PRICE STABILITY EFFECT OF MONETARY POLICY AND OUTPUT GROWTH IN NIGERIA: A TIME SERIES ANALYSIS


Abstract
In the past decade, significant changes in the design and conduct of monetary policy have occurred around the world. Many developing countries, including Nigeria have adopted various policy measures to achieve targeted objectives. The monetary policy is essential to achieve desired objectives which traditionally include promoting price stability. The estimated results revealed that the first lag of price gap, current money supply gap, first lag of money supply gap, current real output gap and first lag of real output gap exert positive influence on current price gap in Nigeria between the inception of a decade after independence and 2011 fiscal year and it was only the effect of real output gap that does not conform with the theoretical expectation. While, second lag of price gap exerts negative effects on inflationary pressure in Nigeria during the review periods and this does not conform to the apriori expectations based on sign. Also, the Johansen cointegration test result indicated evidence of long-run relationship. The study recommends that the monetary authority should endeavour to strengthen the effectiveness of the major instruments of controlling money supply in order to decelerate its effect in influencing inflation pressure in Nigeria.


Keywords: Price stability, monetary aggregate, output growth rate, macroeconomic policy gap, Nigeria

Journal of African Macroeconomic Review Vol. 4, No. 1 (2013-2014)

I. Introduction
In the past decade, significant changes in the design and conduct of monetary policy have occurred around the world. Many developing countries, including Nigeria have adopted various policy measures to achieve targeted objectives. The monetary policy is essential to achieve desired objectives which traditionally include promoting economic growth, achieving full employment level, reduction in the level of inflation, maintenance of healthy balance of payment, sustenance of growth in the economy, increase in industrialization and economic stability. The monetary policy is essential to achieve desired objectives which traditionally include promoting economic growth, achieving full employment level, reduction in the level of inflation, maintenance of healthy balance of payment, sustenance of growth in the economy, increase in industrialization and economic stability. The smoothing of the business cycle, preventing financial crisis and stabilizing long term interest rates and the real exchange rate have been identified recently as other supplementary objectives of monetary policy because of the weaving global financial crisis which engulfed major developed and emerging economic in the world (Mishra and Pradhan, 2008). The central bank is responsible for the conduct of monetary policy to pursue those objectives. Central banks in the world such as the Central Bank of Nigeria (CBN), often employ certain monetary policy instruments like bank rate, open market operation changing reserve requirements and other selective credit control instruments. Central bank also determines certain targets on monetary variables. Although, some objectives are consistent with each other’s, while others are not, for example, the objectives of price stability often conflicts with the objectives of interest rate stability and high short run employment. This often constitutes problems of policy mix in achieving a certain macroeconomic objective such as price stability. Such conflict motivates this paper. The causal relationships between money and income and between money and prices have been an important area of investigation in economics particularly after the provocative paper by Sims (1972). Monetary policy plays an important role in boosting the economic growth of any country provided money is exogenously determined in the economy. Its impact on income and prices has been widely examined in the developed and developing countries in the context of Monetarists and Keynesians controversies (Abbas and Husain, 2006).These two very different theories explain the direction of causation between money, prices and income. According to the Monetarists money plays an active role and leads to changes in income and prices. Hence, the direction of causation runs from money to income and prices without any feedback. The Keynesians, on the other hand, argue that money does not play any significant role in changing income and prices. In fact, changes in income cause changes in money stocks through demand for money implying that there exists a uni-directional causality from income to money. Similarly, changes in prices are mainly caused by structural factors. On the basis of the foregoing discussion, it is evident that there is no clear and precise established relationship between monetary aggregate, output and price stability. Therefore, it would be imperative to add to support of the causal direction among inflation, output and monetary policy in Nigeria between 1970 and 2011. This ranges from the period of Pre Structural Adjustment Programme (SAP), Structural Adjustment Programme (SAP) and Post Structural Adjustment Programme (SAP).

