Thanks. Yours Sincerely, John K. Chime PG/MSC/05/39503

Transcription

1 JOHN K. C. CHIME, MNIM TRUSTFUND PESIONS PLC, ABUJA , st May, 2010 Prof. C. C. Agu Head of Department of Economics University of Nigeria, Nsukka. Sir, Submission of M.Sc Soft Binded Copies I write to submit three soft binded copies of my M.Sc (Econs) Project on MONEY SUPPLY AND INFLATION DYNAMICS: A CRITICAL APPRAISAL OF MILTON FRIEDMAN S HYPOTHESIS IN NIGERIA for your approval and submission for external examination. Recall sir, that you have already corrected the final copy which I sent to you in March, 2010 which contained all corrections and observations noted during my proposal in 2009 and hope that this submission will receive your immediate attention. I remain very grateful for all your assistance and accept the assurances of my highest regards. Thanks. Yours Sincerely, John K. Chime PG/MSC/05/39503

2 DEPARTMENT OF ECONOMICS UNIVERSITY OF NIGERIA, NSUKKA MONEY SUPPLY AND INFLATION DYNAMICS: A CRITICAL APPRAISAL OF MILTON FRIEDMAN S HYPOTHESIS IN NIGERIA AN M.Sc. PROJECT REPORT SUBMITTED TO THE DEPARTMENT OF ECONOMICS UNIVERSITY OF NIGERIA, NSUKKA BY CHIME, JOHN K. C. PG/MSC/05/39503

3 SUPERVISOR: PROF C. C. AGU TITLE PAGE MONEY SUPPLY AND INFLATION DYNAMICS: A CRITICAL APPRAISAL OF MILTON FRIEDMAN S HYPOTHESIS IN NIGERIA BY CHIME, JOHN K. C. PG/MSC/05/39503 PROJECT REPORT SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENT FOR THE AWARD OF DEGREE OF MASTERS, DEPARTMENT OF ECONOMICS UNIVERSITY OF NIGERIA, NSUKKA

4 DECEMBER, 2009 APPROVAL PAGE THIS PROJECT HAS BEEN APPROVED BY THE DEPARTMENT OF ECONOMICS, UNIVERSITY OF NIGERIA, NSUKKA BY... PROF C. C. AGU SUPERVISOR.. EXTERNAL EXAMINER PROF.C.C. AGU HEAD OF DEPARTMENT PROF. P. C. ONOKALA DEAN, FACULTY OF THE

5 SOCIAL SCIENCES DEDICATION To my darling wife, Mrs. Obianuju Chime without whose understanding and support, it would have been difficult for me to complete this course.

6 ACKNOWLEDGEMENT I most sincerely thank the Almighty God whose protection and blessings i enjoyed in doing an Msc program after many years of leaving the University. I also appreciate the encouragements of my supervisor, Prof C. C. Agu who also supervised my first degree thesis 20years ago.

7 I do also appreciate the contributions of my colleagues, Victor, Makua and others and the support of the staff of Central Bank of Nigeria and other institutions we visited in providing needed materials on the Nigerian economy. To God be all Glory. ABSTRACT The study examined the validity of Friedman s hypothesis and subjected to test the stability of money demand function in Nigeria over the period of using the Nigerian time series data. The study applied the Granger causality test and the Distributed Lag Model (DLM) to estimate two distinct equations, while the CUSUM and CUSUM Squares test procedure was used to examine the stability of money demand function. As a matter of necessity, we subjected our variables to

8 time series econometric tests using the Augmented Dickey Fuller (ADF) unit root test for stationary and Engle Granger co-integration procedure. The empirical result showed that there is a unidirectional causality from money supply to inflation and no feedback effect. This finding indicates that inflation truly is a monetary phenomenon and validates the monetarist stance. Hence, there is an existence of Friedman s hypothesis in Nigeria. However, the study also revealed that there is no long run relationship between money demand and inflation in Nigeria, while the stability test provides evidence that money demand function in Nigeria was stable over the period of estimation. TABLE OF CONTENTS CHAPTER ONE: INTRODUCTION Background Information Statement of Problem... 2 Research Questions 4 Research Objectives 4 Research Hypothesis 5

9 Scope of the study 5 Policy Relevance of the study... 5 CHAPTER TWO: LITERATURE REVIEW 2.0 Theoretical Review Quantity theory of money The Keynesian Theory on Inflation and Money Rational Expectations Theory on Inflation and Money Adaptive Expectation Theory Empirical Review Theoretical Framework Limitation of Previous study Money supply, inflation and Monetary Policy in Nigeria 27 CHAPTER THREE: METHODOLOGY 3:0 Introduction 33 Unit Root Test 34 Co integration Test Specification of the Granger-Causality Models Distributed Lag Error Correction Model (DLECM) Method of Result Evaluation Economic Criteria Statistical Criterion Econometric Criteria Autocorrelation Test Test for Model Mis-specification 38

10 Multi-co linearity test Residual Normality Test Tests for Stability of Money Demand Function Justification of the model Sources of the Data Software Package 42 CHAPTER FOUR: PRESENTATION AND DISCUSSION OF RESULTS 4.0 Overview ADF Test for Stationary Co integration test Granger Causality Test Results Interpretation of Result Discussion on findings Presentation of Dynamic Modeling of MS result Interpretation and discussion of findings Money Demand 47 Inflation rate 48 Real Interest rate 48 Gross Domestic Product Coefficient of determination R Test of Autocorrelation F- Test Normality Test Test of Multi-co linearity Stability test results 51

