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CHAPTER ONE
INTRODUCTION
1.1 Background of the Study
The use of economic policy as tool for economic stabilization by
governments of different economies of the world cannot be
overemphasized. Some of these policy measures may have economic-wide
effect (e.g. the budget and inflation) while others may have specific
effects such as the consumption tax on consumer good (Killick, 1981 and
Black, Calitz, Steenekamp, Ajam, 2000). Policymakers around the world
employ various policies, singly or mix, to stabilize the boom-bust
cyclical swings of economic activities. In macroeconomic management, the
two most commonly employed policies are the fiscal and monetary
policies.
The Monetary policy, managed by the Central Bank, is conducted through
changes in the money supply and interest rate. While the Fiscal policy,
which is managed by the government of that economy, is conducted through
changes in government spending and taxes (Liborio, 2011; Hussain,
Wijeweera and Hoang, 2012). Despite the fact that monetary and fiscal
policies are implemented by two different bodies, these policies are far
from independent. In fact, a change in one may influence the
effectiveness of the other and thereby the overall impacts of any policy
change. Since 1980s, there has been a general consensus among
economists in favour of monetary policy as a more effective
stabilization tool relative to fiscal policy (Mishkin, 2004; Mankiw,
2005; and Bullard, 2012), however, the recent global financial crisis of
2007 has renewed much interest on fiscal stimulus.
In recent times, policy makers are prompted to employ unconventional
actions to stabilize the national economy. Precisely, while monetary
policymakers turn to quantitative easing (the purchase of financial
assets so as to lower long-term interest rates, thereby increasing the
money supply), fiscal policymakers increase government spending and
reduce taxes so as to boost employment and output (Liborio, 2011). The
global economic meltdown, which persisted until 2009, had significant
adverse effects on the real economic activities of many developing
countries. For instance the Nigerian real GDP growth rate decline from
7.6 per cent in 2006 to 6.0 per cent at the onset of the crises in 2008.
The effect of the global crisis was pervasive and its adverse effect
remained noticeable in the areas of agriculture, industry and the
wholesale sub-sectors in Nigeria (CBN, 2009). Similar trends were also
observed in other countries of the world. To ensure that their economies
are insulated or protected from the possible negative effects of such
snowballing, many countries especially developing countries had resulted
to the use of domestic macroeconomic policy to re-engineer their
economy and provide some policy palliative that can assist in
stabilizing their economies.
Nigeria in particular had, in response to the global economic crisis,
introduced both monetary and fiscal stimuli as proactive measures to
prevent the economy from nose-diving into further economic depression.
The policy measures adopted by government were mainly on three broad
fronts namely: monetary policy, fiscal policy and trade policy. In
Nigeria, fiscal and monetary policies (especially the tools of
government expenditure, money supply and monetary policy rate (MPR))
have been extensively used by the government and other policy makers to
stimulate output. In order to appreciate the policy-source of these
variations in output performance over the years, it is necessary to take
a retrospective look at the conduct of fiscal and monetary policy in
Nigeria.
1.2 STATEMENT OF THE PROBLEM
Over the years, fiscal and monetary policies have been choicely employed
by policy makers in Nigeria to influence and stabilize the behavior of
the aggregate economy, with more focus on the tools of government
expenditure, broad money and monetary policy rate (MPR) as the operating
instruments. However, neither of these policies individually, could be
unanimously said to have effectively stimulated economic performance
consistently over time. For instance, evidence from CBN (2012) shows
that, for the period 1974-75 (early days of monetary targeting),
government expenditure increased by 117%, money supply rose by 80%,
interest rate fell by 50 basis points but, surprisingly, output dipped
by 5.2% in the same period. Whereas, in 1993-94 period (early days of
partial monetary instrument autonomy), government spending fell by 16%
while broad money rose by 34.5%, interest rate fell by 12500 basis
points and output rose by a paltry rate of 0.1% for that period.
Meanwhile in 2004-05 fiscal year (under the medium-term fiscal
framework), government expenditure climbed 28% while broad money grew by
24%, interestingly, interest rate dipped 200 basis points and output
increased by 5.4%. Surprisingly in 2010-11 fiscal period (under the new
monetary policy framework), when government expenditure grew
insignificantly by 2.5% but with significant growth in broad money by
15.4%, interest rate rose by more than 300 basis but still, output
increased by 6.7% in the same period.
