MANAGING MONETARY POLICY IN AN ENVIRONMENT OF FISCAL DOMINANCE IN THE NIGERIAN ECONOMY

ABSTRACT

This study sets out to examine managing monetary policy in an environment chocked up with huge fiscal deficits and public debt, high inflation rate etc, (which gives rise to fiscal dominance), in Nigerian setting during the period 1980 to 2004.

To accomplish this, statistical hypotheses were stated empirically. In chapter two, of the study, the review of various monetary policies in Nigeria was highlighted. Also there were emphasis on the fiscal policy and arguments on which of the two policies actually dominates.

The theoretical frame work was formulated and presented in chapter three.

While in the forth chapter, the model developed in chapter three was specified and estimated by  the ordinary least square (OLS) technique and the Cochrane-Orcutt as a corrective measure for auto-correlation, using the annual data for the period under study.

The fifth chapter concludes with the findings of the study which are;

Firstly, the results of the model showed that the specified variables which includes; banking system holdings of public domestic debt outstanding, domestic public debt, total government expenditure and inflation rate were all significant in explaining the systematic variation in the level of money supply with the exception of the domestic public debt.

Secondly after the application of the corrective mechanism i.e. the Cochrane-orcutt measure, all variables were statistically significant except that of total government expenditure. And all the variables conformed to Apriori specification.

The study there fore points to the need for a prudent fiscal policy and monetary authorities should place more emphasis on monetary actions than on fiscal action in their drive towards stabilization of the economy.

TABLE OF CONTENT

Title page      

Certification   ……………………………………………………………….   i

Dedication      ……………………………………………………………….   ii

Acknowledgement ………………………………………………………….   iii

Abstract      ………………………………………………………………….   iv - v  

Tables of content

List of figures

CHAPTER ONE

Introduction   

1.1  Background to the study ……………………………………………….   1 – 3

1.2  Statement of problem …………………………………………………..  4 –5

1.3  Objective of the study ………………………………………………….     6

1.4   Hypotheses …………………………………………………………….      6

1.5  Scope of the study ………………………………………………………   6 - 7

1.6  Types of data ……………………………………………………………     7

1.7  Sources of data ………………………………………………………….     7

1.8  Justification of study …………………………………………………….  7 – 8

1.9  Definition of terms ……………………………………………………...    8 - 9

CHAPTER TWO

REVIEW OF LITERATURE

2.1 Introduction ……………………………………………………….      10 -12

2.2 Role of the Autonomy of the Central Bank ……………………….    12 -14

2.3 Appraisal of monetary policy management ……………………….    14 – 17

      Since the 1970’s

2.4 Fiscal dominance or Monetary management ………………………   17 -20

2.5 Financing fiscal Deficits …………………………………………...       20 -21

2.6 Monetary and Fiscal policy conflicts ………………………………     21 -22

2.7 Monetary policy and Fiscal behavior in Nigeria …………………..    22 -23

CHAPTER 3

3.1 Theoretical Framework ……………………………………………      23 -26

3.2 Methodology ………………………………………………………           26

3.3 Model Specification ……………………………………………….        26 – 27

3.4 Method of Data Analysis ………………………………………….          28

3.5 Data Requirements ………………………………………………..          28

CHAPTER 4

4.0 Presentation and Interpretation of results ………………………...     29

4.1 Results …………………………………………………………….      30 -31

4.2 Interpretation of results …………………………………………...   31 -34

CHAPTER FIVE

5.1 Summary of findings ……………………………………………..  

5.2 Recommendations and conclusion ……………………………….

Reference

CHAPTER 1

INTRODUCTION

1.1              BACKGROUND TO THE STUDY

Money is however, unique in a way which attracts “problems” from fiscal authorities (T.A. Oyejide 2003); its value in exchange far exceeds the cost of producing an additional unit and this may give government incentive to print money as a means of gaining free resources through borrowed revenue. This implies that while the central bank may typically wish to control the money supply to fight inflation, money creation allows government to obtain resources without imposing an explicit tax. 