11 CHAPTER FIVE: SUMMARY OF FINDINGS, POLICY RECOMMENDATION & CONCLUSION Summary of findings Policy Recommendation Conclusion 55 REFERENCES 57 APPENDIX 63 LIST OF TABLES AND GRAPHS

12 Graph 1: Money Supply Trend 31 Graph 2: Inflation Trend 31 Table 4.1: Unit Roots Test (ADF Test) 43 Table 4.2: Co integration test result 44 Table 4.3: Granger Causality between Money supply & Inflation 45 Table 4.4: Result Summary 47 Table 4.5: Correlation Matrix 51 Graph 3: Cusum Test 51 Graph 4: Cusum of Square Test 52

13 CHAPTER ONE INTRODUCTION 1.1 Background Information The debate regarding the role of money supply in an economy particularly in the determination of income and prices gained prominence after the Second World War. This debate has been between Monetarists led by Milton Friedman and Keynes. Keynes (1943) argued that the rise in prices and nominal income depend upon the way that government financed the increase in war expenditures. Accordingly, the rise in prices and nominal income vary inversely with the extent to which government financed the rise in war expenditures through taxes as opposed to deficit spending. However according to Friedman (1956) money, not fiscal policy, provided a satisfactory explanation for the common behavior of inflation in the war era. Keynes linked inflation to growth under the AD-AS framework, according to him, too much spending leads to demand-pull inflation. Keynes strongly argued that this is one of the major causes of inflation. Thus excess spending leads to an increase in demand that cannot be matched by the level of supply. As demand is greater than supply, prices will therefore rise. Businesses also experience increasing costs as money supply and inflation increase, which is known as cost-push inflation. As demand increases, labour costs may increase as workers and unions will push for an increase in wages. As Keynes(1943) put it, there are a number of policies that can be used in order to reduce the level of the money supply circulating around the economy which in turn will reduce the level of inflation.

14 Monetarists on the other hand, reemphasized the critical role of monetary growth in determining inflation. Friedman argued that excessive expansion of the money supply is inherently inflationary that monetary authorities should focus solely on maintaining price stability. According to Friedman inflation is always and everywhere a monetary phenomenon. In his quantity theory of money, he gave the idea that money creation determines the behavior of prices. Friedman gave empirical content to the theory by studying instances where historical circumstances suggested that money was the causal factor in this relationship. Friedman (1958) argued that there is perhaps no empirical regularity among economic phenomena that is based on so much evidence for so wide a range of circumstances as the connection between substantial changes in the stock of money and in the level of prices. Statement of Problem The Central Bank of Nigeria seeks to achieve price stability which is one of its core objectives through a monetary policy framework that targets monetary aggregates/intermediate variables. The CBN monetary programme sets explicit targets for broad money, the key intermediate benchmark variable and base money as the operating variable. The target for the intermediate variable according to CBN( Economic & Financial Review 2005)is determined with reference to the programmed inflation rate, external reserves accretion and real GDP growth targets. The link between the ultimate goals of price stability, the intermediate targets of money stock and indicator variables like the inflation rate are not usually so direct, but there is a wide consensus about the relative effect of the proximate variables on the ultimate goals. Incidentally, the movements in the monetary aggregates and changes in price level in Nigeria between 1988 and 2005 have been so dramatic. Between 1988 and 1991,

15 the CBN's intermediate monetary target was the narrow money supply (Ml). During those four years, narrow money supply was expected to grow on, average by 14.3 percent annually. The actual increase in M1 was 36.7 percent per annum. The largest deviations of outcomes from targets occurred in 1988 and 1990 with 26.9 and 31.9 percentage points, respectively. From 1992, the broad money supply (M2) became the intermediate monetary target. Apart from the years 1996 to 1998 when the actual increases in M2 exceeded the targets by an annual average of only 1.6 percentage points, the incidence of excessive monetary expansion was sustained in the review period. The deviations were particularly large between 1992 and By 1999, broad money growth was 10.0%, 27.0% in 2001, 21.6% in 2002, 24.1% in 2003, 14.0 in 2004 and 16.0% in While inflation was expected to be at a single digit, but there was a deviation from this expectation because the target was not met. Inflation actually grew by over 10.5%. Between 1970 and 1975, inflation stood at an average of 14.28%, and 12.70% in 1981, 15.27% in 1997, 28.57% in 1993, 30.7% and 12.41% in 1999 and 2005 respectively. This shows that in the last 36 years, using available data from Nigerian Statistical fact sheet NBS(2005), inflation has stood at an average of 18.99% while money stock growth stood at an average of 19.0%. Hence, there is evidence of one-to-one growth rate between inflation and money stock. The role money play in the inflationary process remains, nonetheless, a highly controversial issue. Friedman and his apostles claim that money plays an active role and leads to changes in income and prices. That is, changes in income and prices in an economy are mainly caused by the changes in money stocks. Hence, there is a unidirectional causation running from money to income and prices without any feedback. The Keynesians, on the other hand, argue that money does

16 not play an active role in changing income and prices. Emphatically they maintain that changes in income cause changes in money stocks via demand for money implying that there is no causality between money changes and prices. Empirical studies have largely borne out of the Friedman s proposition that inflation is always and everywhere a monetary phenomenon however, the findings of these studies are divergent. While some of the studies provide evidence that support the Friedman s hypothesis, some others provide contrary reports. For instance, Fakiyesi (1996), Qayyum (2004), Budina et. al, (2002) and Greene and Canetti (1991) provides evidence that support the validity of Friedman s hypothesis. On the contrary, Mark and Blaug (1996) and Rwegasira (1977) present findings that do not support Friedman s hypothesis. This project is interested in resolving these issues by finding out which monetarist-keynesian inflation theory that prevail in Nigeria. 1.3 Research Questions This study raises the following research questions: 1) What is the causal relationship between money supply and inflation? Is there any long run relationship between money demand and inflation in Nigeria? Is there any stability of money demand function in Nigeria? 1.4 Research Objectives To examine the causal relationship between money supply and inflation in Nigeria To investigate if there is a long run relationship between money demand and inflation in Nigeria. To check for the stability of money demand function in Nigeria. 1.5 Research Hypothesis There is no causal relationship between money supply and inflation in

