ABSTRACT

The study empirically analyzed the sacrifice ratio in Nigeria for the period 1970-2013, using the Instrumental Variables Generalized Method of Moments (IV-GMM) technique. The results revealed that inflation inertia has a significant negative impact on the actual rate of inflation in Nigeria. It was also revealed that the percentage of a year’s real GDP that must be forgone to reduce inflation by 1 percentage point in Nigeria is 5.1. In 1982, 53.55 percent of the GDP was sacrificed. Equivalently, a sacrifice of 26.58 percentage points of cyclical unemployment was made in the same year; while the highest percentage of GDP was sacrificed in 1990 and the lowest in 2007. Based on the findings, the study recommends that the plan to reduce inflation rate, and the rate of reduction should be publicly announced. This will go a long way to reducing personal expectations formed by workers and firms that determine the wages and prices.

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behaviour, can adjust smoothly to tighter monetary policy, thus moderate disinflation is preferable (Kinful, 2007; and Cecchetti & Rich, 2001).

The second group of economists however focussed on identifying the sources of inflation persistence and analyzing the implications of inflation inertia, capital mobility, and trade openness for the pursuit of cost-reducing strategies. Trade openness also has two views. The first explained that in an open economy inflationary policies depreciate the real exchange rate. And real exchange rate depreciation will increase the inflation rate at any given output level. This effect is stronger when the economy is more open. As a result, trade openness reduces the sacrifice ratio. The second view on the other hand posits that trade openness makes demand for domestic output less dependent on domestic income. This makes the firms’ optimal prices less responsive to changes in domestic output. This means that trade openness increases the sacrifice ratio (Daniels & VanHoose, 2007). But with respect to capital mobility, it is viewed that disinflation is likely to entail larger output losses in countries with more open capital accounts. This suggests that the higher expected costs of disinflation in the context of higher capital mobility could temper policymakers’ incentives to create an inflationary scenario (Celasun, 2005).

The relevance of estimating the sacrifice ratios is evident for its implications for policy conduct. For instance, the estimate of the sacrifice ratio will reveal the efforts in real terms a country has put in place in order to gain nominal convergence. Furthermore, the significant progress made in reducing inflation rates in the past years has led to new interests about the effectiveness and credibility of monetary policy in an environment of price stability, since more credible monetary policies may have reinforced inflation inertia or persistence. Thus its estimation will reveal the significant progress made in reducing inflation rates as well as the credibility of monetary policy (Cuñado & de Gracia, 2000).

Credible monetary policy generates substantial inflation inertia or persistence. Inflation inertia refers to the delayed and gradual response of inflation to shocks. It is a process where the current inflation is determined by its past history. Inertia is caused by inflation expectations, relative price adjustments, and monetary policy framework. On the other hand, inflation

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persistence refers to prolonged deviations of inflation from steady state as a result of shocks. In other words, it is the time that it takes for an inflation shock to become weaker until it disappears. It is the slow transition of inflation to its steady state after the initial impact of unexpected shock. The estimate of the magnitude or degree of the inflation inertia is important because it shows whether or not the central bank is too slow to respond to new information that indicates the inappropriateness of current policy. It also indicates the credibility of monetary policy by the central bank (Fuhrer, 2009; and Lendvai, 2004).

Countries reduce inflation by using tight monetary and fiscal policies to slow the growth rate of aggregate demand. In Nigeria, the monetary authority, through the CBN has over the years adopted tight monetary policy to reduce the inflation rate. Periods in which the monetary policy was tightened include 2008, 2010 and 2012. In 2008, the Monetary Policy Rate (MPR) was reviewed twice in the second quarter, owing to inflationary pressure. The tight monetary policy was coupled with the global credit crunch in late 2008. In 2010, the CBN adopted tight monetary policy. The Monetary Policy Rate (MPR) was reviewed upwards six times during the year, in line with the liquidity conditions . Interest rates were generally higher than in the preceding year. Another tight monetary policy stance was maintained in 2012. Growth in money supply was modest, reflecting the tight monetary policy stance. Money supply (M2) was below the indicative growth benchmark of 24.6 % to 15.4 % (CBN annual report, 2012; 2011; 2010; and 2008).

