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AN ASSESSMENT OF THE RELATIONSHIP BETWEEN MONEY SUPPLY, INFLATION AND OUTPUT IN NIGERIA (1970-2016)
1.1 Background to the Study
The relationship between money supply, output and prices is a pertinent issue in economics. It is a relationship that has prompted an unending probe by central bankers and academicians from the time of the Classical quantity theorists in the 20th century to the monetarists in the 1950-1960s to date. The classical economists view money supply as the only factor responsible for inflation through the demand channel. They give more importance to monetary policy in stabilizing the economy. The Keynesians on the other hand opine that when thereis under unemployment in the economy an increase inthe money supply leads to an increase in aggregate demand, output and employment only in the short-run (Hussain, Faarooq&Akram, 2010).
While the Classicals‟ view the aggregate supply (AS) curve as vertical as any increase in money supply leads to increase in prices only, the Keynesians contend that, is an inverted L-shape. As a result, in the long–run there is no effect of money and therefore, the Keynesians recommend the use of fiscal policy in stabilizing the economy (Hussain, et.al. 2010).
According to Waliullah&Fazli-Rabbi (2011), all plausible economic explanations about the relationship between money supply, output and prices have become a debate between two major schools of thought, that is the Keynesian and monetarist schools of thought. According to the Keynesians, in the Hicks-Hansen IS-LM model, money affects output positively through changes in the rate of interest; i.e. changes in money stock are induced by changes in income and not vice versa. In other words, Keynes believes that so long as there is unemployment, output will change with a change in the quantity of money without affecting prices; and contrariwise
when there is full employment (Gatawa, Abdulgafar&Olarinde, 2017). On the other hand, monetarists contend that money has a direct and proportional effect on output. However, in the long-run its effect on income is neutralized, since prices change proportionally to change in money leaving the real value of income unchanged.
It is widely acknowledged that inflation inhibits growth (see: Waliullah&Fazli-Rabbi 2011; Babatunde&Shuaibu 2011). Conversely, Tobin (1965) posits that inflation spurs growth via capital accumulation and interestingly, Mishra, Mishra & Mishra (2010) provide empirical support for Tobin‟s supposition in India. This raises the question of whether inflation promotes or retards output growth.
In Nigeria, output growth and inflation have exhibited significant fluctuations over the years and have witnessed substantial changes since the country‟s attainment of political independence in 1960. Boosting the level of output is of utmost importance given its impact on the standard of living. The Nigerian economy is characterized by structural challenges that limit its ability to sustain growth as the economy is highly dependent on a single commodity for economic activities, fiscal revenues and foreign exchange – oil. For example, the high growth recorded during 2011-2015, which averaged 4.8% per annum is mainly driven by higher oil prices (Ministry of Budget & National Planning, 2017). Interestingly, this oil money is also capable of increasing the price level.
Inflation has been an issue ofconcern to policymakers in Nigeria in recent years, given the need to stimulate domestic demandand to meet government‟s huge fiscal obligations in a post-recessionary period (Babatunde&Shuaibu, 2011). In the Nigerian context, money supply has contributed to the increase in general price level through demand channel ever since the proceeds of oil started flowing into the economy (see: figure 2.1). However, this massive supply
of money has over time failed to translate itself into meaningful development. Inflation is not only a global economic problem but has proven to be very difficult to tackle (CBN, 1974). This is because the forces causing inflation are multifaceted- monetary,demand-pull, cost-push and structural components. As such, difficulty is often encountered in identifying the causes of a particular type of inflation which is the basis for solving the problem.
In Nigeria, one of the cardinal objectives of the Central Bank of Nigeria (CBN) is to maintain price stability (Oyinpreye& Moses, 2014). This is done by ensuring that the rate of inflation is maintained within single digit. This is achieved through the proper management of the quantity of money cost of borrowing, credit expansion capacity of Deposit Money Banks (DMBs) and exchange rate. According to Ojo (2013) the CBN believes that inflation is caused primarily by the persistent expansion in money supply and if there is any apparent solution to the problem of inflation, it lies in the reduction of money supply. But this might adversely affect output growth. Sharew, Wassie&Adugna, (2016) hold similar opinion as they posit that, excessive expansion of the supply of money causes inflation which may in turn inhibit output performance.
In a bid to maintain macroeconomic stability, the apex bank changes the direction of policy in line with emerging developments. For example, during a recession, there is low demand which tends to increase unemployment. This means that the monetary authority responds by increasing money supply in order to boost consumption, production, employment and investment. Therefore monetary aggregate that make up the monetary policy transmission are vital for attaining price stability and increasing output.
Nigeria plunged into recession in the second quarter of 2016 as real GDP growth rate was recorded at –1.58%. In 2017, real GDP turned to positive growth in the second quarter and
sustained its acceleration on a year-on-year basis. Annual real GDP growth rate in 2017 was recorded at 0.82%, signifying economic recovery when compared to corresponding time in 2016 (NBS, 2017). The recovery was due to oil price recovery, fiscal spending and stability in the foreign exchange market (CBN, 2017). On liquidity management, CBN sustained a non-expansionary monetary policy stance in the first half of 2017 to ensure price stability, as high inflation and foreign exchange demand pressure remained the main challenges. As such, Growth in major monetary aggregates was maintained at generally low levels. As broad money supply (M2) and narrow money supply (M1) fell by 7.3 and 10.7 % (CBN, 2018). Hence, the general price level decelerated in the first half of 2017 as the year-on-year headline inflation declined consistently throughout the review period from 18. 7 % in January to 16.1 % at end-June 2017, compared with 18.6 and 16.5 % at end-December and end-June 2016, respectively(NBS, 2017)..