17 Nigeria. There is no long run relationship between money demand and inflation in Nigeria There is no stability in money demand function in Nigeria 1.4 Scope of the study The study covered the period of 1970 to 2006, a sample size of 37 years of observation. Using time series data of this sample size is good enough for a time series analysis. 1.5 Policy Relevance of the study This result of this study is important for policy-makers in dynamic monetary policy formulation in Nigeria. Since the results showed that inflation is a monetary phenomenon as claimed by Friedman, it implies that it would be inappropriate for monetary policy authority to treat money stock variables as endogenous. Again, an important issue concerning monetary policy is to identify a stable money demand function (Friedman, 1959; Friedman and Schwartz, 1963). In turn, a stable money demand function is a necessary condition to establish a direct link between the relevant monetary aggregates and nominal income. The presence of a stable money demand function as shown in the study will thus enhance the ability of monetary authorities to reach predetermined monetary growth targets if price stability is the main objective. CHAPTER TWO LITERATURE REVIEW 2.0 Theoretical Review There is a long standing debate regarding the relationship between money stock and inflation. It is only empirical evidence that can resolve this debate. The Monetarists pioneered by Milton Friedman claim that money plays an active role

18 and leads to changes in income prices. In other words, changes in prices in an economy are mainly caused by the changes in money stocks. Hence, the direction of causation runs from money stock to prices without any feedback, i.e., unidirectional causation according to Friedman (1963). 2.1 Quantity theory of money Friedman in his quantity theory of money argued that money creation determines the behavior of prices. Friedman gave empirical content to the theory by studying instances where historical circumstances suggested that money was the causal factor in this relationship. According to him(1956) there is perhaps no empirical regularity among economic phenomena that is based on so much evidence for so wide a range of circumstances as the connection between substantial changes in the stock of money and in the level of prices. Instances in which prices and the stock of money have moved together are recorded for many centuries of history, for countries in every part of the globe, and for a wide diversity of monetary arrangements. Friedman maintained that the ratio of the stock of money that people want to hold to the value of the transactions they perform each year (or the inverse of this ratio, called the velocity of circulation) is supposed, in the simplest version of this view, to be fixed by such factors as the frequency of wage payments, the structure of the economy, and saving and shopping habits. So long as these remain constant, the price level will be directly proportional to the supply of money and inversely proportional to the physical volume of production. However, the theory assumes that productive capacity is fully employed, or nearly so and that aggregate prices (P) and total money supply (M) are related according

19 to the equation P = VM/Y, where Y is real output and V is velocity of money. The equation was further expressed in the following manner; p = v + m y, where p is the rate of inflation, y = output growth rate, v= velocity of money and m = money stock in Friedman (1963) and Schwartz (1973). The major implication of the quantity theory of money as argued by Bernanke (2002) is that a given change in the rate of money growth induces an equal change in the inflation rate, prompting Milton Friedman to claim that inflation is always and everywhere a monetary phenomenon. Bernanke (2002) argued that Friedman relies on the crucial assumption that the velocity of money or its growth rate is constant and money growth has no effect on real GDP growth at least at a sufficiently long horizon. However, instead of assuming the velocity of money or its growth rate is constant, the quantity theory equation was re-expressed as v = p + y m, this allow the changes in velocity to be dictated directly by inflation, output growth, and money growth. Curwen, (1976) argue that the dynamic interactions among these three variables (money, income and price) can be captured by econometric analysis. In this way, the dynamics of velocity are not restricted a priori and such analysis shows that money growth and inflation are indeed highly correlated in the very long run. Between 1950s and 1960s, Friedman and other economists from Chicago school, revived the quantity theory with the basic contentions that short-period changes of the money supply are, in fact, followed after a varying interval by changes in money income and that of velocity of circulation. According to them, even though it fluctuates to some extent with the money supply, it however tends to be fairly stable, especially over long periods. They drew conclusion from this point, while money supply may not be a reliable instrument for controlling short-term movements in the economy, but it can be effective in controlling longer term

20 movements of the price level. According to them, the prescription for stable prices is to increase the money supply regularly at a rate equal to that at which the economy is estimated to be expanding as noted by Thomas and Wallace (1987) and McCandless and Weber (1995). Thomas and Wallace (1987) argued that in highly developed economies the supply of money varies largely with the demand for it and that the authorities have little power to vary the supply through purely monetary controls. According to them, the correlations observed by the so-called Chicago school between money and income are attributed to variations in the demand for money to spend, which elicit partial responses from supply and are followed after an interval by corresponding changes in money and income. They further attribute the relative stability of the velocity of circulation to the facility with which the supply of money accommodates itself to demand; in as much as supply may be restricted in the face of rising demand, velocity will increase, or equal demand and new sources of credit, such as trade credit, will be exploited. 2.2 The Keynesian Theory on Inflation and Money The Keynesians, on the other hand, argued that money does not play any active role in changing prices in an economy. According to them, changes in prices are mainly caused by structural factors. Keynesian theory does not offer much insight into movements of the price level. Keynesian theory proposes that money is transparent to real forces in the economy, and that visible inflation is the result of pressures in the economy expressing themselves in prices. As monetarists assert that the empirical study of monetary history shows that inflation has always been a monetary phenomenon, by contrast, Keynesians typically emphasise that the role of aggregate demand in the economy rather than the money supply in determining inflation.