The key policy target of the central bank in terms of the inflation rate was 21% in 2005. This was however revised during the year to be 10%, but the outcome was 6.5%. The outcomes of the targets of 7.0% and 10% were 6.0% and 6.5% in 2006 and 2007 respectively. While in 2008, 2010 and 2012; the targets were 9.0%, 11.25 and 11.2%. However the achievements were 15.1%, 11.8% and 12% (CBN annual report, 2012; 2011; 2010; and 2008). The cost associated with moving to a new, lower level of inflation therefore provides the basis for the study of the inflation-output relationship - the sacrifice ratio.

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1.2         Statement of the Problem

The achievement of price stability is the core mandate of monetary policy of central banks across the globe. The aim is to encourage the promotion of investment and consequently economic growth. Indeed, it is widely accepted that low inflation is likely to stimulate investment decisions, because economic agents will have more visibility in the medium and long term and may make projections of realistic results. To this end, central banks, in recent times, have leaned towards employing multiple measures, including the effective conduct of monetary policy. To reduce inflation, tight monetary and fiscal policies must be used. However, at the same time, a policy of low inflation is costly for the economy concerned. Inflation reductions result in short-term costs associated with losses in output (Evans & Nicolae, 2012; Dramani & Thiam, 2012; and Abel, Bernacke, & Croushore, 2008).

Inflationary pressures reflecting in persistently rising price levels have been an issue of concern to the authorities thus, anti inflation policy have become a regular feature of governments’ overall economic policy agenda. In Nigeria, the CBN in particular, has shown commitment to achieving stable and low inflation, consistent with macroeconomic objectives. In its effort to stem the problem of inflation in Nigeria, the policy authorities have over the years used a combination of several measures, ranging from wage freezes, price controls, direct involvement of government in the procurement and distribution of essential commodities, to fiscal strategies and recently monetary strategies including currency devaluation (Migap, 2011).

A look at the records revealed that inflationary pressures reduced substantially after the adoption of disinflation measures. For example, the country succeeded in achieving a single digit inflation rate of 7.2%, 4.2%, 5.4%, and 7.5% in 1982, 1985, 1986, and 1990 respectively. Also, a single digit of 7.9%, 6.6%, 6.9%, 8.2% and 5.4% were recorded in 1998, 1999, 2000, 2006, and 2007. Inflation was reduced by 66.6% from 1981-1982. Also 86.7% reduction was achieved between the periods 1984-1986. Again, the inflation rate was significantly reduced by 76.5% during the periods 1996-2000, and 69.7% for the periods 2006-2007 (CBN Statatistiacal Bulletin, 2009 and 2012).

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These inflation reductions impose a cost to the economy in terms of output lost. A percentage of output has been given off, to achieve these reductions over the years. In addition, across country studies have also demonstrated that the sacrifice ratio differs considerably among countries (see Belke & Böing, 2014; Dramani & Thiam, 2012; Daniels & VanHoose, 2004; and Cecchetti & Rich, 2001). Thus raising interest for what Nigeria’s sacrifice ratio could be after many successful inflation reductions over the years.

Also, studies such as Dramani & Thiam (2012) and Daniels & VanHoose (2004) have revealed that it is possible to reduce the size of the sacrifice ratio without a corresponding increase in the rate of inflation. The high policy relevance of the issue ensures that work needs to be done in Nigeria, and most continue all over the world. There are many issues in Nigeria’s inflation- output relationship. Among these are how inflation inertia impact on the rate of inflation, and the size of the sacrifice ratio.

The sacrifice ratio is an under researched area in Nigeria. Studies such as Umaru & Zubairu (2012) and Fontana & Ononugbo (2013) have studied the Philips curve. They examined the relationship between unemployment and inflation in the Nigerian economy between 1977 and 2009. On the other hand, Fontana & Ononugbo (2013) studied the nature of a new Keynesian type Phillips curve in Nigeria and the implication of disinflationary monetary policy, but no study takes the important issue of knowing the size of Nigeria’s sacrifice ratio into consideration. This study therefore tends to contribute by empirically analyzing the sacrifice ratio using Nigerian data. This study will as well show empirically, the magnitude of inflation inertia in Nigeria. This therefore, will also be a value added. Finally, the study will establish what impact inflation inertia has on the rate of inflation in Nigeria. This will again be a value added.

1.3         Research Questions

The basic questions this study seeks to answer are:

i.                    How does inflation inertia impact on the rate of inflation in Nigeria?

ii.                  What is the output cost of inflation reduction in Nigeria?

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1.4         Objectives of the Study

The broad objective of the study is to estimate the sacrifice ratio in Nigeria. The specific objectives are: