.9868 -0.3542 1

NER 0.2075 0.4190 0.3947 -0.5791 0.3519 1

Source: Researcher’s E-view Results Table 4.5 shows above correlation matrix.

From table 4.5, the correlation matrix is depicted. It was revealed from the table that there was

a negative relationship between growth rate of the Nigerian economy and consumer price

index (correlation coefficient of consumer price index = -0.1513) indicating that inflation

reduces the growth of the economy by 0.1513 units. Inflation is the consistent rise in prices of

goods and services hence the rise in prices of goods and services reduces the ability of the

economy to grow. Also as revealed from the table, there was a negative relationship between

the growth of the Nigeria and money supply (correlation coefficient of money supply = -

98

0.1102). This reveals that an increase in financial deepening of the Nigerian economy through

increase in money supply is not channeled into productive activities that will enhance the

growth of the economy. However, there was a positive relationship between money supply

and consumer price index (correlation coefficient of M2 -0.7966). In a situation of inflation,

an increase in supply of money increases the amount of fund in the hands of the consumer

thereby leading to the chase for few goods available. As shown by the result of the correlation

matrix where it was revealed that an increase in money supply only increases the purchasing

ability of consumers and productive this leads to inflation.

Monetary policy rate which is the rate at which central bank lends to commercial banks also

had negative relation with growth of the Nigerian economy (correlation coefficient of MPR =

-0.2713), consumer price index (correlation coefficient of MPR = -0.0655) money supply

(correlation coefficient of MPR = -0.3198) but had a positive relationship with inter-bank rate

(correlation coefficient of MPR = 0.8090). It indicates that an increase in monetary policy rate

reduces growth rate, reduces inflation and reduces the total quantum of money in circulation.

However an increase in monetary policy rate increases inter-bank lending rates meaning that

as the central bank increase monetary policy rate, commercial banks also increase their inter-

bank lending rate.

Core credit to the private sector also had a negative relationship with growth rate of the

Nigerian economy (correlation coefficient of CCPS = -0.0956), inter-bank rate (correlation

coefficient of CCPS = -0.2094) and monetary policy rate (correlation coefficient of CCPS = -

0.3542). However, it had a positive relationship with consumer price index (correlation

coefficient of CCPS = 0.7015) and money supply (correlation coefficient of CCPS = 0.9868).

Again it was revealed from the results that credit granted to the private sector does not

increase the growth of the Nigerian economy. This could be because the funds are not

channeled into productive activities. The increase in the inter-bank rate also reduces the ability

of banks to lend to the private sector and also an increase in monetary policy rate also do not

increase ability of banks to lend to the private sector of the Nigerian economy. Again, core

credit to the private sector increases inflation. This has been buttressed by lack of growth of

the Nigerian economy which has led to much money chasing too few goods. The positive

relation observed between core credit to the private sector and money supply indicates that

such credit only increases money supply in the economy.

99

There was a positive relationship between nominal exchange rate and growth of the Nigerian

economy (correlation coefficient of NER = 0.2075), consumer price index (correlation

coefficient of NER = 0.4190), money supply (correlation coefficient of NER = 0.3947), core

credit to the private sector (correlation coefficient of NER = 0.3519) but had negative

relationship with inter-bank rate (correlation coefficient of NER = -0.7234) and monetary

policy rate (correlation coefficient of NER = -0.5791). These results indicate that as the naira

exchange rate increase, the growth of the economy also increases. This could be as a result of

the Nigerian economy been dependent on oil revenue which is the main sources of revenue to

Nigeria. Also, as nominal exchange rate increases, consumer price index, money supply, and

core credit to the private sector increases but the inter-bank lending rate and monetary policy

rate decreases meaning that there are other sources of income available to Nigerians apart

from bank borrowing.

4.5 Test of Hypotheses

Three steps were used to test the hypotheses stated. Step one involves the restatement of the

hypotheses in null and alternate forms. In Step two, the results of the test are analyzed while

in step three, decision is taken. In this study, the acceptance of the alternate means the

rejection of the null otherwise accept.

Hypothesis One

Restatement of Hypothesis in Null and Alternate form:

Ho1: The interest rate channel of monetary policy transmission mechanism does not have

positive and significant impact on monetary policy target.

Ha2: The interest rate channel of monetary policy transmission mechanism has positive and

significant impact on monetary policy target.

Table 4.5.1 Summary of Result for Hypothesis One

LOGMPR LOG CPI LOG M2 C

GDP Growth 0.682462 -0.24691 -0.12919 1.42841

Std. error 0.36080 0.33396 0.21842 -0.6922

t-value (1.89150) (0.7393) (-0.5581) -0.0995

Source: E–view Result.

100

Table 5.5.1 shows summary of result for hypothesis one

MPT = 0.682462lnMPR - 0.24691lnCPI -0.12919lnM2

The VAR result above showed that the co-efficient of MPR is positive ie 0.682462 with a t

value of (1.89150) but non-significant in achieving monetary policy targets. Based on this, we

reject the null hypothesis and conclude that the interest channel of monetary policy

mechanism is positive but non-significant in achieving monetary policy targets in Nigeria.

Table 4.5.2 Summary of Result for Hypothesis One

LOGMPR LOGCCPS LOGNER LOGCPI LOGM2

LOGMPR(-1) 0.386441 -0.010760 0.508547 -0.094772 0.178925

(0.28679) (0.21199) (0.84052) (0.25643) (0.17644)

(1.34749) (-0.05075) (0.60504) (-0.36959) (1.01407)

LOGMPR(-2) 0.100237 -0.238893 -3.061146 0.518775 -0.055458 (0.27404) (0.20257) (0.80317) (0.24503) (0.16860)

(0.36577) (-1.17930) (-3.81135) (2.11716) (-0.32893)

Source: E–view Result.

Table 4.5.2 above shows impulse response rate on MPR

The impulse responses of consumer price index due to adjustment in the monetary policy rate

were also revealed from the results of this study. In the first and second period after

adjustment, monetary has a negative and non-significant impact of consumer price index (first

period, coefficient of MPR = -0.094772, t-value =(0.36959), (second period, coefficient of

MPR =0.518775, t-value = 2.11716). This suggests that manipulating the monetary policy rate

to target inflation is not a good measure.

The impulse response of money supply due to adjustment in the interbank rate reveals in the

first period after adjustment, monetary policy rate has positive and non-significant impact

(coefficient of MPR =0.178925, t-value =1.01407) while in the second period, the impact of

the monetary policy rate on money supply was found to be negative and non-significant

(coefficient of MPR = -0.055458, t-value = -0.32893). This suggest that the response of

money supply to the adjustment in the monetary policy rate immediately have more effect in

the short-run on money supply than in the long-run (see appendix ii for results details).

Hypothesis Two

Restatement of Hypothesis in Null and Alternate form:

101

Ho1: Credit channel of monetary policy transmission mechanism does not have positive and

significant impact on monetary policy target.

Ha2: Credit channel of monetary policy transmission mechanism has positive and

significant impact on monetary policy target.

Table 4.5.3 Summary of Result for Hypothesis Two

LOGCCPS LOG CPI LOG M2 C

GDPGrowth -0.2359 -0.06149 -0.01519 -0.50635

Std. error (0.28003) (0.38393) (0.22458) 0.534479

T Value (-0.84224) (-0.16015) (-0.06763) 0.281215

Source: E–view Result.

Table 5.5.2 shows summary of result for hypothesis two.

MPT = -0.2359LNCCPS – 0.06149LNCPl -0.01519LNM2

The VAR result above showed that the co-efficient of CCPS is negative ie -0.2359 with a t

value of -0.84224, and non-significant in achieving monetary policy targets. Based on this, we

reject the alternate hypothesis and conclude that the credit channel of monetary policy

mechanism is negative but non-significant in achieving monetary policy targets in Nigeria.

Table 4.5.4 Summary of Result for Hypothesis Two

LOGMPR LOGCCPS LOGNER LOGCPI LOGM2

LOGCCPS(-1) -0.436913 0.187883 -2.132932 0.274435 -0.107170

(0.47812) (0.35343) (1.40129) (0.42751) (0.29416)

(-0.91381) (0.53160) (-1.52212) (0.64194) (-0.36433)

LOGCCPS(-2) 0.014227 -0.143570 1.031862 -0.627910 -0.021677

(0.45392) (0.33553) (1.33035) (0.40587) (0.27927)

(0.03134) (-0.42788) (0.77563) (-1.54708) (-0.07762)

Source: E–view Result.

Table 4.5.4 above shows impulse and response rate on MPR

The impulse responses of consumer price index due to adjustment in core credit to the private

sector rate was also revealed from the results of this study. In the first period, core credit to

102

the private sector rate has a positive and non-significant impact of consumer price index

(coefficient of CCPS = 0.274435, t-value = 0.64194) while in the second period, the impact of

core credit to the private sector on consumer price index was negative and non-significant

(coefficient of CCPS = -0.627910, t-value = -1.54708 ). This suggests that manipulating the

core credit to the private sector rate (lending rate) to target inflation is a good measure not in

the short run but in the long run.

The impulse response of money supply due to adjustment in the core credit to the private

sector rate reveals in the first period after adjustment, core credit to the private sector rate has

negative and non-significant impact on money supply (coefficient of CCPS = -0.107170, t-

value = -0.36433) while in the second period, the impact on money supply was found to be

negative and non-significant (coefficient of CCPS = -0.021677, t-value = -0.07762). This

suggests that the response of money supply to adjustment in core credit to the private sector

rate have positive impact on money supply in the short-run, however, in the long-run it does

not have an effect on money supply. (For details, see appendix ii)

Hypothesis Three

Restatement of Hypothesis in Null and Alternate form:

Ho1: The exchange rate channel monetary policy transmission mechanism does not have

positive and significant impact on monetary policy targets.

Ha2: The exchange rate channel monetary policy transmission mechanism has positive and

significant impact on monetary policy targets.

Table 4.5.5 Summary of Result for Hypothesis Three

LOGNER LOG CPI LOG M2 C

GDPGrowth -0.611540 0.036321 -0.034678 1.577138

Std. error (1.41995) (0.36095) (0.21248) 0.428293

T Value (-0.43068) (0.10063) (-0.16320) 0.379418

Source: E–view Result.

Table 5.5.5 shows summary of result for hypothesis three.

MPT = -0.611540lnNER + 0.036321lnCPl - 0.034678lnM2

103

The VAR result above showed that the co-efficient of NER negative ie -0.611540 with a t

value of -0.43068, and non-significant in achieving the monetary policy targets. Based on this

we also reject the alternate hypothesis and conclude that the exchange rate channel of

monetary policy transmission mechanism is negative but non-significant in achieving

monetary policy targets in Nigeria.

Table 4.5.6 Summary of Result for Hypothesis Three

LOGMPR LOGCCPS LOGNER LOGCPI LOGM2 LOGNER(-1) -0.033589 -0.040822 0.331701 -0.018220 -0.022666

(0.05755) (0.04254) (0.16868) (0.05146) (0.03541)

(-0.58361) (-0.95951) (1.96643) (-0.35404) (-0.64011)

LOGNER(-2) 0.015031 -0.014804 0.227384 0.001612 0.027016

(0.05727) (0.04234) (0.16786) (0.05121) (0.03524)

(0.26245) (-0.34968) (1.35461) (0.03147) (0.76669)

Source: E–view Result.

Table 4.5.6 above shows impulse response rate on NER

The impulse response of consumer price index due to adjustment in nominal exchange rate

was revealed from the results of this study. In the first period, nominal exchange rate has a

negative and non-significant impact of consumer price index (coefficient of NER = -

0.018220, t-value = -0.35404) while in the second period, the impact of nominal exchange

rate on consumer price index was positive and non-significant (coefficient of NER =

0.001612, t-value = 0.03147). This suggests that manipulating the nominal exchange rate to

target inflation may a good measure in the short run but not in the long run.

The impulse response of money supply due to adjustment in nominal exchange rate reveals in

the first period after the adjustment, that nominal exchange rate has negative and non-

significant impact on money supply (coefficient of NER = -0.022666, t-value = -0.64011)

while in the second period, the impact nominal exchange rate on money supply was found to

be positive and non-significant (coefficient of NER = 0.027016, t-value = 0.76669). This

suggests that the response of money supply to adjustment in nominal exchange rate have

negative impact on money supply in the short-run, however, in the long-run it has an impact

on money supply though not significant. (For details see appendix ii).

4.6 Robustness Test

104

In econometrics, it is generally argued that the higher the number of samples, the closer the

result to unbiased estimate. The three results above would have suffered from this problem as

a result of having just three samples as independent variables. To mitigate this problem, the

entire variable in line with the broad-base model were entered equally.

Table 4.5.7 Summary of Result for the Broad-Based Model

LOGMPR LOGCCPS LOGNER LOGCPI LOGM2

GDPGrowth 0.506499 -0.183962 -0.534617 -0.029302 -0.191447

t-value (1.12468) (-0.55261) (-0.40504) (-0.07277) (-0.69096)

Std Error (1.12468) (-0.55261) (-0.40504) (-0.07277) (-0.69096)

Source: E–view Result.