21 Keynes unlike the neo-classicists did not believe there is always full employment in the economy which resulted in hyperinflation with increase in the quantity of money. To him, with underemployment in the economy, an increase in aggregate demand which leads to increased output and employment is as result of an increase in the money supply. He explains that starting from a depression, as the money supply, increase, and output at first rise proportionately. But as aggregate demand, output and employment rise further, diminishing returns start and certain bottlenecks appears and price start rising. This process continues till the full employment level is reached. The rise in the price level during this period is known as bottleneck inflation. If the money supply increase beyond full employment level, output ceases to rise and prices rise in proportion with the money supply. This is true of inflation according to Keynes. However, some economists like Sargent ( 1982) regard this approach as mere hocus-pocus and disagreed with the view that central banks control money supply. Instead, they contend that central banks have little control over money supply because money supply adapts to the demand for bank credits issued by commercial banks. 2.3 Rational Expectations Theory on Inflation and Money The Rational Expectations theory was initiated by Muth (1961) and advanced by Lucas (1976) and Sargent, Thomas and Wallace (1987). Rational expectations theory holds that economic actors look rationally into future when trying to maximize their well-being, and do not respond solely to immediate opportunity costs and pressure. In this view while generally grounded in monetarism, future expectations and strategies are important for inflation as well. The major crunch of

22 the rational expectations theory according to Dwyer and Hafer (1988) is that actors will seek to head off commercial bank decisions by acting in ways that fulfill predictions of higher inflation. 2.4 Adaptive Expectation Theory The adaptive expectations hypothesis was introduced by Cagan (1956) and Friedman (1957) as a plausible and empirically meaningful approach to modeling expectations of future variables in a world of uncertainty. Their apparent empirical success led to widespread utilization of the adaptive expectations hypothesis before it was ultimately swept away by the rational expectation revolution. Monetarists argued that the expectation of the future price level is driven mainly by agent's experience of previous inflation rates. The application of adaptive expectations became the standard approach for modeling expectations. The adaptive expectations hypothesis (AEH) is a special case of a more general framework in which expectations of P are related to current and past values in a distributed lag fashion. Algebraically, the movement of price expectations following the AEH can be written as which says that economic agents derive their expectations at the outset of period t by a fraction of the forecast error. This implies that expectations in the current period are revised if the value of the price level forecasted in the previous period is different from the actual realization of this variable, i.e., the case when market participants are surprised (e.g. by the actions of the policymaker or unforeseen events). The AEH has the implication that the most recent observations on the actual price level dominate the formation of expectations about the development of prices in the future. Expectations are disproportionately linked with the most recent past.

23 One of the strengths of the adaptive expectations approach is that it was the first to recognize the role of past history in the formation of expectations. By assuming a retrospective position it assumed that the economy is structurally stable in that today's outcomes are not vastly dissimilar from yesterdays. The hypothesis was however criticized on the ground that first, it shows mathematically that expectations are entirely backward-looking, formed without reference to current information about the future. Such a backward-looking way of expectation formation implies that people will make non-random errors in predicting the value of variables in the future. This contradicts the standard neoclassical economic assumption that agents do not consistently repeat the same mistakes. Second, the AEH assumes that economic agents regard only the past values of the variables they are trying to forecast. This means that these agents voluntarily limit themselves to a very narrow set of information when forming expectations. Any improvement over adaptive expectations approach would have to concern itself with the incentives to acquire information and exploit profitable opportunities for revising behaviour (i.e. avoiding regular sources of error) according to Ferguson ( 2001) and Evans and Rameym, (2004). 2.5 Empirical Review Budina et. Al, (2002) estimate the relationship between inflation and money creation in Romania. Specifically, they tested statistically the extent to which money creation causes of inflation. They applied the Johansen procedure for co integration to test for the rank of the matrix of co integrating relations among the

24 variables in question. They interpret the unique co integrating relationship as an extended Cagan (1956) money demand equation, and estimate error correction mechanisms, in which excess supply of real money contributes significantly to the short-run dynamics of inflation and real money. The evidence suggests than in the period considered, including the sub-sample between the liberalization shocks, inflation was largely a monetary phenomenon. Contrary, Mark and Blaug (1996) demonstrated in their study that the long run relationship between inflation and money growth may not necessarily be driven by purely monetary forces, but instead by forces such as permanent movements in GDP and non-monetary shocks. Their result show that about 18 percent of the long-run movement of inflation at frequency zero is attributable to money growth shocks; the remaining 82 percent is due to shocks that can have permanent longrun effects on output and the velocity of money. This result suggests that endogenous monetary policy may have allowed non-monetary shocks to have a stronger effect on inflation than autonomous movement in money supply. They concluded that while the close long-run link between money growth and inflation supports Friedman s proposition, the significance of this link for monetary policy requires further investigation of the underlying factors that drive inflation and money growth. Masha, (2002) examined the interactions between nominal money, output and prices using quarterly data from Nigeria, in an error correction specification. The co integration test confirmed that there is a long run relationship between nominal money, price level, the real exchange rate and output in Nigeria. The short run dynamics confirmed that variations in nominal money stock affect the price level