On the whole, there seems to be light at the end of the tunnel as the government rolled out the Economic Recovery and Growth Plan coupled with its renewed effort in trying to diversify the economy, CBN, (2018) believes that the economy will be strengthened.
1.2 Statement of the Research Problem
The Keynesians posit that in an economy that is below full employment level like Nigeria, an increase in money supply will increase output through the demand channel while leaving the level of prices unchanged (Hussain et. al. 2010). It is also thought of as a policy tool to curb inflation (CBN, 2015). In other words, money supply as a CBN policy tool ought to be a driver of output capable of expanding the productive base of the economy particularly in the real sector activities which will consequently reduce the pressure on the overall prices of goods and services in the economy.
However, changes in money supply may not have had any appreciable impact on inflation and the output level in Nigeria over the years. This is because amidst several attempts to achieve a sustained level of output growth and to lower prices, the alteration of money supply seems to be effort in futility. In the words of Babatunde&Shuaibu (2011), Since 1960s, there has been massive injection of liquidity into the economy arising from rapid monetization of oil inflows, minimum wage adjustments e.t.c. For example, the money growth rate was at 29.7 % and 44 % in 1962 and 1969 respectively, the GDP only grew at an average of 2.5 % annually throughout that period (CBN, 2012). However the opportunity cost of this seemingly increases in output was even at the expense of increase in the level of prices. It is on record that inflation increased from 6.4% in 1961 to 12.1% in 1969 and climbed to 33.9% in 1975.
Also, available data from CBN (2012) revealed that on the average, from 1980 to 1990, money supply growth rate and inflation stood at 18.09 and 19.66 respectively, whereas output contracted by 0.13%. In the same vein, during the period 1991 to 2000 money supply grew by 38.4% and this caused the inflation rate to have increased to 30.59% while leaving the output at 1.88% growth rate throughout the period (CBN, 2012).
This trend of sluggish growth amidst high level of inflation has continued to bedevil the Nigerian policy space up till the present time. Most recently, the GDP figures of the first and second quarters of 2016 contracted by 0.4% and 1.58% respectively. During the same periods, the monetary aggregate grew by 10.4% and 19%. Consequently, inflation rose to 17.85 % and 18.55 % in the last two quarters of 2016 (NBS, 2017).
Inflation negatively affects all economic agents. It makes locally produced goods and services less competitive, decreases the value of the local currency and widens income inequality. Conversely, Tobin (1965) argued that inflation spurs growth. In other words inflation hysteria causes money-holders to substitute their monetary asset with capital which in turnbooststhe level of output- the so-called “Tobin effect”. Interestingly, Mishra, Mishra & Mishra (2010) study conducted in India empirically supports the Tobin‟s supposition.
In Nigeria however, it is intriguing as could be empirically seen in figure 2.1 that the level of output as measured by the Gross Domestic Product (GDP) is increasing in the wake of surging level of prices. This gives rise to the following questions: does the “Tobin effect” hold in Nigeria? If yes, by how much?
To answer these questions, the following research questions need to be addressed:
(i) What is the impact of money supply on the output growth in Nigeria?
(ii) What is the impact of inflation on the output growth in Nigeria?
1.3 Research Objectives
The broad objective of the study is to assess the relationship between money supply, inflation and output growth in Nigeria with a view of ascertaining the existence or otherwise of the Tobin effect from 1970-2019. The specific objectives are to examine:
(i) the impact of money supply on the output level in Nigeria; and
(ii) the impact of inflation rate on the output level in Nigeria
1.4 Research Hypotheses
This study seeks to test the following hypotheses;
H01: Money supply has no impact on the output level of Nigeria.
H02: Inflation has no any significant effects on the output growth of Nigeria.
1.5 Justification of the Study
Keynesian economists opine that money supply increases output while inflation retrogresses output. On the flip side, Tobin (1965) opined that inflation drives output through increased level of capital stock-“the Tobin effect”. Mehrara and Musai (2011) studied ten oil exporting countries including Nigeria, Waliullah and Fazli-Rabbi (2011) studied Malaysia, Sharewet al (2016) in Ethiopia are all empirical works carried out in this area. Also, Adesoye(2012), Onayemi (2013), Abiodun (2014), Dan and Zungwe (n.d.) and lastly Gatawaet. al(2017) are similar studies conducted in Nigeria but none has paid attention to the existence or otherwise of the “Tobin effect” rather they studied causation, relationship and impact among the variables, primarily through the Quantity Theory of Money (QTM) and the Keynesians monetary theory. Noteworthy is that, these theories have their own inherent weaknesses (see: section 2.3). However, Babatunde&Shuaibu (2011) used the Tobin model as a framework with a view to analyzing the joint impact of both money supply and inflation on the economic growth of
Nigeria. The value addition here to their study is that this work has extended the data from 2011 to 2016 which covers the recent recession that Nigeria has faced.