II. Literature Review
The causal relationships between money, prices and income have been an important area of investigation in economics particularly after the provocative paper by Sims (1972). Budina et al
(2002) tested Money, inflation and output in Romania for the period 1992-2000 for stationarity, and found it to be integrated of order one. The authors applied the Johansen procedure for cointegration to test for the rank of the matrix of cointegrating relations (one), to test for the weak exogeneity of output (accepted), inflation (rejected) and money (rejected). They interpreted the unique cointegrating relationship as an extended Cagan money demand equation, and estimate error correction mechanisms, in which excess supply of real money contributes significantly to the short-run dynamics of inflation and real money. The evidence suggests than in the period considered, including the sub-sample between the liberalization shocks, inflation was largely a monetary phenomenon. Gilman and Nakov (2004) presents a dynamic general equilibrium monetary economy with a closed form solution for the income velocity of real money in which the exogenous money supply causes changes in the inflation rate and the output growth rate. While inflation and growth rate changes occur simultaneously, the inflation acts as a tax on the return to human capital and in this sense induces the growth rate decrease. Shifts in the model’s credit sector productivity cause shifts in the income velocity of money that can break the otherwise stable relation between money, inflation, and output growth. Applied to two accession countries, Hungary and Poland, a VAR system is estimated for each that incorporates endogenously determined multiple structural breaks. Results indicate Granger causality positively from money to inflation and negatively from inflation to growth for both Hungary and Poland, as suggested by the model, although there is some feedback to money for Poland. Hossain (2005) used annual data for the period 1952-2002 to investigate the inflationary process in Indonesia within the cointegration-and errorcorrection modeling framework. The empirical results suggest that the consumer price index (CPI), the stock of narrow (M1) or broad money (M2) and real permanent income form a (weakly) cointegral relationship for the complete sample period. This relationship remains broadly stable for several subsamples, especially when the model is estimated with a narrow definition of money. The dynamic relationship between money, output, prices, and the exchange rate is investigated within a general-tospecific error-correction modeling framework. The presence of a significant error-correction term implies that given economic growth, there existed along-run causal relationship between money supply growth and inflation.
Abbas and Husain (2006) re-examines the causal relationship between money and income and between money and prices in Pakistan. Using an annual data set for fiscal years 1959–60 to 2003–04 and employing co-integration and error correction models as well as the standard Granger causality analysis their investigated the bivariate and trivariate causal relationships. The co-integration analysis indicates, in general, the long-run relationship among money, income and prices. The error correction and Granger causality framework suggest a one-way causation from income to money in the long run implying that probably real factors rather than money supply have played a major role in increasing Pakistan’s national income. Regarding the causal relationship between money and prices, the causality framework provides the evidence of bi-variate causality indicating that monetary expansion increases, and is also increased by inflation in Pakistan. However, money supply seems to be the leader in this case. Bilquees, Mukhtar, and Sohail (2012) investigates the dynamic interactions among macroeconomic variables such as money supply, prices, interest rate, exchange rate and output level using a the quarterly data for Pakistan over the period 1972Q1 to 2009Q4. The Johansen multivariate cointegration technique, Granger causality test and variance decomposition are employed. The results indicate existence of coinetgartion, the outcomes of causality test tends to support the non-neutrality of money view of the Keynesians and the monetarists at least in the short-run. Also, they report a bi-directional causality between money supply and price level, and interest rate and price level. Ahmed, Asad, and Hussain (2013) analysed the fundamental relationship between money supply, prices and income in Pakistan was determined in this research study. The time series data of real gross domestic product (GDP), nominal GDP, prices and money supply for the period of 1973 to 2007 was used. The stationary properties of the data series were investigated with the help of ADF test and series were found integrated of the order zero. The results indicated a relationship between the growth of money supply and inflation in Pakistan during the study period. The estimated coefficient between the growth of money supply and inflation was positive and significant. Monetarist proposition that money supply determined the price levels and income was accepted in the light of the results of this study. The tight monetary policy along with fiscal measures was suggested to control inflation in Pakistan. Husain and Rashid (2006) extend the analysis
of the causality between price, income and money by taking care of the shift in the variables due to the price hikes in the early 1970s. They investigated the causal relations between real money and real income, between nominal money and nominal income, and between nominal money and prices using the annual data set from 1959-60 to 2003-04. The analysis indicates significant shifts in the variables during the sample period. In this context, the shift of the early 1970s seems to be more important to be incorporated in the analysis. The study finds an active role of money in the Pakistani economy. In the case of income, the study finds the feedback mechanism of money, which is generally missing in the earlier studies.