25 and real exchange rate positively, while the effect on real output is negative. The role of monetary policy in price stability is further reaffirmed. Essien and Eziocha (2002) attempted to identify the trend of core inflation in Nigeria using trivariate VAR model. The major objective of their study were: to identify the path of three major shocks, namely supply, real demand, and money on inflation in the Nigerian economy, distinguishing the shocks through their respective effects on output and CPI measured rate of inflation, identify which of the shocks leads to core/pure inflation, and dichotomizing the core shocks to ascertain which of them was predominant or propels inflation most in the Nigerian economy. Their results showed that inflation in Nigeria is predominantly affected by monetary shocks. Based on their results, they recommended that appropriate action should be taken by the monetary authorities to expedite model-based measurement of core inflation in Nigeria. They also noted in passing that government should complement this effort by ensuring a purposefully fiscal expansion and that a framework for good monetary and fiscal relations should be worked out to ensure a planned injection of liquidity that could be neutralized by appropriate use of intervention instruments. Busari (2007) examined the main economic determinants of inflation in Nigeria over the period using quarterly data. Based on the time series characteristics of the variables used in the analysis, they adopted the general tospecific modelling approach to investigate the main determinants of each component. The results confirm that, in the long run, inflation is largely and positively related to the level of (narrow) money supply and, marginally, to fiscal deficit. In the medium term inflation is observed to be positively related to exchange rate depreciation and the growth of money supply. In the short run, it is

26 observed that inflation is positively related to growth in money supply and exchange rate depreciation while it is negatively related to growth in real GDP. Some marginal significance is observed for the influence of pump price adjustment of petroleum products. The study further observed that inflation is positively related to growth in money supply, exchange rate and growth in non-oil GDP. The author further observed that money supply affects inflation in the short to long run while exchange rate is influential in the short to medium run. Adamson (1989) using a basic macroeconomic accounting framework, developed a framework for analyzing Nigeria s inflationary experience, and discovered that any adjustment policy that does not take into account the role of money and credit is likely to fall short of the overall goal of non inflationary economic growth. This dictates that the estimate of inflation rate for next year should have an influence on this year's money supply. If inflation is predicted, which means that next year's price level will be greater than this year's price level, then the supply money can only be a fraction of the wage bill. The implication is that the country can not support that level of wage bill and that the wage bill must have to come down. Whereas, in a period of price stability when next year's price level may be equal this year's price level, then the level of money supply should be equal to the wage bill. The major lesson from the study is that reckless increases in the supply of money without due regard for the absorptive capacity of the economy will always lead to inflation. Then, inflation retards economic growth and can only negate the development efforts of the country. Louis Kuijs (1998) estimated a model that determined the determinants of Inflation, Exchange rate, and Output in Nigeria. After the long run equilibrium

27 conditions on the market for broad money (monetary), the market for foreign exchange (balance of payment) and non-oil goods market (output) gap had been determined, a dynamic model was estimated in which the disequilibria in the three markets were allowed to influence the price level, the real exchange rate and the output. The result of the study follows the classical assertions concerning the dichotomy between the real and monetary spheres. First, the price level, in the long run, determined by monetary policy, as an excess of money supply over money demand leads to a rise in the rate of inflation, while the long run effect of import prices is insignificant. Prices also do not respond to either to balance of payment disequilibrium or to deviations of output from potential and, the price level does not in the short run, respond to variations in output. Second, the long run equilibrium real exchange rate is determined by the real demand for and supply of foreign exchange. The real exchange rate responds to balance of payment disequilibrium but not to excess money supply or output. Third, the results also suggest that, although deviations from potential output can be sustained for prolonged periods, output is attracted to potential output. Although, neither the monetary nor balance of payments disequilibrium have an impact on the growth of output, an increase in the supply of foreign exchange does not lead to a short-run increase in output. Qayyum (2006) investigated the linkage between the excess money supply growth and inflation in Pakistan and tested the validity of the monetarist stance that inflation is a monetary phenomenon. The results from the correlation analysis indicate that there is a positive association between money growth and inflation. The money supply growth at first-round affects real GDP growth and at the second

28 round it affects inflation in Pakistan. The important finding from the analysis is that the excess money supply growth has been an important contribution to the rise in inflation in Pakistan during the study period, thus supporting the monetarist proposition that inflation in Pakistan is a monetary phenomenon. The results indicates that in the long run there is a one to one relationship between the rate of inflation and growth in money supply, growth in real income and growth in velocity of money. Akhtar (2005) used annual data for the period to investigate the causal relationship between money growth, inflation, currency devaluation and economic growth in Indonesia. He tested three hypotheses; does money supply growth Granger-cause inflation?, Does currency devaluation Granger cause inflation? Does inflation affect economic growth? The empirical results suggest that there existed a short-run bi-directional causality between money supply growth and inflation and between currency devaluation and inflation. For the complete sample period, the causality running from inflation to narrow money supply growth was stronger than that from narrow money supply growth to inflation. He concluded that the result is consistent with the view that in a high-or hyperinflationary economy, inflation does have a feedback effect on money supply growth and this generates a self-sustaining inflationary process. The short-run bi-directional causality between currency devaluation and inflation was, however, weak or not so robust for the complete or any shorter sample period. On the relationship between inflation and economic growth, the results suggest that there was no short-run causality from inflation to economic growth for the complete or any sub-sample period. Gokal and Hanif (2004) reviewed several different economic theories to ascertain consensus on the inflation growth relationship. Classical economics through

