CHAPTER TWO

2.0 INTRODUCTION

This chapter contains introduction, conceptual literature, theoretical

model, empirical literature and research gap.

2.1 Conceptual literature

Monetary policy is a set of tools used by a nation's central bank to

control the overall money supply and promote economic growth and

employ strategies such as revising interest rates and changing bank

reserve requirements. Economic statistics such as gross domestic

product (GDP), the rate of inflation, and industry and sector-specific

growth rates influence monetary policy strategy.

A central bank may revise the interest rates it charges to loan money to

the nation's banks. As rates rise or fall, financial institutions adjust rates

for their customers such as businesses or home buyers.

Additionally, it may buy or sell government bonds, target foreign

exchange rates, and revise the amount of cash that the banks are

required to maintain as reserves.

Monetary policies are seen as either expansionary or contractionary

depending on the level of growth or stagnation within the economy.

A contractionary policy increases interest rates and limits the

outstanding money supply to slow growth and decrease inflation, where

the prices of goods and services in an economy rise and reduce the
purchasing power of money.

During times of slowdown or a recession, an expansionary policy grows

economic activity. By lowering interest rates, saving becomes less

attractive, and consumer spending and borrowing increase.

Monetary policy major goals is to achieve maximum employment, stable

price and long term interest rate, An expansionary monetary policy

decreases unemployment as a higher money supply and attractive

interest rates stimulate business activities and expansion of the job

market.

Money supply

The money supply is the sum total of all of the currency and other liquid

assets in a country's economy on the date measured. The money supply

includes all cash in circulation and all bank deposits that the account

holder can easily convert to cash.

Governments issue paper currency and coins through their central banks

or treasuries, or a combination of both. In order to keep the economy

stable, banking regulators increase or reduce the available money supply

through policy changes and regulatory decisions.

2.1.1 Tools of monetary policy

Open Market Operations

In open market operations (OMO), the Federal Reserve Bank buys bonds

from investors or sells additional bonds to investors to change the

number of outstanding government securities and money available to

the economy as a whole. The objective of OMOs is to adjust the level of

reserve balances to manipulate the short-term interest rates and that

affect other interest rates, By using Open market operation , the Fed can

adjust the federal funds rate, which in turn influences other short-term

rates, long-term rates, and foreign exchange rates. This can change the

amount of money and credit available in the economy and affect certain

economic factors, such as unemployment, output, and the costs of goods

and services.

Interest Rates

The central bank may change the interest rates or the required collateral

that it demands. this rate is known as the discount rate. Banks will loan

more or less freely depending on this interest rate. The discount rate is

the interest rate the Federal Reserve charges commercial banks and

other financial institutions for short-term loans. The discount rate is

applied at the Fed's lending facility, which is called the discount window.

Commercial banks have two primary ways to borrow money for their

short-term operating needs. They can borrow and loan money to other

banks without the need for any collateral using the market-driven

interbank rate, or they can borrow money for their short-term operating

requirements from the Federal Reserve Bank.

Reserve Requirements

Authorities can manipulate the reserve requirements, the funds that

banks must retain as a proportion of the deposits made by their

customers to ensure that they can meet their liabilities. Reserve

requirements are a tool used by the central bank to increase or decrease

the money supply in the economy and influence interest rates and also

its the amount of cash that financial institutions must have, in their

vaults or at the closest Federal Reserve bank, in line with deposits made

by their customers

2.1.2 INFLATION

Inflation is an economy-wide, sustained trend of increasing prices from

one year to the next. An economic concept, the rate of inflation is

important as it represents the rate at which the real value of an

investment is eroded and the loss in spending or purchasing power over

time. Inflation also tells investors exactly how much of a return (in

percentage terms) their investments need to make for them to maintain

their standard of living.

The easiest way to illustrate inflation is through an example. Suppose

you can buy a shirt for N1000 this year and the yearly inflation rate is

10%. Theoretically, 10% inflation means that next year the same burger

will cost 10% more, or N2000. So, if your income doesn't increase by at

least the same rate of inflation, you will not be able to buy as many
burgers; however, a one-time jump in the price level caused by a jump in

the price of oil or the introduction of a new sales tax is not true inflation,

unless it causes wages and other costs to increase into a wage-price

spiral.

Likewise, a rise in the price of only one product is not in itself inflation,

but may just be a relative price change reflecting a decrease in supply for

that product. Inflation is ultimately about money growth, and it is a

reflection of too much money chasing too few products.

