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Empirical evidence shows a divergence between the way the Central Bank of Nigeria changes its policy rate in reaction to the variations in macroeconomic variables and the models used to estimate such reaction. This study empirically examined the linearity assumptions, and hence, re-estimates a nonlinear Monetary Policy Reaction Function (MPRF) for the Central Bank of Nigeria (CBN), which was hitherto, variously, estimated using linear method. The study employed quarterly data from 2007Q1 to 2016Q2 to estimate an Exponential Smooth Transition Regression (ESTR) model. Results show that the trend (time horizon) is the transition variable. For comparative purposes, a simple quadratic nonlinear model was estimated, in which the central bank’s reaction to changes in exchange rate is assumed to be nonlinear relation. The quadratic model was estimated using the Nonlinear Two Stage Least Square (N2SLS), which appears to strengthen the findings from the ESTR. The results of the ESTR revealed that the MPRF of CBN is empirically nonlinear and that changes in the monetary policy rates do not appear to follow the Taylor’s Principle. It was also found that the CBN, as expected, reacts to inflation and exchange rates volatilities quite significantly. The reaction is, however, aggressive when inflation exceeds the threshold value of 10 percent. In addition, it was found that only the current and none of the leads, of inflation was significant. This is interpreted as reflecting the inability of the CBN to correctly forecast inflation beyond the current quarter. Hence, the study recommends that the CBN should focus on developing greater capacity for inflation forecast, which is a critical requirement for a smooth transition to the inflation targeting framework.
1.1 Background to the Research
The Monetary Policy Reaction Function (MPRF) of the Central Bank of Nigeria (CBN) gives the
summary of how the CBN changes its interest rate decision in response to changes in
macroeconomic variables relative to some targets. The MPRF with respect to inflation is an
upward sloping relationship between the real interest rate and inflation rate. Bernanke & Frank,
(2008) also explained MPRF as a relationship between inflation rate and unemployment rate,it
summarizes how central banks react to changes in macroeconomic variables. In Nigeria, the
actions of the CBN exert substantial influence on the behavior of economic agents and by and
large the general performance of the macro-economy. Hence the MPRF is sine qua non for
understanding and predicting actual monetary policy action because it provides the means for
assessing the current stance as well as forecasting the future path of monetary policy action.
Towards the end of twentieth century, monetary policy objective almost always and everywhere
aimed at dampening inflation(MIles & Scott, 2005, p. 377), Nigeria is not an exception. Granting
independence to CBN in 2007 and consolidation of commercial banks in 2004 paved a smooth
way for the eventualoperation of inflation targeting (IT) in Nigeria (Bello 2014). Under inflation
targeting framework, investors will know the targeted inf
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