Monetary and fiscal policies

Monetary and fiscal policies are the key major policies use in managing demand pressures in the economy (CBN, 2017). Monetary policy is the manipulation of the economy through the use of monetary instruments such as open market operation, money supply, liquidity ratio and interest rates to influence overall demand in the economy (Micheal & Ebibai, 2014), while fiscal policy is the manipulation of government expenditure, taxes, subsidy and debt to control aggregate demand in the economy (Ahmad, 2008).

Monetary policy is implemented by the monetary authorities, the Central Bank, while fiscal policy is implemented by the fiscal authorities, the Ministry of Finance (Abdulazeez, 2016). Meanwhile, both monetary and fiscal policies pursue the same ultimate objectives but they apply different instruments (Abdulazeez, 2016).                                                                                    On the basis of economic principles, fiscal policy and monetary policy are used to manage the health of an economy by expanding aggregate demand and economic growth (Khaysy & Gang, 2017). The reason is that monetary policy and fiscal policy complement each other (Khosravi and Karimi, 2010). The monetarists believe that monetary policy influences economic activity while the Keynesians believe that fiscal policy rather than monetary policy has more influence on economic activity (Khosravi and Karimi, 2010).

Fiscal policy involves either increasing or decreasing taxation or either increasing or decreasing government spending. All these are done to influence aggregate demand (Kibiwot et al., 2012).  To embark on expansionary policy, there should be decrease taxation which might be a decrease in income tax or expenditure tax. This will cause consumption to increase since one’s disposable income increases when income tax falls. In addition, if corporate profit taxes fall, this will make the firms have more profit which can be reinvested into the business, hence, resulting in an increase in investment, all other things remaining unaltered (Ghulam, 2014). These will influence the aggregate demand.  In a more simplified form, if taxes decrease, consumption will increase, investment will increase and finally aggregate demand will increase (Joab & Daney, 2017).                                                                                                                                            Alternatively, we can increase government spending be it current expenditure or capital expenditure. This will also cause the aggregate demand to increase (see Lee & Gordon, 2005; Koeda Kramarenko, 2008; Miron, 2013).

Public debt may crowd out investment through increase in interest rate brought about by public debts. When government finances her budget deficit through domestic borrowing, it reduces the loanable funds available for private investment. This makes the demand for loanable fund higher than its supply (International Monetary Fund, 2009). The increased borrowing leads to higher interest rates and reduces the level of private investment. Also, external debt may crowd out private investment. This occurs especially in countries with more dominant public sector. Increased public external debt reduces private sector access to foreign loans because public external debt increases the risk of lending to the private sector. It reduces the available foreign credits, and increases the price of accessing the foreign loan, thereby reducing private access to external markets (International Monetary Fund, 2009).

On the other hand, monetary policy is a demand side policy that the government uses to achieve macroeconomic objectives (Osasohan, 2014). These objectives are sustained economic growth, price stability, low unemployment, balance of payment equilibrium and sustainable development. Monetary policy comes into being when there is a change in interest rate, a change in money supply and a change in exchange rate.  If we assume that an economy wants to expand, then, the government, through the central bank, can decrease the interest rate which will further cause exchange rate to decrease. The possible effects are: (1) decrease in mortgage payments; (2) increase in purchases on credit and (3) decrease in savings (Taylor, 1995).  The decrease in interest rate will cause consumption and investment to increase. Likewise, the decrease in exchange rate will cause exports to be more competitive (rise) and imports to be less competitive (fall). The increase in the three injections will lead to more money coming into the economy, hence, the attainment of economic growth, this means that either of these two policies (fiscal policy and monetary policy) can influences an economy positively or negatively (Dwivedi, 2005).