Muhd Zulkhibri (2007) examines the causality relationship between monetary aggregates, output and prices in the case of Malaysia. The study used a vector autoregression (VAR) model applying the Granger no-causality procedure developed by Toda and Yamamoto (1995). The results indicate a two-way causality running between monetary aggregates, M2 and M3 and output which is consistent with theoretically conjecture by Keynesian and Monetarist views whereas there is a one-way causality running from monetary aggregate, M1 and output. In addition, the results suggest that all monetary aggregates have a strong one-way causality running from money to prices but no evidence for the opposite causality. Thus, the results add the empirical support to the argument in the literature that inflation is a monetary phenomenon. Liang and Huang (2011) examined the relationship between money supply and the economic output in United State from theoretical and statistical perspectives. An equation indicating this relationship, focusing on d(GDP) and d(M2), is estimated by OLS. Based on the research, they conclude that lagged changes in GDP play a significant role in estimating the change in M2, and they also predict the estimated change of M2 in 2011Q1 and the corresponding M2 at the end of the first quarter of 2011 through the estimated equation. However, among the empirical evidence documented for Nigeria includes Asogu (1998) examined the influence of money supply and government expenditure on Gross Domestic Product. He adopted the St Louis model on annual and quarterly time series data rom 1960 -1995. He finds money supply and export as being significant. This finding according to Asogu corroborates the earlier work of Ajayi (1974) Nwaobi (1999) while examining the interaction between money and output in Nigeria between the periods 1960- 1995. The model assumed the irrelevance of anticipated monetary policy for short run deviations of domestic output from its natural level. The result indicated that unanticipated growth in money supply would have positive effect on output. A clear examination of the above shows that there is no general agreement on the determinant of economic growth in the Nigerian economy. In Nigeria, Nwaobi (1999) following the earlier work of Ajayi (1974) and Asogu (1998) examined the interaction between money and output between 1960 and 1995. His findings indicated that unanticipated growth in money supply has positive effect on output. Although, the findings of Iyoha (1969, 1976) and Taiwo (1990) show that there is a clear relationship between money and economic growth. In a broader scope, Omoke and Ugwuanyi (2010) examined the causality between money, price and output in Nigeria between 1970 and 2005, and employed cointegration and granger-causality test analysis. Their analysis revealed that no existence of a cointegrating vector in the series used. Money supply was seen to Granger cause both output and inflation. The result suggest that monetary stability can contribute towards price stability in the Nigerian economy since the variation in price level is mainly caused by money supply and they conclude that inflation in Nigeria is to an extent a monetary phenomenon. Ogunmuyiwa and Ekone (2010) investigated the impact of money supply on economic growth in Nigeria between 1980 and 2006, applying ordinary least square equation, causality, and error correction model to the considered time series. The results revealed that although money supply is positively related to growth but the result is however insignificant in the case of GDP growth rates on the choice between contractionary and expansionary money supply. Omanukwue (2010) examined the modern quantity theory of money using quarterly time series data from Nigeria for the period 1990:1-2008:4. The study uses the Engle-Granger two –stage test for cointegration to examine the long-run relationship between money, prices, output and interest rate and ratio of demand deposits/time deposits (proxy for financial development) and finds convincing evidence of a long-run relationship in line with the quantity theory of money. Restrictions imposed by the quantity theory of money on real output and money supply do not hold in an absolute sense. The granger causality is also used to examine the causality between money and prices. The study establishes the existence of “weakening” uni-directional causality from money supply to core consumer prices in Nigeria. In all, the result indicates that monetary aggregates still contain significant, albeit weakening, information about developments in core prices in Nigeria. Also, the study finds that inflationary pressures are dampened by improvements in real output and financial sector development. Adesoye (2012) examined the examined the cointegration and causality between price, monetary aggregate and real output in Nigeria from the period1970 to 2009 using the inflationary gap model that emanates from the quantity theory of money. The study test of stationary revealed that money and price gaps are stationary at level, while real output is found stationary at first difference. The Johansen cointegration test revealed presence of one cointegrating vector and causality is found to significantly run from money supply to price. Also, his econometric findings suggest that inflation is amonetary phenomenon and previous price and output gap are strong indicators of controlling monetary aggregate in Nigeria. The impulse response function analysis indicated that price is more responsive to one squared variance of its own shocks, monetary and output shocks as the horizon prolonged. Also, Akinbobola (2012) provides quantitative analysis of the dynamics of money supply, exchange rate and inflation in Nigeria. The study utilizes secondary data that were obtained from the International Financial Statistics (IFS), of all variables investigated in the model. The sample covers quarterly data from 1986:01 to 2008:04. The model was estimated using Vector Error Correction Mechanism (VECM). The empirical results confirms that in the long run, money supply and exchange rate have significant inverse effects on inflationary pressure, while real output growth and foreign price changes have direct effects on inflationary pressure. Empirical deductions also signify the presence of significant feedback from the long run to short run disequilibrium. However, there exists a causal linkage between inflation, money supply and exchange rate in Nigeria.