Statistical agencies measure inflation by first determining the current

value of a “basket” of various goods and services consumed by

households, referred to as a price index. To calculate the rate of inflation,

or percentage change, over time, agencies compare the value of the

index over one period to another, such as month to month, which gives a

monthly rate of inflation, or year to year, which gives an annual rate of

inflation.

2.1.3 Causes of inflation

They are two primary type or causes of inflation ;

Demand-pull inflation occurs when the demand for goods and services in

the economy exceeds the economy’s ability to produce them. For

example, when demand for new cars recovered more quickly than

anticipated from its sharp dip at the beginning of the COVID-19

pandemic, an intervening shortage in the supply of

semiconductors made it hard for the automotive industry to keep up

with this renewed demand. The subsequent shortage of new vehicles

resulted in a spike in prices for new and used cars.

Cost-push inflation occurs when the rising price of input goods and

services increases the price of final goods and services. For example,

commodity prices spiked sharply during the pandemic as a result of

radical shifts in demand, buying patterns, cost to serve, and perceived

value across sectors and value chains. To offset inflation and minimize

impact on financial performance, industrial companies were forced to

consider price increases that would be passed on to their end

consumers.

The money supply of a country is a major contributor to whether

inflation occurs. As a government evaluates economic conditions, price

stability goals, and public unemployment, it enacts specific monetary

and fiscal policies to promote the long-term well-being of its citizens.

These monetary and fiscal policies may change the money supply, and

changes to the money supply may cause inflation. Inflation can happen if

the money supply grows faster than the economic output under

otherwise normal economic circumstances. Inflation, or the rate at

which the average price of goods or services increases over time, can

also be affected by factors beyond the money supply.

2.1.4 Monetary policy measures on inflation

Most modern central banks target the rate of inflation in a country as

their primary metric for monetary policy. If prices rise faster than their

target, central banks tighten monetary policy by increasing interest rates.

Higher interest rates make borrowing more expensive, curtailing both

consumption and investment, both of which rely heavily on credit.

Likewise, if inflation falls and economic output declines, the central bank

will lower interest rates and make borrowing cheaper, along with several

other possible expansionary policy tools.

As a strategy, inflation targeting views the primary goal of the central

bank as maintaining price stability. All of the tools of monetary policy

that a central bank has, including open market operations and discount

lending, can be employed in a general strategy of inflation targeting.

Inflation targeting can be contrasted to strategies of central banks aimed

at other measures of economic performance as their primary goals, such

as targeting currency exchange rates, the unemployment rate, or the

rate of nominal Gross Domestic Product (GDP) growth. In Nigeria the

central bank has adopted new policy called cashless in other to tackle

inflation, The cardinal aim of the cashless initiative was to reduce the

number of naira notes and coins used for business but not to eliminate

cash usage in its entirety and seeks to ensure a seamless, inclusive and

equitable implementation of the exercise for the overall benefit and

growth of Nigerians, the financial system and the economy as a whole,

No doubt, the policy has helped to achieve slower growth in inflation as

well as a more stable exchange rate regime in the economy. handling

costs while the government will enjoy increased tax collections, greater

financial inclusion, and increased economic development. The central

bank implemented the Naira redesign policy also as a policy for which

research shows that the redesign of the Nigerian naira notes has no

impact on curtailing the rising prices of goods and services across Africa’s

biggest economy.

the Central Bank of Nigeria(CBN) currency redesign policy, currency in

circulation has dropped from N3.28 trillion in December 2022 to N1.38

trillion in January and estimated N982.09 billion in February 2023,

representing a 235 percent decline.

It was expected that the scarcity of redesigned notes, which caused a

cash crunch in the economy in January 2023, would stimulate a

slowdown in demand-pull inflation, especially given the series of interest

rate hikes from the Central Bank (500 basis points since May 2022).

Nigeria’s current inflation rate is at 21.91 percent, a new 17-year high

from 21.82 percent in January 2023.

Nigeria’s annual inflation rate remained high and largely unchanged

across all categories in February 2023. The cash crunch which has

affected consumer expenditure following the earlier redesign of the

naira, doesn’t seem to have slowed down inflation yet, despite a 500-
basis interest rate hike since May 2022 and a 235 percent decline in cash

in circulation.

2.2 Theoretical model

The determinants of inflation have been well researched based different

school of thoughts. A lot of theories have been propounded on this issue

and some of them are:

2.2.1 Monetarist Theory

This theory states that money supply has a major influence of inflation.