• Statement of Research Problem

Monetary and fiscal policies in Nigeria are aim at influencing aggregate demand to stabilize economic growth. Various monetary policies strategies have been adopted by the Central Bank of Nigeria and fiscal policies through the federal ministry of finance over the years to influence aggregate demand and economic growth. Despite the manipulation of monetary and fiscal policies in Nigeria, the problem affecting its aggregate demand and economic growth still persists. Such problems include low investment, low consumption, high unemployment rate, high importation of consumable and capital goods, low exportation etc. These observed problems are being responsible to the fast reduction in the aggregate demand components (private investment, private consumption, government consumption and export-import) and consequently economic growth of Nigeria.                                                                                                                                   The continuous increase of fiscal deficits have been apprehend for much of the economic crisis that attack Nigeria about two decades ago resulting in over indebtedness and debt crisis, poor investment and growth (Chimobi & Igwe, 2010). For instance, the country recorded an increase in budget deficits from N3,902.10 million in 1981 to N8,254.30 million in 1986 to N15,134.70 million in 1989 but catapulted to N133,389.30 million and N301,401.60 million in 1998 and 2002 respectively (CBN, 2012). As of 2003-2006, government fiscal deficits witnessed a moderate declined from N202,724.70 million in 2003, N172,601.30 million in 2004, N161,406.30 million in 2005, to N101,397.50 million in 2006 (CBN, 2012).                                             In Nigeria, the conflict over which policy tool (monetary and fiscal) to use is frustrating the economy in terms of stimulating macroeconomic variables such as private consumption, private investment, government consumption as well as export. Ultimately, decisions in Nigeria about whether to use monetary policy or fiscal policy mechanisms to implement macroeconomic policy are, in part, a political decision rather than a purely economic one. These constitute low aggregate demand and consequently economic growth in Nigeria.

Aggregate demand (private consumption, Private investment, government expenditure and export-import) which has been recognized as one of the pillars for achieving sustainable economic growth (Kahuthu, 1999; Seruvatu & Jayaraman, 2001) have remain low and insignificant to move the economy. The ratio of private investment to GDP in Nigeria was 7.6% in 2007, 7.1% in 2008, 8.8% in 2009 and 11.2% in 2011.             These percentages are below the levels being experienced in successful economies and which is required to spur economic growth needed for employment creation and poverty reduction (World Bank, 2018). In fact the World Bank (2017) and CBN (2018) stressed on the need to achieve higher economic growth through increased private investment and private consumption. According to Herandez-Cata (2000), the ratio of private investment to GDP averaged 16% in Latin America, 18% in developed countries and 16.5% in newly industrialized countries in Asia. CBN (2017) proposed that this proportion should not be less than 15 per cent of the GDP at any time.                                                          Furthermore, Nigeria is a country endowed with abundance of human and natural resources. However, these resources are not put to good use. As a result, majority of Nigerians continue to wallow in poverty. About 67 per cent of Nigerians live below the poverty line (NBS, 2018). Basic amenities such as portable water, food and shelter are in short supply. According to United Nation report (2018), Nigeria has overtaken India as the country with the most people in extreme poverty. People living in extreme poverty are unable to meet even the barest minimal needs for survival.                                                                                                                             Economic recession is the order of the day as prices continue to go up and cost of living is on the rise. The rate of inflation in the country is over 18 per cent (NBS, 2018) and is continually on the increase. One of the major sources of inflation is the rise in oil prices which affects most areas of the Nigerian economy. The current interest rate stands at about 26.77 – 27 per cent (CBN, 2018) which is a turn-off for many potential investors as well as existing investors. High-interest rate decreases company gross profit. Poor investments, in turn, cause an increase in unemployment rate, decrease in consumption. It, therefore, important to examine the monetary and fiscal policies in Nigeria and analyse the extent to which it has actually contributed to aggregate demand growth in Nigeria.

• Research Questions

In order to investigate impact of monetary and fiscal policies on aggregate demand in Nigeria, the formulated research questions are:

1. What is the trend of selected monetary and fiscal policies variables in Nigeria?
2. What is the impact of monetary policy on aggregate demand?

iii. What is the impact of fiscal policy on aggregate demand?

