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1.1 Background Information

The debate regarding the role of money supply in an economy particularly in the determination of income and prices gained prominence after the Second World War. This debate has been between Monetarists led by Milton Friedman and Keynes. Keynes (1943) argued that the rise in prices and nominal income depend upon the way that government financed the increase in war expenditures. Accordingly, the rise in prices and nominal income vary inversely with the extent to which government financed the rise in war expenditures through taxes as opposed to deficit spending. However according to Friedman (1956) money, not fiscal policy, provided a satisfactory explanation for the common behavior of inflation in the war era.

Keynes linked inflation to growth under the AD-AS framework, according to him, too much spending leads to demand-pull inflation. Keynes strongly argued that this is one of the major causes of inflation. Thus excess spending leads to an increase in demand that cannot be matched by the level of supply. As demand is greater than supply, prices will therefore rise. Businesses also experience increasing costs as money supply and inflation increase, which is known as cost-push inflation. As demand increases, labour costs may increase as workers and unions will push for an increase in wages. As Keynes(1943) put it, there are a number of policies that can be used in order to reduce the level of the money supply circulating around the economy which in turn will reduce the level of inflation .

Monetarists on the other hand, reemphasized the critical role of monetary growth in determining inflation. Friedman argued that excessive expansion of the money supply is inherently inflationary that monetary authorities should focus solely on maintaining price stability. According to Friedman ‘inflation is always and everywhere a monetary phenomenon’. In his quantity theory of money, he gave the idea that money creation determines the behavior of prices. Friedman gave empirical content to the theory by studying instances where historical circumstances suggested that money was the causal factor in this relationship. Friedman (1958) argued that there is perhaps no empirical regularity among economic phenomena that is based on so much evidence for so wide a range of circumstances as the connection between substantial changes in the stock of money and in the level of prices.

•           Statement of Problem

The Central Bank of Nigeria seeks to achieve price stability which is one of its core objectives through a monetary policy framework that targets monetary aggregates/intermediate variables. The CBN monetary programme sets explicit targets for broad money, the key intermediate benchmark variable and base money as the operating variable. The target for the intermediate variable according to CBN( Economic & Financial Review 2005)is determined with reference to the programmed inflation rate, external reserves accretion and real GDP growth targets. The link between the ultimate goals of price stability, the intermediate targets of money stock and indicator variables like the inflation rate are not usually so direct, but there is a wide consensus about the relative effect of the proximate variables on the ultimate goals.

Incidentally, the movements in the monetary aggregates and changes in price level in Nigeria between 1988 and 2005 have been so dramatic. Between 1988 and 1991,

the CBN's intermediate monetary target was the narrow money supply (Ml). During those four years, narrow money supply was expected to grow on, average by 14.3 percent annually. The actual increase in M1 was 36.7 percent per annum. The largest deviations of outcomes from targets occurred in 1988 and 1990 with 26.9 and 31.9 percentage points, respectively.

From 1992, the broad money supply (M2) became the intermediate monetary target. Apart from the years 1996 to 1998 when the actual increases in M2 exceeded the targets by an annual average of only 1.6 percentage points, the incidence of excessive monetary expansion was sustained in the review period. The deviations were particularly large between 1992 and 1994. By 1999, broad money growth was 10.0%, 27.0% in 2001, 21.6% in 2002, 24.1% in 2003, 14.0 in 2004 and 16.0% in 2005. While inflation was expected to be at a single digit, but there was a deviation from this expectation because the target was not met. Inflation actually grew by over 10.5%. Between 1970 and 1975, inflation stood at an average of 14.28%, and 12.70% in 1981, 15.27% in 1997, 28.57% in 1993, 30.7% and 12.41% in 1999 and 2005 respectively. This shows that in the last 36 years, using available data from Nigerian Statistical fact sheet NBS(2005), inflation has stood at an average of 18.99% while money stock growth stood at an average of 19.0%. Hence, there is evidence of one-to-one growth rate between inflation and money stock.

The role money play in the inflationary process remains, nonetheless, a highly controversial issue. Friedman and his apostles claim that money plays an active role and leads to changes in income and prices. That is, changes in income and prices in an economy are mainly caused by the changes in money stocks. Hence, there is a unidirectional causation running from money to income and prices without any feedback. The Keynesians, on the other hand, argue that money does

not play an active role in changing income and prices. Emphatically they maintain that changes in income cause changes in money stocks via demand for money implying that there is no causality between money changes and prices.

Empirical studies have largely borne out of the Friedman’s proposition that ‘inflation is always and everywhere a monetary phenomenon’ however, the findings of these studies are divergent. While some of the studies provide evidence that support the Friedman’s hypothesis, some others provide contrary reports. For instance, Fakiyesi (1996), Qayyum (2004), Budina et. al, (2002) and Greene and Canetti (1991) provides evidence that support the validity of Friedman’s hypothesis. On the contrary, Mark and Blaug (1996) and Rwegasira (1977) present findings that do not support Friedman’s hypothesis. This project is interested in resolving these issues by finding out which monetarist-keynesian inflation theory that prevail in Nigeria.

1.3 Research Questions

This study raises the following research questions:

1) What is the causal relationship between money supply and inflation?

•         Is there any long run relationship between money demand and inflation in Nigeria?

•         Is there any stability of money demand function in Nigeria?

1.4 Research Objectives

•         To examine the causal relationship between money supply and inflation in Nigeria

•         To investigate if there is a long run relationship between money demand and inflation in Nigeria.

•         To check for the stability of money demand function in Nigeria.

1.5 Research Hypothesis

•            There is no causal relationship between money supply and inflation in


•         There is no long run relationship between money demand and inflation in Nigeria

•         There is no stability in money demand function in Nigeria

1.4 Scope of the study

The study covered the period of 1970 to 2006, a sample size of 37 years of observation. Using time series data of this sample size is good enough for a time series analysis.

1.5 Policy Relevance of the study

This result of this study is important for policy-makers in dynamic monetary policy formulation in Nigeria. Since the results showed that inflation is a monetary phenomenon as claimed by Friedman, it implies that it would be inappropriate for monetary policy authority to treat money stock variables as endogenous. Again, an important issue concerning monetary policy is to identify a stable money demand function (Friedman, 1959; Friedman and Schwartz, 1963). In turn, a stable money demand function is a necessary condition to establish a direct link between the relevant monetary aggregates and nominal income. The presence of a stable money demand function as shown in the study will thus enhance the ability of monetary authorities to reach predetermined monetary growth targets if price stability is the main objective.

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