Table 5.5.7 shows summary of result for broad-base model.

The results show that interest rate channel was positive but non-significant in achieving

monetary policy target, while credit and exchange rate channels were both negative and non-

significant. The broad-based model results above are consistent with the individual results.

This shows that the problem of small sample did not introduce any bias in the results. (For

details see appendix i).

4.7 Discussion of Objectives with Findings

The transmission mechanism of monetary policy traces the relationship between changes in

the supply of money and real output (GDP). In this section, the discussions of findings are

carried out based on the objectives of this study. Three channels were examined. There are the

interest rate channel, the credit channel and the exchange rate channel.

Objective One -To Examine the Importance of Interest rate Channel of Monetary policy

Transmission Mechanism on Monetary Policy target.

According to the traditional Keynesian interest rate channel, a policy induced increase in the

short-term interest rate leads to first to an increase in long-term nominal interest rate

.According to CBN (2010), most conventional models of the interest rate channel indicates

that a change in the policy rate affects bank’s lending and deposit rate which in turn affects

households and business spending decisions. This is partly due to the fact that changes in

policy rate impact immediately on the money market by affecting treasury bills and interbank

rates including deposit money banks’ short-term instrument. As observed from the findings of

this objective in this study, the interest rate channel is the most effective channel of

transmission in Nigeria. This is consistent with the works of Bems (2001), Mohanty and

Turner (2008).

105

Objective Two -To examine the effectiveness of credit channel of transmission

mechanism in achieving the desired combination of monetary policy goals

The relevance of the credit channel stems from the importance role of commercial banks in

the financial intermediation process. The credit channel is usually discussed under the bank

lending and the balance sheet mechanism. The Modigliani-Miller theorem (Modigliani, 1971)

states that bank lending will depend on bank’s financial structure and lending opportunities as

well as on market interest rates. The effects of monetary policy on bank lending will therefore,

depend on the capital inadequacy of the banking sector. The theory further states that banks

with low capital has delay and then amplified reaction to the interest rate shocks, relative to

well capitalized banks. As observed from the findings of the study this channel is not an

effective mechanism of monetary policy transmission unlike the interest rate channel.

Economic literature has recently re-examined the credit channel for transmission mechanism

of monetary policy. This literature suggests that banks are not neutral conveyors of monetary

policy impulses. This could be attributed to the weak response of the credit channel as

revealed in this study (Gertler, 1989, Bernanke, 1993).

Objective three- To examine the effectiveness of exchange rate channel on the monetary

policy target

Exchange rate fluctuations induce changes in the relative prices of goods and services, as well

as spending by households and firms, especially if a large proportion of wealth is held in

foreign currencies. Changes in exchange rate therefore have implications for spending

behaviour of individuals and firms, all of which affects aggregate demand. The strength of the

exchange rate channel, however, depends on the responsiveness of the exchange rate to

monetary shocks, the degree of openness of the economy and the exchange rate arrangement

of the country. Under a floating exchange rate, expansionary monetary policy depreciates

domestic currencies and increases the price of imported goods. However, adoption of a

managed floating regime in some countries resulted in a relatively weak transmission process

in affecting real output and prices. The result of this study indicates that the exchange rate

channel is not the dominant channel of monetary transmission in Nigeria. This is consistent

with CBN (2008) which suggest that the effectiveness of the exchange rate channel was

largely limited by the rigid exchange rate regime that allowed the nominal exchange rate to

fluctuate only within a narrow band.

106

References

Bems, R. (2001), “Monetary Transmission Mechanisms in the Baltic States”, Baltic Economic

Trends, 2, 3-6 Bernanke, B.S (1993), “Credit in the Macro-economy”, Federal Reserve Bank of New York

Quarter Review, 18(1) 50-70 CBN (2008), Real and Nominal Exchange Rate Mechanism in Nigeria, Abuja: Central Bank

of Nigeria Research Department CBN (2010), Monetary Policy transmission Mechanism in Nigeria, Abuja: Central Bank of

Nigeria Research Department Gertler, P (1989), “Market Based Measures of Monetary Policy Expectations”, Journal of

Business and Economics Statistics, 25, 201-212 Gujarati, D.N. and Porter, D.C. (2009), Basic Econometrics, 5ed, Singapore: MacGraw.Hill

International.

