DETERMINANTS OF DEMAND FOR MONEY AND ITS STABILITY IN NIGERIA (1991-2014)

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DETERMINANTS OF DEMAND FOR MONEY AND ITS STABILITY IN NIGERIA (1991-2014)

ABSTRACT

This study examines the determinants of the broad money demand and its stability in Nigeria over the quarterly period 1991:Q1 to 2014:Q4. Most studies on the determinants and stability of the money demand function have been focused on the advanced economies. Only a few empirical studies are focused on the demand for money in Nigeria, differing by time period, monetary aggregate, data frequency and model specification. The specific objectives were to: (i) evaluate how income, interest rate, inflation rate, exchange rate and foreign interest rate affect the quantity of money demand in Nigeria, (ii) examine the money demand function and to understand its long-run cointegrating relationship with the selected macroeconomic variables and (iii) study the short-run dynamics of the money demand function in Nigeria so as to incorporate both short-term deviations and long-run expectations. The research utilizes secondary data sourced from the Central Bank of Nigeria’s statistical bulletin and the International Monetary Fund’s world economic outlook database and employs the ordinary least square regression technique, the autoregressive distributed lag modeling to cointegration and the error correction model in order to ascertain whether monetary targeting is still relevant in setting monetary policy framework in Nigeria. The findings of the study reveal that real income, domestic interest rate, inflation rate, exchange rate and foreign interest rate have a predictable impact on the quantity of money demand in Nigeria. Real income and exchange rate are positively related to the real broad money balances while domestic interest rate, inflation rate and foreign interest rate are inversely related to the demand for broad money. Also, the results indicate that a long-run relationship exists between the real broad money aggregate and its determinants. Furthermore, both the CUSUM and CUSUMSQ tests confirm that the short-run and long-run parameters of the real money demand function are robust and exhibit parameter constancy. The remarkable stability of the money demand function provides validity for the monetary authorities to target the broad money supply in its effort to achieve price and financial system stability in Nigeria.

Keywords: Broad money demand, autoregressive distributed lag, monetary policy, stability.