III. Methodology
3.1 Theoretical Framework and Model Specification†
The theoretical framework found relevant to explain the causality among price, money and quantity step from the inflationary gap model following the classical quantity theory of money. The inflationary gap model is also known as the P-Star (P*). The concept was first developed by the United State Federal Reserve as a simple, yet comprehensive, indicator of inflationary pressure (Hallman et al., 1989). P* is defined as the price level which is consistent with current money supply and equilibrium in goods and financial markets. As the gap between the actual price level (P) and P* is zero in equilibrium, deviations of P from P* indicate the amount of price adjustment which has not yet materialized and can help predict future movements in the price level (Peter and Pierre, 1991).

Modeling the precise causal link among price, money and quantity, the quantity theory of money is adopted and it is expressed as: MV = PQ (1)
Where M is nominal monetary aggregate; V is the income velocity of money; P is the actual price level; and Q is the output at constant prices. Expressing actual price level in terms of other incorporated components in the quantity theory of money model gives the velocity identity as:
Q
P º M ´V (2)
Denoting equilibrium (trend) values by “*”, the identity (2) becomes:
* * Q*
P º M ´V (3)
The expression (3) indicates that P* is proportional to money stock per unit of potential output.
Dividing expression (3) by (2) gives:
Q
P M V
Q
P M V
º ´
* º *´ *
(4)

Following division rule, taking the logarithms of both sides gives: p * - p º (m* -m) + (q - q *) (5)
The gap between equilibrium and actual prices, p * - p, the P* model predicts the direction of movement of the price level: it will rise, fall or remain unchanged as the actual price level is below, above or at equilibrium level. The price gap, however, does not contain information about the dynamics of adjustment of P to P*.

Following Peter and Pierre (1991), an error-correction model of the adjustment process was adopted. A general dynamic specification of such a model is:

The coefficient a is the speed of adjustment of prices to P*, should be positive and the coefficient b and d sum to one in order to ensure the equality of the actual and potential price levels in the long-run. In equation (6), the two components of the price gap,  the money supply and output gaps are constrained to have the same coefficient. Considering both gaps separately yields the expression:
255
As implied by the basic identities, the consumer price index is used as the price variables, and real GDP as the output variable. Although, a key question in implementing the inflationary gap approach is how to measure trend output (Q*) and trend money supply (M*). Following Peter and Pierre (1991), it is conventional to measure the equilibrium components using the simple linear time trend.

Model Specification
Emanating from the quantity theory of money in formulating the inflationary gap model (1-7), the empirical model for examining the effect of monetary aggregate and real output on changes in price level in Nigeria is specified as:




Where: p = log of CPI; m = log of broad money supply; q = log of real output; m*is trend or equilibrium monetary aggregate measure as m m c m * = l = - ˆ ; q * is trend or equilibrium real output measure as q q c q * = l = - ˆ ; Dp is change in price level; ( ) Y
- - - = D = D t t GAP t m m m m 1
*
1 is monetary
aggregate gap; ( ) Y
- - - = D = D t t GAP t q q* q q
1 1 real output
gap; ( ) 1
*
-1 - D - D t t m m is the previous changes in
monetary aggregate gap; ( * )
t j t j q - q - D - D is the
previous changes in real output gap; 0
f is the constant or intercept; t u is the stochastic error term.