Modigliani, F. (1971), “Monetary Policy and Consumption, in Consumer Spending and Monetary policy: The Linkage”, Boston, Federal Reserve Bank of Boston, 9-84

Mohanty, M.S and P. Turner (2008), “Monetary Policy Transmission in Emerging Market

Economies; what is new?” In “Transmission Mechanism for Monetary Policy in Emerging Market Economics” BIS papers, 35

107

CHAPTER FIVE

SUMMARY OF FINDINGS, CONCLUSION AND RECOMMENDATIONS

5.1 SUMMARY OF FINDINGS-

The specific findings of this study are:

1. The interest rate channel is an effective channel for monetary policy transmission in

Nigeria. The monetary policy rate was used in this study as the major conduit through

which the interest rate channel of monetary policy works through. It was revealed

from the results that monetary policy rate has positive and non-significant impact on

economic growth implying that an adjustment in interest rate through the monetary

policy rate results in a positive impact on economic growth within the period under

review in this study. This could be attributed to the monthly injection of fund through

the sharing of the federation account which is done monthly leading to regular

intervention by the CBN to curtail volatilities in the interbank rate.

2. The credit channel is not an efficient monetary policy transmission mechanism in

Nigeria during the period studied. The core credit to the private sector was used in this

study as the major conduit through which the credit channel of monetary policy works

through. The credit to the privates sector represents the lending ability of deposit

money institutions to lend to the private sector. It was revealed from the results that

core credit to the private sector as a measure of financial deepening has negative and

non-significant impact on economic growth.

3. The exchange rate channel is not an efficient monetary policy transmission mechanism

in Nigeria. The nominal exchange rate was used in this study as the major conduit

through which the exchange rate channel of monetary policy transmission works

through. The nominal exchange rate represents the rate at which the naira is exchange

to the currency of other nations. It was revealed from the results that nominal

exchange rate as a measure has negative and non-significant impact on economic

growth.

5.2 Conclusion

This study set out to examine the dominant channel of monetary policy transmission in

Nigeria. The study adopted the vector autoregressive model (VAR) to trace the impact of

108

interbank interest rate, core credit to the private sector and nominal exchange rate in line with

the interest, credit and exchange rate channels respectively. To identify the peculiarities of the

Nigerian economy, gross domestic product growth rate was used as the dependent variable

while the major independent variables used to trace the conduit were interbank rate (interest

rate channel), core credit to the private sector (credit channel) and nominal exchange rate

(exchange rate channel).

The findings of the study reveals that the interest rate channel was the dominant channel of

monetary policy transmission while the credit and exchange rate channel was weak in

explanation monetary policy transmission mechanisms in Nigeria within the period of the

study. An examination of the interest rate channel revealed that the degree of pass through and

speed of adjustment are dependent on the rise and fall in response to output, prices and money

supply shocks. These could be attributed to huge funds from the federation account which is

usually share among the three tiers of government monthly. As a result, the CBN regularly

intervenes in the interbank market to regulate the volume of funds to curtail inflation inducing

responses to rise or fall in growth of the economy.

From the findings of the credit, it was revealed that the credit channel was weak relative to the

interest rate channel. The basic philosophy underlying the credit channel is the role played by

banks in financial intermediation. That is mobilizing savings from the surplus units to the

deficit units of the economy and granting such funds to the investors. Banks often rely on

deposits as a principal source of fund for investment hence the aprior expectation was that

this channel will be the dominant channel of monetary policy. However, as observed from the

findings of this study, this channel was weak. This could be attributed to the inability of

deposit money banks in Nigeria to properly channel such funds for productive purposes in

Nigeria. Even when such funds are granted, corruption and mismanagement may not lead to

proper transmission to growth of the Nigeria economy.

From the findings on the exchange rate channel, it was revealed that the channel is weak

relative to the interest rate channel. This findings is consistent with the Miskin (1996) who

observes that the central bank’s intra-marginal interventions are able to reduce the effects of

higher rates on the nominal and the real exchange rate , hence the real effects transmitted

through the exchange rate channel are smaller. This may succinctly explained the weak effect

of this channel on the growth of the Nigerian economy.

109

5.3 Recommendations

The following policy recommendations are drawn from the findings of this study.

1. The role of deposit money banks as agents of financial intermediation in the Nigerian

economy should not be neglected. The Central bank of Nigeria should strive to make

these deposit money banks in Nigeria loans transaction more amendable to monetary

policy actions or seek a more effective channel of transmitting monetary actions to the

economy. Such measure will include sufficient control over the reserves of deposit

money banks and the timely application of reserve requirements in monetary policy

control.