Up until this time, the implementation of monetary policy in Nigeria has been complicated by a number of factors including fiscal largesse, lack of operational authority of the central bank, insufficient low quality statistics, a weak transmission mechanism and a weak financial system. Monetary policy is a central bank’s action to influence the availability of cost of money and credit, as a means of helping to promote national economic growth and goals. In other words, the CBN manipulates interest rates and the money supply to push the economy in the direction it deems necessary. On the other hand, the role of government is to counteract undesirable trends – to push the economy out of recession and to slow it down if it becomes over heated and inflation occurs. If the economy is headed on a downward trend, fiscal policy is often used to stimulate the economy. In essence, fiscal policy in trying to recover or boost the economy often resorts to deficit spending and borrowing.

Using Nigeria for instance, its performance from 1978 to 1984 showed a decline averaging 2.2 % in real GDP as against the real GDP average of 7.3% in 1970 to 1977. the declining trend observed in domestic output since 1980 continued in 1984, following the adverse developments in the international oil markets in the early 1980’s, which resulted in a sharp fall in oil prices (see J. M Ojo 2003).

Consequently, Nigeria’s export lead to increase in public spending and this resulted in the build-up of large fiscal and external deficits. In the bid to finance the domestic deficits, government resorted to borrowing heavily from banking system, especially the central bank (CBN) while the financing of foreign deficits led to massive foreign borrowing and the drawing down of external reserves.

These government excesses and huge budget deficits coupled with public debt caused a lot of negative economic trends. Thus, in an attempt to curb these government excesses and bring about economic stability, the CBN formulated monetary policies on tightening the country’s financial budgets.

In principle, fiscal dominance occurs when fiscal policy is set exogenously to monetary policy in an environment where there is a limit to the amount of government debt that can be held by the public. For instance in oil-dependent countries, a major issue are how to stabilize fiscal spending when government revenue fluctuates along with the international price of oil. Nigeria is highly dependent on revenue from oil exports, in terms of both its balance of payments and government revenue. Most of Nigeria’s oil and gas resources, which are abundant relative to current production levels, are exploited by joint ventures between foreign oil companies and the Nigerian National Petroleum Corporation (NNPC). Domestic income from oil and gas accrues to a very large extent to the government in the form of proceeds from equity oil sales and taxes on private companies. Private income from oil and gas leaves Nigeria largely through profit remittances. Because international oil prices are volatile, the government’s revenue from oil and gas is also volatile. Fiscal spending has been equally volatile, leading to boom-bust cycles, which are partly to blame for Nigeria’s disappointing growth performance since independence, (Menachem Katz June 24, 2005).

The economy environment that guided monetary policy before 1986 was characterized by the dominance of the oil sector, the expanding role of the pubic sector in the economy and over-dependence on the external sector. The objectives of monetary policy since 1986 have remained the same even with the slight fiscal changes and subsequently in the monetary policies, the fiscal stance in the economy, still poses a problem to the CBN.

Further in this chapter 1.2 will discuss the statement of the problem of the study, 1.3 I will highlight the objectives of the study. 1.4 will be on the hypotheses of the study, 1.5 will be on the scope of the study, 1.6 will be on the methodology, 1.7 will shoe the model specification and 1.8 is on the limitation of the study.

1.2              STATEMENT OF THE PROBLEM

The major source of problems in monetary management was the nature of monetary control frame work, the interest rate regime on the non-harmonization of fiscal and monetary policies. In the perfect world, monetary and fiscal policies would be perfectly coordinated and synchronized and they would impact the economy in a complementary and mutually reinforcing way. But in the real and imperfect world of policy making, myopic behavior, particularly on the fiscal side, may create problems for the overall economic management, Arthur smithies defines fiscal policy as “a policy under which the government uses its expenditure and revenue programs to produce desirable effects and avoid undesirable effects on national income, production and employment”. In the context of this imperfect world, conflict may often arise between the central bank which pursues its primary goal is to maintain economic stability and the government whose primary goal of economic goal is running a stream of large fiscal deficits. According to T. Ademola Oyejide, 2003, conflicts are inevitable because such a macro economic program is inherently infeasible and unsustainable.

In general, conflicts between the fiscal authorities (i.e. government)  and the monetary authorities (CBN), in this context typically arises with respect to the impact of fiscal and monetary policies on public debt, domestic credit conditions and inflation, exchange rate management and measures to ensure the institutional stability of the financial system.

