Adebiyi, Michael Adebayo, Phd

Monetary Policy Transmission Mechanism in an Estimated Dynamic Stochastic General Equilibrium (DSGE) for the Nigerian Economy

by Adebiyi, Michael Adebayo, PhD Central Bank of Nigeria, Nigeria E-mail [email protected] or [email protected] Tel: 234-0946235913 or 234-8073356300 & Charles N.O. Mordi Central Bank of Nigeria E-mail [email protected] Tel: 08037851373

Keywords: DSGE Model, Monetary Policy Transmission Mechanism, Nigeria JEL Classification Numbers: E52, C22, C51

EXTENDED INTRODUCTION

1 Substantial research work has been conducted in the area of monetary policy transmission mechanism (MPTM) in many countries focusing on the empirical analysis of how monetary policy shock affects output, prices, exchange rates, as well as other key economic variables (Christiano, Eichenbaum, and Evans, 2000; Kim and Roubini, 2000; Peersman and Smets, 2003; Saxegaard, 2006; Ceng, 2006; Chmielewski, 2005; Al-Mashat and Billmeier, 2007; Agha et. al., 2005; Mayes 2004 and Goeltom, 2008; Taylor, 1995; Mohanty and Turner, 2008 and Bernanke and Gertler, 1995). Using different methodologies covering different periods, the summary of the findings is as follows: first, that excess liquidity in the sub-Saharan African weakens the MPTM and thus hinder the ability of monetary authorities to influence demand conditions in the economy; second, that low inflation is associated with higher openness in the South African economy; third, that an exogenous increase in the short-term interest rate tends to be followed by a decline in prices and appreciation in the nominal exchange rate in Kenya, but has insignificant impact on output; fourth, that banks tend to reduce credit supply after a monetary tightening and less capitalised banks are more vulnerable to react to a monetary tightening in Poland; fifth, that the exchange rate channel continues to play an important role in the transmission of the monetary policy in Egypt; sixth, that the role of bank lending is prominent because of the dominance of the banking sector; seventh, that firms’ balance sheet variables are very important determinants of the firms’ investment in Indonesia and that small firms are more sensitive to balance sheet changes than large firms; eighth, that expected inflation is determined predominantly by the exchange rate, past inflation, and the interest rate in Indonesia; and lastly, that interest rate channel plays a dominant role in the transmission process in a developed financial system.

In Nigeria, past studies on the channels of MPTM included, among others, Oke (1995), Uchendu (1994), Ojo (2000), Adebiyi (2006) and CBN (2008). The main empirical results of these papers are that (i) the interest rate channel of monetary policy appears to be weak in Nigeria; (ii) the credit and exchange rate channels are very pronounced; (iii) expectation channel plays a very limited role in transmitting monetary shocks to the economy; and (iv) the dominance of the channels of MPTM is influenced by regime shifts and structural breaks in Nigeria.

2 Thus, the identification of the dominance of the channels of MPTM, which is critical to the proper design, management, and implementation of monetary policy, has not been clearly addressed in the Nigerian financial system. Until recently, the monetary authority in Nigeria was confronted with the enormous challenges of conducting monetary policy in the face of unclear directions and speed. Identifying the channels of transmission of monetary policy is important because they determine the most effective set of policy instruments, the timing of policy changes, and hence the main challenges that central banks face in decision making. Since there are lags in the transmission mechanism (i.e. between monetary policy initiatives and their impact), the chain of events emanating from a change in central bank policy rate or base money needs to be studied and analyzed. The knowledge of these intricate links between economic variables will ensure that correct policy measures are taken to produce specific outcomes in the future.

The focus of this study is to empirically investigate the monetary policy transmission mechanism in Nigeria using DSGE model. Specifically, the paper intends to examine credit rate, interest and exchange rates channels of monetary policy transmission with the objective of exploring their strengths, speed of transmission and ultimately determining the more dominant channel. The paper also attempts to forecast output and price based on the baseline model developed. The outcome of the study is expected to guide policy choices for a more effective monetary management.

The rest of the paper will be structured as follows. Section 2 will briefly describe the appraisal of monetary policy in Nigeria, while Section 3 will discuss basic structure of DSGE models. Section 4 will focus on the microfoundation of a DSGE model. Section 5 will present the methodology, covering model set-up, description and calibrations, while section 6 will provide the results and interpretations. Section 7 will give the summary, conclude and provide policy implications.

3 REFERENCES Adebiyi, M. A. (2006). Financial Sector Reforms and Impact of Monetary Policy Shocks in Nigeria: An Implication of Vector Autoregressive (VAR) Model. In: Heterodox Views on Economics and the Economics of Global Society, Published by Wageningen Academic Publishers, Netherlands, Edited by Meijer G., Heijman W.J.M., Van Ophem, J.A.C and B.H.J. Verstegen. Mansholt Publication Series Vol. 1, pp. 359-376 Agha, A. I., Ahmed, N., Mubarik, Y. A. And Shah, H. (2005): “Transmission Mechanism of Monetary Policy in Pakistan”. SBP Research Bulletin Vol. 1, No. 2.

Al-Mashat, R. and Billmeier, A. (2007): “The Monetary Transmission Mechanism in Egypt”. International Monetary Fund, Working Paper (WP/07/285).

Bernanke, Ben and Mark Gertler (1995), “Inside the Black Box: The Credit Channel of the Monetary Policy Transmission," Journal of Economic Perspectives, Vol.9, No. 4, pp. 27-48.

CBN (2008). The Monetary Policy Transmission Mechanism in Nigeria, Central Bank of Nigeria, Research Department, forthcoming Cheng, K. C. (2006). A VAR Analysis of Kenya’s Monetary Policy Transmission

Mechanism: How Does the Central Bank’s REPO Rate Affect the Economy? IMF Working paper Series WP/06/300

Christiano, L., M. Eichenbaum, and C. Evans, 2000, “Monetary Policy Shocks: What Have We Learned and to What End?” in Handbook of Macroeconomics (Amsterdam: North Holland).

Goeltom S. M. (2008): “The Transmission Mechanisms of Monetary Policy in Indonesia” In “Transmission Mechanism for Monetary Policy in Emerging Market economies” BIS Papers, No. 35.

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Peersman, Gert and Frank Smets, 2003, “The Monetary Transmission Mechanism in the Euro Area: Evidence from VAR Analysis,” Monetary Transmission Mechanism in the Euro Area, Cambridge University Press Saxegaard, Magnus, 2006, “Excess Liquidity and the Effectiveness of Monetary Policy: Evidence from Sub-Saharan Africa,” IMF Working Paper, No. 6/115. Taylor, John B. (1995) "The Monetary Transmission Mechanism: An Empirical Framework," Journal of Economic Perspectives, Vol. 9, No. 4, pp. 11-26. Uchendu, O. A. (1994): “The Transmission of Monetary Policy in Nigeria”, CBN Economic and Financial Review, Vol 33, No.2 June.