2. The role of banks in propagating monetary policy impulses to the economy should also

be recognized as crucial. Hence the CBN should evolve policies which will have

pronounced effects on the lending rate since it could be a potent medium in monetary

policy transmission.

3. Lastly, money supply and inflation targeting should remain a major consideration in

the choice of monetary policy framework in Nigeria and efforts should be made to

ensure that the right volumes of currencies are in circulation to avert increasing

inflation.

5.4 Contribution to Knowledge

This study will not claim novelty on monetary policy studies in Nigeria. However, this study

is unique in two ways. First, most studies along this area used monetary policy transmission

mechanisms such as balance sheet channel, expectation channel, asset pricing channel, bank

lending channel, interest rate channel and exchange channel. This is among the first study in

Nigeria that isolated other channels and selected three channels that have been identified as

most appropriate given the peculiarity of the Nigerian economy.

Second, most empirical literature only investigates the relationship between monetary policy

targets and their transmission mechanisms. This went a step further to determine the most

effective transmission channel which is novel for studies along this area.

Finally, the study used the impulse response estimator to measure the effect of monetary

policy manipulation for a lag period of one year and two years respectively. The essence is to

determine the speed of adjustment of monetary policy transmission mechanism on monetary

policy targets, which is also novel.

110

5.5 Recommended Areas for Further Studies

This study recommends the following for further studies.

1. Studies should be undertaken to ascertain the impact of monetary policy rate as a

conduit for the interest rate channel in monetary policy transmission in Nigeria. This

will lead to a more comprehensive interest rate channel.

2. Other transmission mechanism channels such as the asset price channel, balance sheet

channel and the inflation expectation channel can also be explored in future studies to

determine the suitability of those channels in cash-based economy like Nigeria.

111

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120

APPENDIXES

Appendix I

Table 4.11 The Broad-based VAR Result.

Date: 11/29/14 Time: 12:47 Sample(adjusted): 1980 2012 Included observations: 31 after adjusting endpoints Standard errors & t-statistics in parentheses

LOGMPR LOGCCPS LOGNER LOGCPI LOGM2

LOGMPR(-1) 0.386441 -0.010760 0.508547 -0.094772 0.178925

(0.28679) (0.21199) (0.84052) (0.25643) (0.17644)

(1.34749) (-0.05075) (0.60504) (-0.36959) (1.01407)

LOGMPR(-2) 0.100237 -0.238893 -3.061146 0.518775 -0.055458

(0.27404) (0.20257) (0.80317) (0.24503) (0.16860)

(0.36577) (-1.17930) (-3.81135) (2.11716) (-0.32893)

LOGCCPS(-1) -0.436913 0.187883 -2.132932 0.274435 -0.107170

(0.47812) (0.35343) (1.40129) (0.42751) (0.29416)

(-0.91381) (0.53160) (-1.52212) (0.64194) (-0.36433)

LOGCCPS(-2) 0.014227 -0.143570 1.031862 -0.627910 -0.021677 (0.45392) (0.33553) (1.33035) (0.40587) (0.27927)

(0.03134) (-0.42788) (0.77563) (-1.54708) (-0.07762)

LOGNER(-1) -0.033589 -0.040822 0.331701 -0.018220 -0.022666

(0.05755) (0.04254) (0.16868) (0.05146) (0.03541)

(-0.58361) (-0.95951) (1.96643) (-0.35404) (-0.64011)

LOGNER(-2) 0.015031 -0.014804 0.227384 0.001612 0.027016

(0.05727) (0.04234) (0.16786) (0.05121) (0.03524)

(0.26245) (-0.34968) (1.35461) (0.03147) (0.76669)

LOGCPI(-1) 0.220801 0.011091 0.557214 0.666488 -0.026346

(0.26575) (0.19645) (0.77888) (0.23762) (0.16350) (0.83085) (0.05646) (0.71541) (2.80481) (-0.16114)

LOGCPI(-2) -0.029172 -0.021030 0.601788 0.270743 0.057904

(0.34211) (0.25289) (1.00265) (0.30589) (0.21048)

(-0.08527) (-0.08316) (0.60019) (0.88509) (0.27511)

LOGM2(-1) 0.142610 0.926498 0.226948 -0.011602 1.251548 (0.49188) (0.36360) (1.44161) (0.43981) (0.30262)