1.4 Objectives of the Study

Broadly, this study assessed the impact of monetary and fiscal policies on aggregate demand (such as consumer spending and total investment) in Nigeria. To achieve this, the following specific objectives are to be pursued, to:

1. Determine the trend of selected variables of monetary and fiscal policies in Nigeria;
2. Examine the impact of monetary policy on aggregate demand in Nigeria;

iii. Evaluate the impact of fiscal policy on aggregate demand in Nigeria.

1.5 Research Hypotheses

The following null hypotheses are tested:

H₀₁: Monetary policy has no significant impact on aggregate demand in Nigeria

H₀₂: Fiscal policy has no significant impact on aggregate demand in Nigeria

• Significance of the Study

The study is relevant in that it sheds light on the impact of monetary and fiscal policies on aggregate demand in Nigeria as well as contributes to existing literature on economic policies in Nigeria.

The results are useful in implementing effective monetary and fiscal policies that can drive the economic to achieve the desired level of development through aggregate demand. The study make available to policy makers on the choice of policy as well as providing guidelines on the implementation of such policy to promote economic performance through stimulating aggregate demand. In addition, the study creates an understanding on the different category of monetary and fiscal variables and how they affect the overall welfare of different economic agents with particular reference to aggregate demand. This is desirable for budget making process since it can be used as a guiding principle when allocating national resources under different votes.

The study contributes to the body of knowledge on the effectiveness of monetary and fiscal adjustment in achieving sustainable economic growth. It also provokes researchers to critically evaluate the effectiveness of different government policies in order to prescribe or suggest to the policy makers the best course of action for achieving economic goals through aggregate demand.

The study is motivated by the fact that Nigeria is yet to attain the desired level of economic growth/development. The economy of the country is characterized by high level of inflation rate, high interest rate, low investment opportunity, and high unemployment rate. Majority of Nigerians are living below the poverty line which lowers aggregate demand and slows the general growth of the economy. Furthermore, government policies fail to address these fundamental issues. These foregoing factors are the rationale for the study. This study provides answers to some of the questions raised and in the process add to the existing literature on the subject matter. Finally, the study uses macro-econometric model build in block forms which provides information on the dynamics of adjustment process and also performed simulation experiment that shows the shocks in aggregate demand from monetary and fiscal policy variables.

 1.7 Scope of the Study

This study focuses on the impact of monetary and fiscal policies on aggregate demand in Nigeria spanning the period 1986-2017. The choice of the period is as a result of the introduction of the Structural Adjustment Programme (SAP) in 1986. The scope of the study captures the various fiscal regimes under different government regimes experienced in Nigeria. Also, the choice of this period is informed by the availability of uniform time series data on the variables used in the study. Macro-econometric model was employed in the conduct of the investigation. The model consists of four structural sectors with 18 behavioural equations which data on some of the variables were not easily accessible in Nigeria while the ones accessible conflict each other from different sources.

CHAPTER TWO

LITERATURE REVIEW

2.1 Introduction

This chapter presents theoretical and empirical literatures on the impact of monetary and fiscal policies on aggregate demand in Nigeria between 1986 and 2017. The first part of this section deals with the conceptual issues, while the second part dwells on the theoretical and empirical literature. The empirical literature explores previous studies that have been conducted by researchers on monetary and fiscal policies. The empirical literature is divided into three sub-sections: studies on monetary policy, studies on fiscal policy and summary of the policies.

2.2 Conceptual Issues

2.2.1 Monetary Policy

According to Dwivedi (2005), monetary Policy is the deliberate use of monetary instruments (direct and indirect) at the disposal of monetary authorities such as central bank in order to achieve macroeconomic stability. Monetary Policy is the tool for achieving the mandate of monetary and price stability. Monetary policy is a programme of action undertaken by the monetary authorities, generally the central bank, to control and regulate the supply of money to the public and the flow of credit with a view to achieving predetermined macroeconomic goals (Dwivedi, 2005).

According to Wrightsman (1976), monetary policy is the actions initiated by the central bank which aim at influencing the cost and availability of credits. Central bank of Nigeria (2006) defined monetary policy as a policy measure designed by the federal government through the central bank to control cost availability and supply of credit. It also referred to as the regulation of money supply and interest rate by the Central Bank of Nigeria in order to control inflation and to stabilize the currency flow in an economy.

