TRANSMISSION MECHANISM OF MONETARY POLICY IN NIGERIA By SAMUEL OLATUNDE OREKOYA (Matriculation Number: 118305) Bachelor of Science in Economics (O. A. U., Ile-Ife) Master of Science in Economics (U.I., Ibadan) A Thesis in the Department of Economics, submitted to the Faculty of the Social Sciences in partial fulfilment of the requirements for the award of the degree of DOCTOR OF PHILOSOPHY of the UNIVERSITY OF IBADAN NOVEMBER 2011 i ABSTRACT The Central Bank of Nigeria (CBN) has pursued, among other goals, low and stable domestic price level and output growth using various monetary policy instruments. Despite these efforts, output growth rate averaged 1.32% between 1980 and 1989 and 2.87% between 1990 and 1999. Also, the monetary authority’s inflation rate target of 5.00% in 1992 and 31.00% in 1995 escalated into 44.59% and 72.81% respectively. There has been limited attempt to investigate the channels through which monetary policy affects output and prices in Nigeria. This study, therefore, empirically investigated monetary policy transmission mechanism and sought to establish the relative effectiveness of various monetary policy instruments in Nigeria. A Monetary Transmission Mechanism (MTM), predicated on Mishkin framework, that captures the impact of monetary policy in an economy was employed. The MTM focused on bank lending, exchange rate and interest rate channels that are evident in most developing economies like Nigeria. A Structural Vector Autoregressive (SVAR) model, based on monetary policy transmission dynamics, which identified the magnitude and impact of structural shocks, was developed to test the importance of these channels. Generic, composite and separate models including the impulse responses of the channels were estimated. Variance decomposition was also conducted to determine the magnitude of fluctuation attributable to different shocks. With quarterly data from 1970 to 2008, the time series properties of the models’ variables were ascertained using the Augmented Dickey-Fuller and Phillips-Perron tests. The effectiveness of Reserve Money (RM) as a monetary policy instrument over Interest Rate (IR) was evident as a marginal increase of 0.15% in RM precipitated output and prices decline by 0.20% and 0.60% respectively. The weakness of interest rate (IR) as a policy instrument was shown with an increase of 2.02% in IR yielding no significant response from output and prices. Bank lending declined from 0.89% in the first quarter to 0.23% below the baseline in the second quarter following a marginal increase of 0.05% in RM. Output declined consequently below the baseline by 0.12% and 0.15% while prices rose by 0.15% and 0.10% in the second and third quarters respectively. By implication, the weak response of exchange rate to similar increases in IR of 2.02% and RM of 0.15% suggests that this channel did not capture MTM in Nigeria. Also, output and prices’ non-response to increase in IR of 2.02% and RM of 0.15% suggested that interest rate channel is weak. Bank lending channel remained the existing MTM in Nigeria, while the impact of monetary policy shock on output and prices occurred only after a time-lag of 6years. Reserve Money was a potent policy instrument with output responding more to policy variations than prices. Bank lending remained a significant channel for propagating policies to target variables. The CBN should therefore focus more on the use of RM as a policy instrument rather than a hybrid of reserve money and interest rate. There should also be emphasis on price level stability since this has the tendency of fostering output growth. Key words: Output, Price level, Monetary policy, Monetary transmission mechanism, Structural vector autoregressive. Word count: 492 ii DEDICATION This doctoral thesis is dedicated to my Lord and King; El Elohim Israel. He is the GOD of all Glory, the Author and Giver of knowledge. iii ACKNOWLEDGEMENTS My GOD and my Father; this is thanking You for making good your promise to be with me at every stage of this doctoral journey both at home and abroad. You sent men who stood out as gems among their peers to mould me into what you desire me to be. To these chosen treasures who laboured on me during the core-courses and electives stages in the University of Ibadan and at the JFE in Arusha Tanzania: Professors Akin Iwayemi, Sam Olofin, Olawale Ogunkola, Adeola Adenikinju, Oluwole Owoye, S.I Ilori, Festus Egwaikhide, Tomson Ogwang, Tafa Edokat, Drs Fidelis Ogwumike, Thompson Ekanem, Adam Mugume, Eugene Kouassi and Sanni Badayi, I pray God’s unending favour upon all the fruits of their loins My profound appreciation to Professor Ademola Oyejide, my thesis committee chair, for taking the pains to read through the various drafts as well as providing the needed encouragement and guidance at different stages of the work. Honestly, you are a true father. Sir, even though I am and will always remain greatly indebted to you, I can only trust God to fully repay you. I also appreciate in no small measure the effort