However, following the New Keynesian, Gordon (1990), and Peter and Pierre (1991) in which they focused on the changes in output gap and monetary gap in respect to changes in price gap, therefore the specified inflation gap model is assumed to be adaptive and represented by past inflation up to second lag and then inflation increases when the output and monetary gap opens up, while the price level is indeterminate. Therefore, first lag of both monetary and output gap tends to be constant i.e. 0 1 d = and 0 2 d = .

On the basis of the above argument, the empirical model (8) is re-specified as:


The apriori expectation provides expected signs and significance of the values of the coefficient of the parameters under review on the part of the empirical evidence and theoretical assertions. The expected signs are expressed symbolically as follows:




256
3.2 Research Hypothesis
The research hypothesis that assists in accepting or refuting certain theoretical and empirical assertions relating to this study is re-stated as follow:
H0: Monetary aggregate and Output growth rate have no significant effect on price stability in Nigeria.
Hi: Monetary aggregate and Output growth rate have significant effect on price stability in Nigeria.

3.3 Estimation Techniques
In estimating the specified multiple regression model the unrestricted Classical Least Square (CLS) is used. The estimated parameters are subjected to evaluation by using the student t-statistic test and Fstatistic test. While, the overall stability of the specified empirical model is tested using multiple coefficient of determination (R2), adjusted R2 and Durbin-Watson test.

3.4 Stationarity Test
The time series properties of the variables incorporated in static model (9) is examined using the
Augmented Dickey-Fuller unit root test in order to determine the long-run convergence of each series to its true mean. The test involves the estimation of equations with drift and trends as proposed Dickey and Fuller (1988). The test equations are expressed as:

The time series variable is represented by Z, t and tn as time and residual respectively. The equation (10) and (11) are the test model with intercept only, and linear trend respectively.

3.5 Cointegration Test
The long-run analysis of the relationship among price, money and output in Nigeria from 1970 to 2011 is established using the Johansen cointegration test. The Johansen cointegration test is a vector autoregressive (VAR) based technique with the null hypothesis “no at least one cointegrating vector”. The rejection of this hypothesis indicates dynamic longrun relationship or cointegrating vector.

3.6 Scope, Data Description and Sources
In examining the precise macroeconomic effect of monetary policy and output growth on price stability in Nigeria, the study shall span over a period of 1970 to 2011 based on the availability of data. This research time frame is chosen in order to precisely cover major structural economic and financial eras in Nigeria since a decade after independence.

The time series data required for this study. The nature of this study requires basically secondary data compiled by various Bureaus in the country. The secondary data were sourced from the Central Bank of Nigeria (CBN) Statistical Bulletin, December 2012 and World Bank Development Indicators (WDI),January 2013 Edition.

IV. Results and Discussion
4.1 Unit Root Test Results
The stationary test results of the incorporated times series variables in the regression model expressed in equation (9) is presented in Table 4.1using the ADF unit-root test. The test result indicated that the time series variables, price gap (Dpt ) and output gap ( DqY ) were found to reject the null hypothesis “no stationary” at level. This indicates that the first difference or gap of price level and real output growth have no unit-root or are stationary at level. This implies that these series are mean reverting and convergences towards their long-run equilibrium at the level which they are incorporated in the regression analysis. The other incorporated time series, monetary policy gap (DmY ) proxied by first difference of broad money supply was found not to reject the null hypothesis “no stationary” at level but after several iterations based on the number of lag length and differencing, the series are found to reject the null hypothesis at another differencing level. This indicates that the second-difference of money gap is integrated of order one.