However, it is pretty difficult for policy makers to ascertain which of
the fiscal and monetary actions is actually responsible for driving the
economy at a specific point in time, and how the interaction between
them have enhanced or inhibited output performance in Nigeria. In an
attempt to unravel the uncertainty around fiscal and monetary policy
effectiveness and interactions, various studies have been conducted,
with different approaches. In fact, country-specific evidences on
Nigeria have shown diverse results with two main strands; some in favour
of monetary policy effectiveness (e.g. Ajayi, 1974; Asogu, 1998;
Adefeso and Mobolaji, 2010; Okpara and Nwaoha, 2010; Iyeli, Enang and
Emmanuel, 2012) while a few of them favours fiscal policy effectiveness
(Aigbokhan, 1985; Egwaikhide, Enoma and Saheed, 2012).
The pro-monetary effectiveness studies argue that the effectiveness of
the government fiscal policy in a country like Nigeria is very doubtful.
Their argument is premised on the fact that: first, for many years,
government has been practicing budget of incremental which has had
little correlations with obtained economic performance. Even with the
implementation of the Medium-Term Fiscal Framework (MTFF) since 2010,
budget performance still remains abysmal. Secondly, the Nigerian economy
comprises of a very huge informal sector which is largely untaxed and
unaffected by the various tax reforms of the government over the years,
thereby making the reforms less effective (Ogbuabor, 2013). More so, the
rising trend of government spending over the years seems to have little
correlation with growth. Evidence from research has shown that, many a
times, large chunk of government expenditure for a proposed project is
lost to corruption and individual’s subjective utility maximization of
the bureaucrats while a little proportion of it actually trickles down
for grassroots development, thereby making government spending to have a
very weak link, or at best erratic effect, on output performance which
is contrary to some theoretical postulations (Ajisafe and Folorunso,
2002; Abata, Kehinde and Bolarinwa, 2012).
In a similar way, the pro-fiscal effectiveness studies argue that, in a
developing country like Nigeria, where the financial system is at best
rudimentary while government plays a significant role in major sectors
of the economy, monetary policy conduct is most likely difficult with
very few chances of influencing the aggregate economy significantly.
They premised their argument on the fact that: first, due to the weak
structure of the economy’s financial system, the CBN policy rate
(MRR/MPR) which is the primary signal of the money market seems to be
weak in channeling financial resources from surplus spending units to
deficit spending units. This implies that interest rate may not be the
stimulating/deciding factor in saving and investment decisions in the
Nigerian economy (CBN, 2010). Corollary to this is the weak link between
interest rates and aggregate output performance of the economy. For
instance there were some periods where the policy rate (MRR/MPR) was
constant (e.g. 1970-74, 1984-86, 1994-97, 2012-13Q1), however, the
economy posted significant growth differentials for same periods, which
is contrary to economic theory (CBN, 2012).
Furthermore, recent evidence reveals that, due to the structural
imbalance in the real (productive) sector of the Nigerian economy,
growth in money aggregates translates into inflation rather than
output/productivity growth, thereby leaving monetary policy conduct with
much questions than results (Egwaikhide, Enoma and Saheed, 2012).
Despite the plausibility of various arguments portrayed by these strands
of studies on Nigeria, most of them did not consider any form of
interaction between fiscal and monetary policy, and a need for
policy-mix in their analysis of policy management, which might have
affected their outcomes. Whereas, recent evidences on macroeconomic
policy management have shown that for effective performance of both
fiscal and monetary policy, individual policy transmission is not
sufficient, rather, there is a need for policy-mix or interaction as
well as a mutual coordination between fiscal and monetary authorities
(Leith and Thadden, 2006; Raj, Khundrakpam and Das, 2011). And it is
expected that the nature of this interaction, complementarily or
confliction, between these policies may have severe consequences on
their ability to effectively stabilize the economy or dampen business
cycles (Okafor, 2013).
In the light of the above analysis, one may wonder how fiscal and
monetary policies interact with each other in Nigeria; the nature of
interaction between them – whether these policies conflict (substitute)
rather than complement each other or whether any of the policies
dominates the other in the process of transmission; how these policies
have influenced economic performance, both singly and interactively; why
these policies have continually missed their economic targets and how
they can be used to mitigate external shocks in a different exchange
regime despite the special attention given to them and the cost of
running them; and what institutional framework need to be put in place
in order to harness the potency of these policies, singly and
interactively. It is therefore necessary to investigate the level to
which this interaction can transmit in to an effective output
performance (effective demand management policy) and guide against
external shocks. Guided by the Killick’s (1981) criteria for assessing
policy efficiency, this study therefore, seeks to answer the following
questions:
1. What is the nature of interaction between fiscal and monetary policy in Nigeria over time?
2. How does fiscal and monetary actions transmit to output response in Nigeria?
3. Can this policy mix mitigate the degree of openness in Nigeria?
1.3 OBJECTIVE OF THE STUDY
The broad objective of this study is to analyze the role of policy
interaction in the assessment of the relative effectiveness of fiscal
and monetary policy on output response in Nigeria growth. The Specific
objectives are to examine the:
1. nature of interaction between fiscal and monetary policy in Nigeria over time
2. transmission mechanism of fiscal and monetary policy on output
3. analyze the impact of policy mix on the degree of openness in Nigeria
1.4 RESEARCH HYPOTHESES
In line with the specific objectives of this study, this research shall be guided by the following hypotheses:
Ho1: There is no interaction between fiscal and monetary policy mix in Nigeria.
Ho2: Fiscal and monetary policy mix does not transmit to output response.
Ho3: the degree of openness does not have impact on the Nigerian economy
1.5 SIGNIFICANCE OF THE STUDY
This study belongs to the area of Macroeconomic Public Policy (MPP)
which deals with policy simulation, evaluation and analysis within a
macroeconomic framework. By analyzing the interaction between various
fiscal and monetary instruments, this study shall improve the
understanding of the policymakers on the nature, extent and effect of
policy interaction on macroeconomics targets, like output, in Nigeria.
And the examination of the nature of policy interaction under different
policy regimes in the country shall guide the fiscal policymakers and
monetary authority on the optimal policy-mix for a specific target under
a similar scenario of a particular policy regime in the future. This
study shall guide policy makers of the policy mix that can mitigate the
impact of external shock on domestic economy. Also, the outcome of this
study shall help the government and the monetary authority to discover
some areas of weakness in the choice and usage of specific policy
instruments and how to improve on them for effective stabilization.
Moreover, the study shall help both fiscal and monetary policymakers to
design better policies, as well as make good economic forecasts based on
the chosen policy instruments.
Furthermore, the study shall add to the existing literature on the
interaction of fiscal and monetary policy, especially for developing
counties, like Nigeria, where the government has been playing a
prominent role while the financial system is at best rudimentary.
Finally, the study shall lend a voice to the ongoing advocacy for a
cordial and mutual relationship between the fiscal (government) and
monetary (CBN) authorities, especially in the area of policy management
and macroeconomic stabilization.
1.6 SCOPE/DELIMITATION OF THE STUDY
This research is a country-specific study concentrating on the Nigerian
economy. For relevance and in-depth analysis, the study span through the
period 1960-2014, the study considered annual data instead of quarterly
data, as is common in much of the literature. The main advantage of
using annual data is that the economic interpretation of external shocks
identified with quarterly data may be more problematic, as
(substantial) economic reversions do not usually take place at that high
frequency. Although there are many instruments of fiscal and monetary
policy that have been employed in empirical research, for the purpose of
this study, fiscal balance and interest rate shall be employed as
proxies for the respective policies, while output performance shall be
captured with GDP gap.
1.7 ORGANIZATION OF THE STUDY
This empirical study is divided into five chapters and, each of which is
further sub-divided. The first chapter is introduction. These include:
the introduction, background of the study, statement of the problem,
objective of the study, hypothesis of the study, significance of the
study, scope and delimitations of the study and organization of the
study.
In the second chapter, relevant theoretical and empirical literatures are reviewed.
Chapter three is the methodology. The researcher’s model is stated. The
sources of the data and their description, the estimation procedure are
all stated. Chapter four shows the presentation, analysis and
interpretation of results. The fifth chapter is the concluding part of
the work, under which the researcher states the summary of findings,
policy recommendation and conclusion.
1.8 Definition of Term
Economic policy: Economic policy refers to the actions that governments
take in the economic field. It covers the systems for setting levels of
taxation, government budgets, the money supply and interest rates as
well as the labor market, national ownership, and many other areas of
government interventions into the economy.
Fiscal Policy: In economics and political science, fiscal policy is the
use of government revenue collection (mainly taxes) and expenditure
(spending) to influence the economy. According to Keynesian economics,
when the government changes the levels of taxation and government
spending, it influences aggregate demand and the level of economic
activity. Fiscal policy is often used to stabilize the economy over the
course of the business cycle.
Monetary Policy: Monetary policy is the process by which the monetary
authority of a country, like the central bank or currency board,
controls the supply of money, often targeting an inflation rate or
interest rate to ensure price stability and general trust in the
currency.
Economic Diversification: Economic diversification can mean different
things depending on the context. The predominant way of thinking about
it is what is known as economic complexity, which is the idea that
countries should not be dependent upon a small number of products for
their economic livelihoods.
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