of my other supervisors; Professor Wale Ogunkola for the unrestricted access you offered me to reach you for counsel, advice and even the tweaking. Honestly, Uncle Wale, you are just unique to me and I will forever appreciate knowing you. Also Dr Abiodun Folawewo for your understanding and the assistance you gave when the initial work needed direction and focus. I pray God of all glory to perfect all that concerns you. With deep gratitude, I acknowledge the contribution of all the other lecturers in the Department of Economics, University of Ibadan; Drs Remi Ogun, Lanre Olaniyan, Biodun Bankole, Adeolu Adewuyi, Omo Aregbeyen, Yinka Lawanson, Alarudeen Aminu, Tunji Babatunde, Babajide Fowowe, my dear friend Bimbo Oyinlola (“Clean Thing”) and Elisa Olubusoye of Statistics Department. Your comments during my “several” seminar presentations and personal interactions helped a lot in improving the quality of the work. There are several other administrative staff of the department deserving a place in this work. Mrs Paulina Okebugwu (Aunty P) remains outstanding in terms of her response to distress calls both at home and from abroad. You are just too wonderful. May His Grace ever abound in your life. My sincere gratitude to the departmental IT technocrat, Mrs Ojebode, for her invaluable assistance right from the master’s degree period together with her brother Tay. Aside from your readiness to help even when it is glaringly inconvenience, your approachable iv disposition and smiles were encouraging. Mrs Adeosun’s warm smile and reception provided the needed comfort at a crucial stage of the programme. May the favour of God always locate you and all that are yours. I also want to appreciate the encouragement of my dear friends and some colleagues: Drs Eric Ogunleye (Cantona), Tosin Adeniyi (Saino), Jemilat Yaqub, Ibrahim Kargbo (BIB), William Bekeo, Idowu Olayinka (Double Mayor), Dayo Olutade (D1), Henry Hundjo (Baleco), Toyin Fashae and Messrs Abidemi Abiola, Ayoola Omojolaibi, Olusegun Omisakin, Afolabi Olowookere, Kilishi Abdulhakeem, Babatunde Ekundayo (Noble), Biola Oresajo, Riskat Balogun, Anthonia Odeleye, Felix Adekunjo, Sunkanmi Odubunmi, Dele Ogunbayo (Doexy), Gbenga and Funke Olamigoke, Funmi Odubiyi, Akeem and Banke Adepoju, Damilola Akinbami, Pere Benson, Tosin Ogunrounbi, Femi Ibrahim, Wunmi Obembe, Bolaji Oyewole, Bunmi Ibigbami, Itoro Akpan, Doyin Ariyo-Adeniyi, Salmat Saibu,Taiwo Ayantunji, Ayo Adigun and Temilade Faleti. Thanks for all the support. To my very dear students some of who are already my junior colleagues; Adefolajuwon Adekoya, Omotilewa Jaiyeola Lawal, Ifeoluwakiitan Jeje, Oluwatoyin Fashua, Oyindamola Adejumo, Tobi, George Igiehon, Babatunde Akinmoladun, Fadekemi Ajakaiye, Bukola Babatunde, Yinka Otesile, Bamise Oyewole, Joshua David Oduntan, Akintola Akinola and those of you outside the “dy/dx” unit like Ige Babatunde, Maryam Adefuyi, Okemute Ogbeni, Onyiye, I challenge you to “seek not yet repose”. To my fellow Balewites and colleagues in this dynamic struggle especially Mrs Mercy Koroyin (and my family viz Preye, Tare, Tj, MamaB and Dise Fiepere), Dr Anarado, Aunty Meg, Gloriah Momoh, Krystal Strong, Patrick and Ada Chieze, Esenowo Kokoete, Colman Goji, Daddy Odeseye, Waheed Ashagidigbi, Dr Ijeoma Egeonu, Dr Justina Porbeni, Dr Marie Octavie, Joyce Tondo, Blessing Eboigbe Oligbi, Subulade Olaniyan, Anna Tizhe, Mohammed Shaibu, Sam Omenka, Foluke Olorunfemi, IfeOluwa Kayode, Comrade Olutusin, Clement Meseko, and so many others that I cannot cover for want of space. I love and appreciate you all. To you all for providing support when all hopes seems gone; Sesan Ajala (My Prof.), Olumuyiwa Akinola Ajayi (for the laptops), Dr Akanni Akinyemi, Dr Victor Ola-Akande, Ebun Odeniyi, Ambrose Oke, Osborne Iweka, Tunde Ogundele, Dele Olaitan, Biodun Awodipe, Mike Smith and Tope Adeniyi. May the pillar of support in your live never disappear. v My family in The Latter House, Ibadan; Pastors Yomi & Funke Odeleye and their wonderful children (Bunmi, Moyo, Adeniran and Saino) for being there at all times as a true family and making their abode a home for me, Pastors Niyi & Deborah Olorunkosebi and my team in the house (Prof, Kemogxy and G.O.K) for the financial and moral supports, Pastors Segun & Bisi Ajayi (and their children Miye, Toyo and Tooni) for your prayers, Prophet Adegbola Adeniyi for standing by me, Pastors Akindolani & Aralola Olusuyi (not forgetting my dear Oluwafeyisayo) for being a source of encouragement and Pastors Ayodeji & Funlola Olorunda. I pray God for multiple rewards for all you have done during this travail. Also to my wonderful friends and families God brought across my path in the house; My Mother in the house - Prof. (Mrs) Longe, my very dear friend Seyi Akanbi (and her wonderful kids Tobi and Tomi), Elder Bode and Mrs Bose Oyewole, Pastors Wale Adeyemo, Jide Adeniran and Taiwo Joseph (and their wonderful families), Mr Oyewole and Mrs Toyin Adegoke (and my baby girl Oluwatooni), Bro Tunde & Dr Boladale Adebowale, Bro.