(0.28993) (2.54814) (0.15743) (-0.02638) (4.13567)

LOGM2(-2) 0.088363 0.119480 0.304165 0.337227 -0.132330

(0.55824) (0.41265) (1.63610) (0.49915) (0.34345)

121

(0.15829) (0.28954) (0.18591) (0.67561) (-0.38530)

C 1.279893 -0.234509 5.040133 -0.232538 -0.065246

(0.84104) (0.62169) (2.46493) (0.75201) (0.51744)

(1.52181) (-0.37721) (2.04474) (-0.30922) (-0.12609)

GDPGROWTH 0.506499 -0.183962 -0.534617 -0.029302 -0.191447

(0.45035) (0.33290) (1.31990) (0.40268) (0.27707)

(1.12468) (-0.55261) (-0.40504) (-0.07277) (-0.69096)

R-squared 0.759174 0.997078 0.894409 0.993281 0.997802

Adj. R-squared 0.603346 0.995187 0.826085 0.988934 0.996379

Sum sq. resids 0.133730 0.073072 1.148702 0.106917 0.050619 S.E. equation 0.088693 0.065562 0.259944 0.079305 0.054567

F-statistic 4.871864 527.2791 13.09075 228.4740 701.4354

Log likelihood 36.84964 45.61300 5.666401 40.09432 50.93622

Akaike AIC -1.713768 -2.318138 0.436800 -1.937539 -2.685257

Schwarz SC -1.147990 -1.752360 1.002578 -1.371761 -2.119479

Mean dependent

1.104692 5.339835 1.521870 1.369910 5.565911

S.D. dependent 0.140826 0.944986 0.623320 0.753872 0.906823

Determinant Residual Covariance

7.03E-13

Log Likelihood 200.0081

Akaike Information Criteria -9.655729

Schwarz Criteria -6.826841

Source: E–view Result.

122

APPENDIX II

VAR Result for Hypothesis One

Date: 11/29/14 Time: 12:56 Sample(adjusted): 1980 2012 Included observations: 31 after adjusting endpoints Standard errors & t-statistics in parentheses

LOGMPR LOGCPI LOGM2

LOGMPR(-1) 0.323739 0.135359 0.172429

(0.20439) (0.18919) (0.12373) (1.58389) (0.71547) (1.39354)

LOGMPR(-2) 0.229504 0.403730 -0.036970

(0.19430) (0.17985) (0.11763)

(1.18116) (2.24483) (-0.31430)

LOGCPI(-1) 0.261952 0.829464 -0.014401 (0.22636) (0.20953) (0.13703)

(1.15721) (3.95878) (-0.10509)

LOGCPI(-2) -0.069658 0.010802 0.019416

(0.26565) (0.24589) (0.16082)

(-0.26221) (0.04393) (0.12073)

LOGM2(-1) -0.099288 0.030718 1.189537

(0.40800) (0.37765) (0.24699)

(-0.24335) (0.08134) (4.81609)

LOGM2(-2) -0.126442 0.041149 -0.183893

(0.47298) (0.43780) (0.28633)

(-0.26733) (0.09399) (-0.64224)

C 1.428414 -0.692179 -0.099531

(0.64937) (0.60106) (0.39311)

(2.19970) (-1.15160) (-0.25319)

GDPGROWTH 0.682462 -0.246906 -0.121912 (0.36080) (0.33396) (0.21842)

(1.89150) (-0.73932) (-0.55816)

R-squared 0.736060 0.992109 0.997667

Adj. R-squared 0.648080 0.989479 0.996890

Sum sq. resids 0.146565 0.125569 0.053712

S.E. equation 0.083542 0.077327 0.050574

F-statistic 8.366220 377.1812 1283.034 Log likelihood 35.52073 37.76257 50.07630

Akaike AIC -1.897981 -2.052591 -2.901814

Schwarz SC -1.520796 -1.675406 -2.524628

123

Mean dependent

1.104692 1.369910 5.565911

S.D. dependent 0.140826 0.753872 0.906823

Determinant Residual Covariance

3.57E-08

Log Likelihood 125.2192

Akaike Information Criteria -6.980634

Schwarz Criteria -5.849078

124

APPENDIX III

VAR Result for Hypothesis Two

Date: 11/29/14 Time: 13:15 Sample(adjusted): 1980 2012 Included observations: 31 after adjusting endpoints Standard errors & t-statistics in parentheses