4.2 Cointegration Results
The long-run analysis of the relationship among price, money and output in Nigeria from 1970
to 2011 was examined using the Johansen cointegration technique and the test results are shown
on Table 4.2. The vector of cointegration among inflation rate, monetary policy and output gap using
the multivariate Johansen cointegration test for linear deterministic trend model with intercept to determine the long-run relationship that exist among the considered series between 1970 and 2011.
The cointegration result presented in Table 4.2indicated that at McKinnon-Haug-Michelis 5%
significance level of the Trace and Max Eigen value tests suggest that the incorporated time series variables are cointegrated at the third hypothesized cointegration equations order i.e. r =3 for linear deterministic trend model with intercept. This implies that there exist three cointegrating equations among the incorporated series in the estimated VAR system. This implies that there exist a long-run relationship among price, money and output in Nigeria from 1970to 2011.

4.3 Long-Run Estimates
The result of the estimated regression is presented in the result appendix and the summary result is shown in table 4.3. The estimated result for the multiple parameters regression specified to capture the effect of money supply and economic output gaps on price gap in Nigeria between 1970 and 2011 presented in table 4.3 revealed the effect of incorporated factors for the econometric analysis of the study. The table 4.2reports that first lag of price gap, current money supply gap, first lag of money supply gap, current real output gap and first lag of real output gap exert positive influence on current price gap in Nigeria between a decade period after Nigeria’s independence and 2011 fiscal year and it is only the effect of real output gap that does not conform with the theoretical expectation. This implies that for a unit increase in first lag of price gap, current money supply gap, first lag of money supply gap, current real output gap and first lag of real output gap, price level or inflation rate will increase by 0.66, 1.61, 1.27, 7.41, and 6.56 units respectively. The table 4.3 also reports that second lag of price gap exerts negative effects on inflationary pressure in Nigeria during the review periods and this does not conform to the apriori expectations based on sign. However, in terms of magnitude of effect, an increase in second previous price gap will deteriorate the inflation level by unit of 0.155.In assessing the partial significance of the estimated parameters for the incorporated gap indicators, the t-statistics results are presented in the table 4.3. The result shows that the estimated parameter for the first previous price gap was found to be partially statistically significant at 5% critical level because their p-values are less than 0.05 and the second previous price gap was statistically significant at 10% significance level. While, the parameters for current money supply gap, first lag of money supply gap, current real output gap and first lag of real output gap were found insignificant at both 5% and 10%critical level. Although, the F-statistic result shows that all the incorporated gap indicators are simultaneously significant at 5% critical level. While, the R-squared result reveals that 87.4% of the total variation in inflationary pressure is accounted by changes in the first-two previous price gap, current money supply gap, first lag of money supply gap, current real output gap and first lag of real output gap during the review period. The Durbin- Watson test result reveals that there is presence of weak positive serial correlation among the residuals, because of the d-value (1.7874)is far from zero but closer to two.

V. Conclusion and Recommendations
The detailed econometric analysis of the effect of monetary policy and economic output on price
level in Nigeria between 1970 and 2011 following the adoption of the Keynesian inflationary gap model that emanates from the quantity theory of money revealed that previous price gap tends to be significant determinants of inflationary pressure where the first previous gap enhance the current price pressure and the second previous gap decelerate the inflationary pressure. Also, changes in monetary aggregate and output gap were found to enhance the inflationary pressure in Nigeria and this is as a result of the ineffectiveness of monetary and macroeconomic policies in stabilizing price level. Therefore, this study rejects the null hypotheses and concludes that there is significant causality among money supply, economic output and price level in Nigeria during the period of a decade after independence from colonial rule and 2011 fiscal year.

On the basis of the findings, the paper proffered the following:
1.      Price stability oriented policies should be instituted and ensure current inflation rate is well stabilized through monetary aggregate and economic output. This is to decelerate the consequential effect of previous inflationary pressure on the current price level.

2.      Economic resources should be optimally utilized in expanding national output and productivity at minimum cost possible in order to avoid the accelerating effect of output expansion on inflationary pressure in Nigeria.

3.      The Central Bank of Nigeria should keep the monetary policy rate at optimal level in mobbing excess liquidity in the economy that determine the level of monetary aggregate level and considering its pull effect on price stability.

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