29 supply-side theories emphasize the need for incentives to save and invest if the nation s economy is to grow. Keynesian theory provides the AD-AS framework, a more comprehensive model for linking inflation to growth. Monetarism re emphasized the critical role of monetary growth in determining inflation, while Neoclassical and Endogenous Growth theories sought to account for the effects of inflation on growth through its impact on investment and capital accumulation. After a thorough review of literature both theoretical and empirical, they tested whether a meaningful relationship held in Fiji s case. The tests revealed that a weak negative correlation exists between inflation and growth, while the change in output gap bears significant bearing. The causality between the two variables ran one-way from GDP growth to inflation. Thomas (1994) used band spectral regression techniques to examine the dynamic properties of the responses of inflation and interest rates to money shocks. The procedure identified the frequency movements that were most important in the relationships between money growth and inflation, and between money growth and nominal interest rates. In doing so, it provided answers to questions about whether high- or low-frequency movements in money growth cause movements in inflation and the nominal interest rate, and whether the movements caused are themselves of high or low frequency. The study obtained baseline money-inflation and moneyinterest rate causality results. Then, band spectrum regression techniques similar to Engle (1974) were used to remove particular frequencies from money growth, inflation, and the change in the interest rate. Using band spectral regression techniques, they shows the cycles in the money growth rate from one to two years long produce higher frequency cycles in inflation and the change in the nominal interest rate, and that there are two distinct sets of cycles in the change in the

30 nominal interest rate that correspond to the liquidity and anticipated inflation effects. Rolnick and Weber (1998) examined the behavior of money, inflation, and output under fiat and commodity standards to better understand how changes in monetary policy affect economic activity using time series data for 15 countries. They established several facts about the differences in the relationships between money and inflation and between money and output when economies operate under a commodity standard and when they operate under a fiat standard. They discovered that under fiat standards, the growth rates of various monetary aggregates are more highly correlated with inflation and with each other than they are under commodity standards. They also found out that money growth and inflation are higher. In contrast, their results did not show that money growth is more highly correlated with output growth under one standard than under the other but that under fiat standards, output growth is higher. Greene and Canetti (1991) investigated the relationship between domestic money supply and inflation in six African countries. They used Granger and Pierce causality tests in order to investigate the role of domestic money supply on inflation in those six African countries. Their findings show that growth in money supply (and the nominal exchange rate) had a significant casual influence on inflation. The findings support the Friedman s endogenity of the money supply. On the other hand, Saini (1982) conducted a research on six Asian countries to show that the monetarist explanation of inflation does not always fully accord with the experience of the six Asian countries examined in terms of its implication for policy. He provided evidence that empirically, monetarist explanation of inflation may not be fully applicable to the Asian context for a variety of reasons,

31 policymakers may be forced to reorient and recalibrate other aspects of policies such as those relating to central government budget policies and exchange rate setting practices. Asogu (1991), used ten different specifications that covered monetary, structural and open economy aspects of inflation, He used Distributed lag model lag in his regressions. The variables include money supply, real GDP, aggregate domestic credit to the economy, government expenditure. Others are industrial production index, import price index and the official exchange rate. All the variables were expressed in terms of their rate of change. The results of the estimations suggested that real output, especially industrial output, net exports, current money supply, domestic food prices and exchange rate changes were the major determinants of inflation in Nigeria. Soludo, (1998a) in his study on Fiscal Deficit, Exchange rates and External Balance: Evidence from Nigeria, concluded that money supply, lagged of changes in money supply credit to government by the banking system, and government deficits are factors that jointly explain inflationary tendencies in Nigeria. Ugwu, (1997) also showed that inflation in Nigeria is essentially monetary phenomenon. This is evidenced from his estimation on the Determinants and Consequences of Budget Deficits in Nigeria over the period of He discovered that the major determinants of movement in price level is exchange rate of naira to the US dollar, the level of government expenditure and domestic money supply. Also, government deficits and financing through the banking system, and the consequent growth in money supply are largely responsible for inflation in Nigeria over the period studied.

32 While Anyanwu et al (1995) on the other hand, provided empirical evidence that inflation rate is positively correlated with fiscal deficits in Nigeria. According to them, the overall deficit resulting from federal government fiscal operation in 1988 amount to N m representing 43% over the envisaged deficit for that year.consequently, the inflation rate rose from 10.2% in 1987 to 38.3% in Also, with large fiscal deficit and its financing, the level of fiscal deficit was estimated at about 90% of GDP at the end of 1994, while inflation rate was estimated to be at rate of 57.0%. Osakwe (1983) carried out a study on Government Expenditures Money Supply and Prices in Nigeria using a quarterly time series data that spans from His empirical results showed that there is statistical relationship between increases in net current expenditure and growth in money supply on the one hand, and growth in money supply and inflation on the other hand. Further increase in money wage rates and money supply (with lag-in-effect) were identified as the two most important factors which influenced the movement of prices during the period. Fakiyesi (1996) also used the autoregressive distributed lag model of lag length one in his study of inflation phenomenon. His result shows that inflation depended on the growth in broad money, the rate of exchange of the naira vis-à-vis the dollar, the growth of real income, the level of rainfall, and the level of anticipated inflation, which is based on the previous year s level of inflation. Balagon Dele (2007), examined the monetary and macroeconomic stability perspective for entering into monetary union, using data available on West African Monetary Zone (WAMZ) countries. It tested the hypothesis that independent monetary and exchange rate policies have been relatively ineffective in influencing