Furthermore, conflicts tends to reoccur and sometimes grow in terms of level of acrimony in a country facing fiscal dominance, whose financial system is fragile and has no clear robust and institutionalized mechanism for synchronizing and coordinating monetary and fiscal policies e.g. Nigeria. In addition Odozi (1992) concluded that the greatest problem which has reduced the effectiveness of current monetary and banking policies in Nigeria is the persistence of large government deficits and its mandatory financing by the central bank (T. A Oyejide).

This paper therefore, seeks to answer the following questions;

1. What is the relationship between monetary policy and fiscal dominance in monetary management?
2. What is Nigeria’s experience with fiscal and monetary policies behavior in the economy?
3. How can monetary and fiscal policy be properly synchronized in order to balance the economy?
4. How effective will monetary policy be, if the Central Bank is an autonomous body?

1.3 OBJECTIVE OF THE STUDY

This study sets out to examine empirically the effect of managing monetary policy in an environment of fiscal dominance and the conflicts that arises as a result of running both policies concurrently in the Nigerian economy.

More specifically the objectives of this paper includes

1. to know the relationship between the autonomy of the central bank and the conduct of monetary policy
2. to know how monetary policy is being managed in correlation with the governments own policy
3. To understand why fighting inflation and economic stability is so difficult for monetary policy to achieve.

1.4 HYPOTHESES OF THE STUDY

H0: There is a negative relationship between the effectiveness of monetary policy and the                       fiscal policy existing in the economy

H0: fiscal deficits give rise to money supply

1.5 SCOPE OF THE STUDY

The scope of the study covers the period of 1985 to 2004. This is because the economic instability started since the late 1970’s and intensive monetary policy and fiscal dominance since late 1980’s or there about. The selected scope therefore, will help in tracing the relationship between the central bank’s policy decisions and the governments’ decisions and how they have affected the economy.

1.6 TYPES OF DATA

Due to the nature of the study in review, the secondary data will be used. This is because of the time lag and records are on time series. Thus it would be appropriate to use the annual time series data.

1.7 SOURCES OF DATA

The source of the required data (statistical data) would be from the following sources;

a)      The central bank’s statistical bulletin

b)      The central bank’s Annual reports and statements of account.

c)      The federal office of statistical bulletin

d)     The internet.

1.8 JUSTIFICATION OF THE STUDY

The problem of managing monetary policy in an economy where its fiscal policies existing overrides the implementation and effects of the monetary policies in the control of revenues is very disturbing, but still an issue that has not fully come to light.

Fiscal dominance, resulting from excessive deficits financed through money creation, is the bane of macroeconomic stability in West Africa.

Put differently, the days of ways and means advances, underwriting and direct purchase of debt instruments, including treasury bills, and treasury certificates, will soon be a thing of the past.

1.9 DEFINITION OF TERMS

Fiscal policy: this refers to the whole range of government’s taxing and spending decisions. This that part of government policy which is concerned with rising revenue through taxation and other means and deciding on the level and pattern of its expenditure.

Fiscal dominance: Fiscal dominance is a situation whereby fiscal policy is set exogenously to monetary policy in an environment where there is a limit to the amount of government that can be held by the public.

Fiscal deficits: this is as a result of excessive spending by the government of an economy. It is a situation where by the government spends more than it receives over a period of time, that is to say it accumulates over time. Put in other words, it is when the government is not operating a prudent fiscal policy.

Public debt: public debt is the accumulation of deficits that the governments have run into. It is the sum total of debt owed by a country. It could be domestic or external.

Monetary policy: theses are measures designed to regulate and control the volume, cost availability and direction of money and credit in the economy to achieve some specified macroeconomic policy objectives.

Monetary management: monetary management refers to the process in which monetary policy is used to maintain macroeconomic stability.

Monetary authorities: this is the monetary authority that is responsible por the management of monetary system. In Nigeria, the CBN is the sole monetary authority responsible for supervising the monetary system.

Central Bank’s Autonomy: this refers to the level of freedom given to the central bank to carry out its monetary functions in achieving its primary objective which is basically control money supply to fight inflation.