LOGCCPS LOGCPI LOGM2

LOGCCPS(-1) 0.428232 -0.019886 0.007448

(0.26047) (0.35711) (0.20889) (1.64407) (-0.05569) (0.03566)

LOGCCPS(-2) -0.239824 -0.439600 -0.166390

(0.25965) (0.35598) (0.20823)

(-0.92366) (-1.23492) (-0.79908)

LOGCPI(-1) 0.037933 0.924740 -0.021887 (0.17677) (0.24236) (0.14177)

(0.21459) (3.81563) (-0.15439)

LOGCPI(-2) -0.073437 0.174622 0.103315

(0.21787) (0.29870) (0.17472)

(-0.33707) (0.58460) (0.59130)

LOGM2(-1) 0.740186 0.503737 1.320966

(0.32705) (0.44839) (0.26228)

(2.26322) (1.12345) (5.03644)

LOGM2(-2) 0.156423 -0.181373 -0.227464

(0.37599) (0.51549) (0.30153)

(0.41603) (-0.35185) (-0.75436)

C -0.506352 0.534479 0.281215

(0.34771) (0.47671) (0.27885)

(-1.45626) (1.12118) (1.00848)

GDPGROWTH -0.235854 -0.061486 -0.015188 (0.28003) (0.38393) (0.22458)

(-0.84224) (-0.16015) (-0.06763)

R-squared 0.996449 0.989512 0.997520

Adj. R-squared 0.995265 0.986016 0.996693

Sum sq. resids 0.088793 0.166901 0.057107

S.E. equation 0.065025 0.089150 0.052148

F-statistic 841.7910 283.0335 1206.578 Log likelihood 42.78750 33.63675 49.18757

Akaike AIC -2.399138 -1.768052 -2.840522

Schwarz SC -2.021953 -1.390867 -2.463337

125

Mean dependent

5.339835 1.369910 5.565911

S.D. dependent 0.944986 0.753872 0.906823

Determinant Residual Covariance

2.44E-08

Log Likelihood 130.7404

Akaike Information Criteria -7.361409

Schwarz Criteria -6.229854

126

APPENDIX IV

VAR Result for Hypothesis Three

Date: 11/29/14 Time: 13:18 Sample(adjusted): 1980 2012 Included observations: 31 after adjusting endpoints Standard errors & t-statistics in parentheses

LOGNER LOGCPI LOGM2

LOGNER(-1) 0.518984 -0.047037 -0.030691

(0.21412) (0.05443) (0.03204)

(2.42374) (-0.86418) (-0.95785)

LOGNER(-2) 0.310794 -0.012182 0.031350

(0.21697) (0.05515) (0.03247)

(1.43241) (-0.22087) (0.96558)

LOGCPI(-1) -0.020176 0.878886 -0.004502

(0.96629) (0.24563) (0.14460) (-0.02088) (3.57813) (-0.03113)

LOGCPI(-2) 0.610119 0.129709 0.100425

(1.13745) (0.28914) (0.17021)

(0.53639) (0.44861) (0.59001)

LOGM2(-1) -2.163969 0.298587 1.281981 (1.59768) (0.40613) (0.23908)

(-1.35445) (0.73521) (5.36219)

LOGM2(-2) 1.828553 -0.354572 -0.359783

(1.76542) (0.44877) (0.26418)

(1.03576) (-0.79010) (-1.36189)

C 1.577138 0.428293 0.371498

(1.81813) (0.46216) (0.27207)

(0.86745) (0.92671) (1.36547)

GDPGROWTH -0.611540 0.036321 -0.034678

(1.41995) (0.36095) (0.21248)

(-0.43068) (0.10063) (-0.16320)

R-squared 0.768678 0.989782 0.997553

Adj. R-squared 0.691570 0.986375 0.996737

Sum sq. resids 2.516503 0.162607 0.056350

S.E. equation 0.346170 0.087995 0.051801

F-statistic 9.968912 290.5857 1222.823

Log likelihood -5.705044 34.01463 49.38101

Akaike AIC 0.945175 -1.794113 -2.853863

127

Schwarz SC 1.322361 -1.416928 -2.476677

Mean dependent

1.521870 1.369910 5.565911

S.D. dependent 0.623320 0.753872 0.906823

Determinant Residual Covariance

7.69E-07

Log Likelihood 80.69282

Akaike Information Criteria -3.909850

Schwarz Criteria -2.778295