33 domestic activities (especially GDP and inflation), and that when they do, they are counter productive. Using econometric methods, regression result show that, erstwhile domestic monetary policy, as captured by money supply and credit to government hurt real domestic output of these countries. Indeed, rather than promote growth, it was a source of stagnation. It also confirms that there appear to be a two quarters lag in monetary policy transmission effect with regard to real sector output. The results also show that although expansion in domestic output dampened aggregate consumer prices (inflation), it was however, not adequate enough to dampen the fuelling effects of past inflation. This was accentuated by money supply variable (MS2) and aggravated by exchange rate variable which are mostly positive, confirming the a priori expectations that rapid monetary expansion and devaluations fuels domestic inflation. A country by country comparison of the single and simultaneous equations model results show that expansionary monetary policy contributed more to fuelling prices than it did to growth. It also shows that interest rates policy had adverse effects on GDP by exhibiting a positive sign contrary to the theoretical expectation of an inverse relationship. The results also show that exchange rate devaluations manifest mainly in domestic inflation and have no effect at all on the growth variable, in the short term. The study concludes that these countries would be better-off to surrender its independence over these policy instruments to the planned regional body under appropriate monetary union arrangements. Characterizing inflation as a monetary phenomenon is unsatisfactory in the case of Tanzania as Rwegasira (1977) show in his study. It is probable that monetary factors, which may be shown to be statistically significant in determining the rate of inflation in Africa, may be reflecting structural difficulties associated with the

34 development process. Hence, it would be the correction of these difficulties that would eventually lead to a moderation of inflationary pressures. Milas (2007) using UK data showed that: (i) the relationship between inflation and money growth is not stable over time, and (ii) the tendency of money to exert inflationary pressures is conditional on annual money growth exceeding 10%. Above 10% threshold, a 1 percentage point increase in the annual growth rate of 10% increases annual inflation by only 0.09 percentage points, whereas a 1 percentage point increase in the disequilibrium between money and its long-run determinants increases annual inflation by only 0.07 percentage points. Since the money effects are very small, the implication is that the Monetary Policy Committee should not be particularly worried for not paying close attention to 10% money movements when setting interest rates. He argued that since in the high money growth regime, a 1 percentage point increase in the output gap increases inflation by five times as much as a 1 percentage point increase in either annual 10% growth, or money deviations from equilibrium, he concluded that the money effects are too small to justify worries that 10% movements which are indeed above average of 8% are highly inflationary that Monetary Policy Committee don t need to be particularly worried about 10% movements when setting interest rate policy. Holod (2000) estimated the relationships between prices, money supply and exchange rates in Ukraine using Identified Vector Auto regression Approach. The results showed that exchange rate shocks significantly influenced price level behavior. Therefore, he concluded that exchange rate can serve as an efficient intermediate target for the monetary policy. There is some evidence that positive money supply shocks lead to a rise in the price level. However, this influence is not

35 very strong, which can be explained by the fluctuations in the demand. He also find strong evidence that money supply responds to the positive shocks in the price level by monetary contraction, which can be a sign of the conduct of the inflation targeting policy by the National Bank of Ukraine. 2.6 Theoretical Framework The adaptive theoretical framework is derived from the work of Begg et al (1994) who extensively analyzed the Friedman s hypothesis. Following Friedman s argument, they developed the basic link between the nominal money supply and the price level. That provided the link between the rate of growth of the nominal money supply and inflation, or the rate of growth of the price level. Their analysis focused on the market for money; where: The real money supply M/P is the nominal money supply M divided by the price level P. They opined that people demand money because of its purchasing power in terms of goods. Thus, according to them, demand for money will be a demand for real balances. Because Keynes used the term liquidity preference to mean the demand for money, economists often used the symbol L to denote the demand for real money balances. Thus, they used the symbol L(Y, r) to denote the quantity of real balances demanded when real income is Y and the interest rate is r. An increase in real income increases the quantity of real balances demanded since people are undertaking more transactions. By increasing the opportunity cost of holding money rather than interest-bearing assets, an increase in the interest rate r will reduce the quantity of real balances demanded.

36 They went further to show that if the money market is in equilibrium, the supply of real balances M/P must equal the quantity of real balances demanded. They summarized this equilibrium condition in equation (a) below: M/P = L(Y, r) (a) They assumed that flexible interest rates keep the money market continuously in equilibrium. Equation 1 holds at all points in time. Suppose that nominal wages and prices are slow to adjust in the short run. An increase in the nominal money supply M leads initially to an increase in the real money supply M/P since prices P have not had time to adjust fully. There is now an excess supply of real money balances which bids interest rates down until the demand for real balances has increased enough to restore money market equilibrium. Lower interest rates boost aggregate demand for goods. Gradually this excess demand for goods bids up goods prices, and in the labour market the increased demand for employment starts to bid up money wages. When wages and prices have fully adjusted, a once-andfor-all increase in the nominal money supply leads to an equivalent once-and-forall increase in wages and prices. Output, employment, interest rates, and the real money supply are restored to their original levels. When adjustment is complete and long-run equilibrium restored, real income, interest rates, and hence the demand for real balances are all unchanged. Hence the price level must have changed in proportion to the original increase in the nominal money supply. According to them, this result is the essence of the quantity theory of money which is stated thus: The quantity theory of money says that changes in the nominal money supply lead to equivalent changes in the price level but do not have effects on output and employment. In other words, nominal money supply is positively associated with price levels (inflation rates). Thus,

