MONETARY POLICY RATE AND ITS IMPACT ON INFLATION TARGET IN NIGERIA

                              MONETARY POLICY RATE AND ITS IMPACT ON INFLATION TARGET                                                                                IN NIGERIA     

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

Monetary policy is typically concerned with the way in which monetary authorities use the instruments at their disposal to influence the decision of economic agents with the intention of achieving overall macroeconomic stability (Abubakar, 2014). Generally, monetary policy is discussed under two paradigms viz: the money supply or the interest rate theories (Masnan,  Shaari and Hussain, 2013). The money supply view is associated with the QTM approach in which money is considered as exogenous and under the control of central banks (CBs).  Underlying this is the notion that inflation correlates with the growth rate of money supply so that money becomes the most appropriate instrument of monetary policy (Mehrara, Soufiani,  and  Rezaei, 2016). The interest rate paradigm generally follows the Wicksellian structure where money is considered as endogenously determined in the economy and outside the control of the authorities (Rashid and Jehan, 2014). In the absence of shocks, therefore, inflation reflects government interest rate policy decisions. Following the proven inability of CBs to control money supply, emphasis has shifted essentially to the short-term nominal interest rate as the instrument of monetary policy; hence, the fall of monetarism.

Around the world, many countries have adopted various monetary policies achieving various results in the process. 

In the United States and many developed European countries, there are visible effects of monetary policies; but for many developing African countries, Nigeria, for instance, monetary policies have largely been debated leading to little or no effect of monetary policies. 

Monetary policies are vital to economic growth and must be adopted rightly to achieve positive results (Aziakpono and  Wilson 2010).  The argument of monetary policy and its instrument dates back to the early 70s where there was the analysis of the choice between the nominal interest rate and the nominal money stock. Without risk, the choice of the nominal interest basically means a willingness to allow the money stock to adjust form within to make room for the nominal interest rate target. Further research went on to show that, following rational expectations, hinging monetary policy on nominal interest rate led to a middle-level price level. It was subsequently revealed that minor specification change of the model could restore price control and determination, such as specifying the aggregate demand function in terms of the real money stock.

Interestingly, another monetary policy instrument adopted by certain economies is the smoothing of interest rates by central banks. It is argued that interest rate smoothing is an important factor in optimal monetary policy under commitment, and Taylor and  John (2011) state that it is most favourable to delegate (under discretion) monetary policy to a central bank with an interest rate smoothing term in the objective function. Moreover,Taylor and John (2011) posit that monetary sturdiness can help reduce the problems of price indeterminacy. And in general, interest rate rules having interest rate smoothing seem to perform well practically in various countries and in different data samples.

Basically, each country must continually adapt to changing financial market strategies to ensure economic robustness and price level maintenance. 

What is, therefore, the most efficient policy to achieve its final target? In some countries, many central banks have adopted short-term interest rates as their monetary policy instrument to influence the investment and save decisions of households, firms and foreigners as the rates are periodically changed by the banks and other financial institution (Abdul, 2014).  Instruments of monetary policies are divided into two main strands – the quantitative, general or indirect; and the qualitative, selective or direct. They influence the level of aggregate demand through the cost of money, the supply of money, and the availability of credit. The first category encompasses factors such as bank rate variations, open market operations and changing reserve requirements and is meant to regulate the overall economic credit through commercial banks. The direct or selective instrument, on the other hand, controls the specific type of credit such as margin requirement change and consumer credit regulation (Ahiabor, 2013).

Inflation is a dreaded economic phenomenon as it breeds many undesirable economic results. It is described as the increase in the price of a commodity over a long period of time. The problem of inflation has ravaged the Nigerian economy for years. In the early 1970s, after an improved economic performance, the economy experienced worrisome moments between the late 1970s and the early 1980s largely due to the fiscal policy expansion initiated by the federal government. This was engendered by the monetary expansion as large debts were paid off by the Central Bank of Nigeria, exacerbated by the movement of certain government sector funds to the commercial banks and the resulting increase in their free reserves with adverse effects on the general price levels (Abubakar, 2014). Furthermore, inflation was overvaluation of the naira which made imports cheaper than locally made products led to an increase in the demand for the importation of consumer goods and intermediate input. 

These obstacles may be referred to as cost and economic theory states that for-profit to be maximised, the cost must be minimised. Inflation is a cost which has eaten deep into the economic fabric of the Nigerian economy. 

1.2 Statement of the Problem

The problem of inflation is a global  and affects many countries. Over the years, monetary policies have been put forward and strategies have been developed, targeted at improving the ability of the economy by controlling price. The problem always facing Central Banks is financial stability. It has become a natural situation that central banks always devote more attention to how to prevent or reduce the risk of financial crises. It has been argued that by making interest rate changes smaller and more predictable, Central Banks reduce the volatility of commercial banks’ profits and lower the risk of bank insolvencies.  According to Gyebi and Boafo (2013), high and persistent inflation undermines public confidence in the economy with potentially adverse effects on risk-taking, investment and other productive activities. 

The effect of high inflation has made it difficult for some households to obtain basic necessities such as foods, cloths among others.  Furthermore, when domestic prices rises, imports become cheaper hence more goods will be imported. This affects the Balance of Payment and also depreciates the value of current and it is against this background that this study seeks to investigate Monetary Policy and its impact on inflation targeting in Nigeria. 

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