TABLE OF CONTENTS

Title i

Certification ii

Approval iii

Dedication iv

Acknowledgements v

Abstract vi

Table of Contents vii

List of Tables viii

List of Figures ix

CHAPTER ONE: INTRODUCTION

Background to the Study 1

Statement of the Research Problem 2

Objectives of the Study 4

Research Questions 4

Hypotheses of the Study 4

Scope of the Research 4

Significance of the Study 5

Operational Definition of Terms

References

CHAPTER TWO: REVIEW OF RELATED LITERATURE

2.1 Conceptual Framework 6

2.1.1 Variables in the Money Demand Function 6

2.2 Theoretical Review 8

2.2.1 Quantity Theory of Money 8

2.2.2 Keynes’s Liquidity Preference Theory 10

2.2.3 Further Developments in the Keynesian Approach 12

2.2.4 Friedman’s Modern Quantity Theory of Money 13

2.2.5 Distinction between the Friedman and Keynesian Theories 14

2.3 Empirical Review 15

2.3.1 Review of International Empirical Studies 15

2.3.2 Review of National Empirical Studies 20

2. 4 Summary of Empirical Review 25

2.5 Knowledge Gap 38

2.6 Conceptual Model 41

References

CHAPTER THREE: METHODOLOGY

3.1 Research Design 39

3.2 Sampling Technique 39

3.3 Specification of Models 39

3.4 Nature and Sources of Data 44

3.5 Techniques of Analysis 44

References

CHAPTER FOUR: DATA PRESENTATION AND ANALYSIS

Diagnostic Tests 46

4.1. 1 Multicollinearity Test 46

Heteroskedasticity Test 47

Autocorrelation Test 47

4.1.4 Stationarity Test 48

Test of Hypothesis 49

Hypothesis One 49

Hypothesis Two 51

Hypothesis Three 53

Stability Test 58

Interpretation of Findings 59

CHAPTER FIVE: SUMMARY OF FINDINGS, CONCLUSION AND RECOMMENDATIONS

5.1 Summary of Findings 63

5.2 Conclusion 63

5.3 Recommendations 64

5.4 Contribution to Knowledge 74

5.5 Suggestion for Further Research 64

Bibliography 65

Appendices

LIST OF TABLES

Table 1.1: Review of International Empirical Studies 25

Table 1.2: Review of National Empirical Studies 32

Table 4.1: Correlation Matrix 46

Table 4.2: Heteroskedasticity Test for the first hypothesis 47

Table 4.3: Autocorrelation Test for the first hypothesis 47

Table 4.4 ADF Unit Root Test from M2 demand function 48

Table 4.5 Regression result of hypothesis one 50

Table 4.6: Wald Test for cointegration 52

Table 4.7: Error Correction Model result 54

Table 4.8: Lag selection result 57

LIST OF FIGURES

Figure 2.1: Diagramatic Structure of the Determinants and Stability of Demand for Money in Nigeria 41

Figure 4.1: Plot of cumulative sum of recursive residuals 58

Figure 4.2: Plot of cumulative sum of squares of recursive residuals 59

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

A sound monetary policy formulation presupposes theoretically coherent and empirically robust model of money demand. To monetary authorities, the stability of the money demand function is necessary for understanding how the formulation and implementation of an effective monetary policy is crucial in offsetting the fluctuations that may arise from the real sector of the economy. If the relationship between the demand for money and its determinants shift around unpredictably, the central bank loses the ability to derive results from the implementation of its policies. In such a case, variations in the money demand function is an independent source of disturbance to the economy. (Bhatta, 2013,p.1).

The identification of a stable relationship between the demand for money and its determinants provides empirical evidence that monetary targeting is an appropriate framework for economic stabilization policy (Rutayisire [as cited in Bhatta, 2013, p.1). Monetary targeting is an attempt by central banks to describe or determine the optimum money stock that will yield the desired macroeconomic objectives. Theoretically, the choice of target is normally between the stock of monetary aggregates and interest rates. Poole; and McCallum (as cited in Owoye and Onafowara, 2007, p.1) expressed that whenever the money demand function is unstable, interest rate is generally the preferred target, otherwise, the money stock remains the appropriate target.

The primary objective of the Central Bank of Nigeria (CBN), in its conduct of monetary policy, is to maintain a stable price level that supports sustainable economic growth and employment (Owoye and Onafowora, 2007,p.1). The CBN has relied on setting predetermined growth rates for the broad money (M2) as a tool for achieving price stability. This is based on the belief that inflation cannot be sustained over the long-term, if it is not accommodated by excessive growth in money supply (Doguwa, Olowofeso, Uyaebo, Adamu and Bada, 2014, p.16). In the conduct and implementation of monetary policy, the assumption that the money demand function is stable is very important, because, the money demand function is used both as a means of identifying medium term growth targets for money supply and as a way of manipulating the interest rate and reserve money for the purpose of controlling both the inflation rate and the total liquidity in the economy (Owoye and Onafowora, 2007, p.1).

Given the importance attached to money demand in the success or failure of monetary policy, it is not surprising that the demand for money is one of the most controversial and heavily researched areas in macroeconomics. If the central bank relies on control of monetary aggregates as its policy instruments, Cameron (as cited in Bhatta, 2013), states that:

it must believe in a known and reliable connection between changes in that aggregate and changes in the arguments of the money demand function in order for its policy to have predictable effects on those arguments. If instead the central bank relies on interest rates as targets and adjusts the monetary aggregate through daily reserve management to whatever level is required to hit them, instability of the demand for money could make the required reserve changes both large and unpredictable. In such a case, disorderly financial markets might well result. (p.2).

Laumas and Mehru (as cited in Ogunsakin and Awe, 2014, p.2) stipulated that the stability of money demand is crucial for the understanding of the monetary policy transmission mechanism. It is crucial because a stable money demand function means that the quantity of money is predictably related to a set of key variables that link money to the real sector of the economy. A stable money demand function always require appropriate instruments and intermediate targets of monetary policy. It enables a policy driven change in monetary aggregates so that the desired values of targeted macroeconomic variables such as fiscal policy, exchange rate, stock market, consumption expenditure, savings and investments, imports, exports, inflation and interest rates are ensured (Sober, 2013, p.32). Therefore, it is important to have knowledge of the determinants of money demand in order to ensure a stable relationship exists between these determinants and the money stock.a

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