37 Inf = f (MS) (b) Begg et al (1994) stated that one of the major issues to be investigated is thus: even if the demand for real balances does remain constant, is it changes in nominal money that cause changes in prices, or changes in prices that cause changes in nominal money? Based on the above theoretical framework, this work adapts equation (b) as the basis for the research model for investigating this important issue vis-à-vis the Nigerian experience from 1970 to Limitation of Previous study There are volumes of studies that have attempted to investigate the validity of Friedman s hypothesis on the relationship between money stock and inflation across different economies. The findings of those studies remain inconclusive. Moreover, most of the studies reviewed in Nigeria focused on trivariate causality that is using three variables money, income and prices or money, output and price for their model. See for instance, Masha (2002) among others. Incidentally, one of these economic variables may be influenced by third party effect; therefore, using bivariate causality to capture the causal relationship between money stock and inflation would be more appropriate so as to get the direct effect of any of the two economic variables on the other. In addition, most of those reviewed especially in our own environment focused on the determinants of inflation rather than testing the validity of Friedman s hypothesis. See for example Fakiyesi (1996) and Asogu (1991). 2.8 Money supply, inflation and Monetary Policy in Nigeria The CBN monetary programme sets explicit targets for broad money (M2), the key intermediate benchmark variable as the operating variable. The factors, which

38 influence the expansion or contraction of money stock, include aggregate bank credit to the private sector and credit to government, net foreign assets and other domestic assets (net) of the banking system. The target for the intermediate variable (M2) is determined with reference to the programmed inflation rate, external reserves accretion and real GDP growth targets. The link between the ultimate goals of price stability, the intermediate targets of money stock (M2) and indicator variables like the inflation rate are not usually so direct, but there is a wide consensus about the relative effect of the proximate variables on the ultimate goals. However, the implementation of monetary policy measures in Nigeria has been organized into two methods of credit control. They are the direct and indirect monetary credit control tools. Direct monetary control techniques were in vogue in the 1960s, 1970s and 1980s till June The main objectives of monetary policy then were the maintenance of relative price stability and a healthy balance of payments position. The major tools were administered interest rates, special deposits, administered exchange rates, prescription of cash reserve requirements, selective credit controls, credit ceilings, etc. However, it was not feasible then to use the market-based tools because of the narrowness and underdeveloped nature of the financial markets, the inadequate supply of the relevant debt instruments and the restrained interest rates. The most popular instrument of monetary policy then was the issuing of credit rationing guidelines, mostly in the form of setting the rates of change from the components and aggregate commercial bank loans and advance to the private sector. The controls of interest rates at relatively low levels were done to promote investment and growth. Occasionally, special deposits requirements were imposed to reduce the amount of free reserves and credit creating capacity of the banks ( Anyanwu and Oikhenan( 1995).

39 With introduction of the Structural Adjustment Programme (SAP) in July 1986, monetary policy was aimed at inducing the emergence of a market-oriented financial system for effective resource allocation. As Anyanwu and Oikhenan (1995) also noted, the objectives of monetary policy however remained the stimulation of output and employment and the promotion of domestic and external stability. The indirect monetary policy tool came on board again in 1993, when the Central Bank of Nigeria formally introduced its open market operations (OMO) as a major indirect tool of monetary policy in Nigeria. The open Market Operations involves the buying and selling of government securities (Treasury Bills, Treasury Certificates and Government Development Stocks) by the Central Bank of Nigeria. Through these activities, the central bank directly changed the levels of banks cash reserves and indirectly induces changes in the level of interest rates, thereby causing changes in terms of credit available and ultimately money supply. The use of open market operations was geared towards achieving a substantial monetary tightening, given the continued upward spiral in inflation rate, the growing pressure of naira, exchange rate and the underlying growth of domestic liquidity arising from the central banks accommodation of the growth of fiscal deficit of the federal government. Similarly of the various direct and indirect methods of credit control, the latter was more effective than the former. The foregoing denotes that in the past the monetary authorities have made efforts to operate an effective monetary policy framework. This difficulty has been that of forecasting money demand and fiscal pressure on the inflation tax by expanding the monetary base rapidly. In brief, the central Bank

40 has had a poor record in managing monetary policy. Put differently, monetary policy management in Nigeria has been relatively more successful during the period of financial sector reform, a period characterized by the use of indirect monetary policy instruments, than under the control regime, that is the direct control. Again, the efficiency of monetary policy in Nigeria has been undermined by the combined influence of fiscal dominance and political interference. Until recently, the granting of instrument of autonomy to the Central Bank of Nigeria has enhanced its operational efficiency, in terms of its ability to achieve its key objective of monetary policy, namely price stability. Finally, the Nigerian experience confirms that the political and legal environment in which a central bank operates is crucial to the success or otherwise of its monetary policy regime. However, the recent attempts at liberalizing and reforming the financial markets particularly the recapitalization of banks and other financial institutions in Nigeria is gradually providing the leeway required to implement an effective monetary policy framework that will stimulate economic growth and usher in development for the country.

41 Money supply Trend: Graph 1 As shown in graph 1, between 1970 and 1979, increase in Money supply has been relatively small but by 1980, money supply jumped from 9,849 in 1979 to 14, in 1980, ever since then money supply has been on constant increase. Inflation Trend: Graph 2

42 The trend in the inflation has been on spiral movement since the 1970 as it can be seen in graph 2. Inflation recorded the lowest value of 3.20 in 1972, while it recorded the highest value of in The major factor responsible for these was the expansionary fiscal stance of the three tiers of government. Contractionary monetary policy led to improvement in fiscal prudence, the inflation rate decelerated rapidly from 72.8 per cent in 1995 to 6.6 and 6.9 per cent in 1999 and 2000, respectively. However, the declining trend in the inflation rate was reversed in 2001 when the rate shot up to 18.9 per cent, owing to excessive government spending as a result of the excess earnings from crude oil exports. The actions taken by the CBN during the year 2001 and early 2002 to contain demand pressure led to the steady deceleration of the inflation rate to an estimated 13.0 per cent in December, In addition, under the recent financial sector reforms, the monetary authority have remained committed to maintaining a single digit inflation, which is one of the reasons inflation rate has relatively been stable.