This means as money supply increases due to growth in production and

employment, this creates an inflationary condition in an economy. The

monetarist explaining this phenomenon using the theory of natural rate

of unemployment believes that increases in the money supply will exert

an increasing impact production and employment in the short run and

not in the long run. Therefore, there will be a positive relationship

between inflation and money supply. Nevertheless, the natural rate of

unemployment conditioned that given resources employment, number

of firms and the type of technology in use, the equilibrium output,

employment and level of employment are certainly definite.

Consequently, an increasing money supply will result in the reduction of

natural rate of unemployment and increase in production, in the short

run. While, in the long run this will lead to an increasing inflation.
2.2.2. Structuralism Theory

The inelasticity in the structures of the economy is the main drive of

inflation based on this theory. This is mainly obtainable in the developing

countries. This is as result of inelasticity in capital formation, institutional

framework, labour force, production level, agricultural sector and

unemployment structures. Therefore, inflation sets in due to inefficiency

in the structures of the economy.

2.2.3. Keynesian Theory

The Keynesian postulation clearly stated in the book, The General Theory

of Employment, Interest and Money published in 1940. Keynes stated

that an aggregate demand driven by increase in private investment,

increase in private consumption and increase in government expenditure

when an economy is at its full employment lead to an increase in the

general price level. This means an aggregate demand level over and

above the full employment of production level will create an inflationary

trend.

The Keynesian position is that if people expect any expansion in demand

to lead to an increase in output and employment, then it will. This

happens because firms will take on more people in anticipation of an

increased level of demand for their product.

2.3 EMPERICAL LITERATURE

Inflation is one of the most important economic variables that can

distort economic activities of any country. As a result, there exist a large

number of empirical studies on the determinant of inflation.

Dania (2013), in her work studied the determinants of inflation in

Nigeria, time series econometric technique (Error Correction Model) was

used to capture the convergence of the inflation determining factors to

achieving long run equilibrium. Yearly data between 1970 and 2010 was

used, and found that expected inflation , measured by lagged term of

inflation, money supply, significantly determine inflation, while trade

openness , capturing the tendencies of imported inflation, income level,

exchange rate and interest rate were found not be significant with all

showing signs that conform with appropriate in the short run. In the long

run likewise, none of the variables was found to be significant.

Iya and Aminu (2014) investigated the determinants of inflation in

Nigeria between 1980 and 2012 using the ordinary least square method.

The result revealed that money supply and interest rate influenced

inflation positively, while government expenditure and exchange rate

influenced inflation negatively. They suggested that for a good

performance of the economy in terms of price stability may be achieved

by reducing money supply and interest rate and also increase

government expenditure and exchange rate in the country.

Hossain and Islam (2013) examined the determinants of inflation using

data from 1990 to 2010 in Bangledesh with the ordinary least square
method. The empirical result showed that money supply, one year

lagged value of interest rate positively and significantly affect inflation.

The result also indicated that one year lagged value of money supply and

one year lagged value of fiscal deficit significantly and negatively

influence over inflation rate. There was an insignificant relationship

between interest, fiscal deficit and nominal exchange rate. The

explanatory variables accounted for 87 percent of the variation of

inflation in during the period

Odusanya and Atanda (2010) using data annual data from 1970 to 2007

to investigate the determinants of inflation in Nigeria, the result revealed

that growth rate of GDP, growth of money supply, real share of import,

first lagged of inflation rate and interest rate exert positive influence on

inflation rate. While, only growth of GDP and preceding inflation rate

have significant effect on current inflation rate in Nigeria during that

period.

Maku and Adelowokan (2013) in their work using annual data from 1970

to 2011 examined the determinants of inflation in Nigeria by employing

the partial adjustment model. The result indicated that fiscal deficit and

interest rate exert decelerating pressure on dynamics of inflation rate in

Nigeria. While, other macroeconomic indicators such as real output

growth rate, broad money supply growth rate, and previous level of

inflation rate further exert increasing pressure on inflation rate in

Nigeria. The real output growth and fiscal deficit were found to be

significant determinants of inflation rate in Nigeria during the period.

Ratnasiri (2009) investigated the main determinants of inflation in Sri

Lanka over the period 1980 to 2005 using vector autoregressive analysis.

The results shows that money supply growth and rice price increase are

the main determinants of inflation in Sri Lanka in the long run. In

contrast, it evident that exchange rate depreciation and output gap had

no statistically significant effect on inflation. However, in the short run,

rice price was the most important variable as it was a totally endogenous

variable. Money supply growth and exchange rate were not so important

variable as they were weakly exogenous in the adjustment process.

Output gap did not have a statistically effect on inflation in both the long

run and short run.

Enu and Havi (2014) studied the macroeconomic determinants of

inflation in Ghana using a co- integration approach. The found out that in

the long run, population growth and service output affect inflation

positively. However, foreign direct investment, foreign aid and

agricultural output increase inflation impact negatively. Also, in the short

run, the past two years inflation had a significant impact on the current

inflation. The population growth and foreign direct investment’s past

records had both positive and negative impact on current inflation.

Nevertheless, they were not significant.

2.3 Research Gap

Although many studies have examined the impact of monetary policy on

inflation in Nigeria, there is a lack of research on the main determinants

of inflation in Nigeria, one of the determinants of inflation is money

supply, Inflation has been widely described as an economic situation

where increase in money supply is faster than the new production of

new goods and services in the same economy (Hamilton, 2001)

According to Vaish (1999)inflation is a sustained rise in the general price

level brought about by high rate of expansion in the aggregate money

supply. Inflation emerges in the economy on account of the increase in

the money income of certain sectors of the economy without any

corresponding increase in their productivity, giving rise to an increase in

the aggregate demand for goods and services which cannot be met at

the current prices by the total available supply of goods and services in

the economy.

The relationship between money supply and and inflation is that

According to Quantity Theory: Inflation is caused when the rate of

increase in the money supply is faster for example printing more notes

than the growth of real output. Because there is more money pursuing

the same quantity of commodities, this is the case. As a result, as

monetary demand rises, enterprises raise their prices. There is an

assumption that prices will always remain constant if the growth of the
money supply is the same as the rate of real output.

when inflation is high, it makes a currency weaker, suppressing

investment, and thus negatively impacting the exchange rate. When

inflation is low, a currency is stronger, improving its exchange rate, this

shows how inflation affects the exchange rate of a country. Inflation also

has an impact of exchange rate’ In Nigeria, low exchange rates have

pushed up the costs of imported consumables and raw materials, and

have been a significant source of worry for both consumers and

importers. The low exchange rate (currency depreciation) problem is one

of the major causes of high inflation rate in Nigeria because the country

imports a large volume of consumables and raw materials annually at

higher prices.

Another determinant of inflation in Real GDP, Real gross domestic

product (GDP) is an inflation-adjusted measure that reflects the value of

all goods and services produced by an economy in a given year. Real GDP

is expressed in base-year prices. It is often referred to as constant-price

GDP, inflation-corrected GDP, or constant-dollar GDP. Put simply, real

GDP measures the total economic output of a country and is adjusted for

changes in price.

Real GDP growth fell to 3.3% in 2022 from 3.6% in 2021, precipitated

mainly by a decline in oil production. This led to 5% shrinkage in overall

industry, which was offset by expansion in services and agriculture . On

the demand side, the decline in GDP growth was driven by contraction in

public consumption and net exports. Growth in income per capita

declined to 0.8% from 1.2% in 2021. The fiscal deficit narrowed to 4.9%

of GDP in 2022 from 5.2% in 2021 and was financed by borrowing,

bringing public debt to $103.1 billion (about 22% of GDP) from $92.6

billion in 2021. Inflation peaked at a two-decade high of 18.8%, fueled by

energy and food price increases and passthrough effects of exchange

rate depreciation. The Central Bank of Nigeria successively raised the

policy rate, which peaked at 16.5% in November 2022 from 11.5% at the

start of the year, to tame rising inflation. Buoyed by relative

improvement in oil exports, the current account recorded a small surplus

of 0.1% of GDP in 2022, reversing three years of deficit. Gross

international reserves declined 7.5% to $37.1 billion (5.7 months of

import cover). The nonperforming loans ratio stood at 4.2% in 2022,

below the regulatory requirement of 5%. The capital adequacy ratio, at

13.8%, exceeded the regulatory benchmark of 10% in 2022. The

multidimensional poverty rate (63%) and unemployment (33.3%)

remained high.

Real GDP growth will remain subdued, averaging 3.3% in 2023–24, with

inflation elevated at 19.6% in 2023 before declining to 13.6% in 2024,

reflecting efforts to shore up domestic food supply and the effects of

contractionary monetary policy. Higher oil exports may not offset

subdued capital inflows, with the current account projected to be in

deficit, averaging 0.2% of GDP in 2023–24. Maintaining the subsidy could

further increase fiscal risks, exacerbated by high debt service costs.