Ogar, Nkamere and Emori (2014) opine that monetary policy is planned to influence the bahaviour of the monetary sector because changes in the behaviour of the monetary variables influence various monetary variables. Usman (2011) defined monetary policy as the adjustment of monetary aggregates such as money supply, interest rate, inflation rate, cash reserve ratio, liquidity ratio etc to influence the economy over a given period of time.

1. Objectives of Monetary Policy

The core objectives of monetary policy are similar to the objectives of fiscal policy. The following are the objectives of monetary policy:

1. Price Stability

Price stability is the main objective of monetary policy in the Country. Many countries and economies face the problem of inflation and deflation from time to time. Both are not good to the economy. Monetary policy, having an objective of price stability, tries to keep the quality and value of money stable such that when the economy suffers from recession. (Jeevan, 2012).

1. Sustainable Economic Growth

Another objective of monetary policy is stimulation of economic growth through controlling real interest rate and its resultant impact on investment. The central bank of Nigeria opts for credit easing by reducing interest rates; investment in the economy can be encouraged. This increased investment can speed up economic growth (Tobin, 1969).

iii. Exchange Rate Stability

Exchange rate is the price of a home currency expressed in terms of any foreign currency (Tobin, 1969). If the exchange rate is volatile, the international community might lose confidence in the economy. Therefore, monetary policy aims at maintaining relative stability in the exchange rate by altering the foreign exchange reserves, tries to influence the demand for foreign exchange (Tobin, 1969).

1. Favourable Balance of Payments (BOP)

When country’s payment is less than country’s received, imbalance in a country’s balance of payments occur (Tobin, 1969). The central bank of Nigeria, through its monetary policy, tries to maintain equilibrium in the balance of payments. Balance of Payment Surplus is considered favourable because more currency is flowing into the country than is flowing out. Such an unequal flow of currency will expand the supply of money in the nation and subsequently cause a decrease in the exchange rate relative to the currencies of other nations, which has implications for inflation, unemployment, production, and other sectors of the domestic economy (Tobin, 1969). Balance of Payment Deficit, on the other hand, stands for stringency of foreign inflow and high out flow of foreign currency. If monetary policy succeeds in maintaining monetary balance, then Balance of Payment equilibrium is said to have been achieved.

1. Full Employment

The concept of full employment was much discussed after Keynes (1936). It refers to the absence of involuntary unemployment. In simple words, “full employment” stands for a situation in which everybody who wants a job gets one (Keynes, 1936). However, it does not mean that there is zero unemployment. In that sense, the full employment is never full. Monetary policy can be used to achieve full employment. If the monetary policy is expansionary, then credit supply can be encouraged which could help in creating more jobs in different sectors of the economy (Tobin, 1969).

1. Equitable Income Distribution

According to Keynes (1936), equitable income distribution refers to the manner in which income is distributed among members of the society. A perfectly equal income distribution would mean everyone in the country has exactly the same income (Tobin, 1969). Many developing countries, including Nigeria, are experiencing inequality in income distribution because resources are never equally distributed. Some labours are naturally more productive and better to produce wealth that consumers want and thus get more income. The same is true for capital, land, and entrepreneur. However, without government intervention, an unequal distribution of income tends to be self-perpetuating (Solodu, 1998).

Those who have more income, can invest in additional productive resources, and thus can add even more to their income. In recent years, (Solodu, 1998; Clarida, Gali & Gertler, 2000) have opined that monetary policy can help by playing a supplementary role in attainting income equality. Central bank of Nigeria can make special provisions for the neglected sectors of the economy such as agriculture, small-scale industries, etc by providing long term cheap credit which can prove fruitful for these sectors.

1. Instruments of Monetary Policy

Monetary policy instruments are broadly divided into two: direct instruments and indirect Instruments.

1. Direct Instruments: Direct Instruments of monetary policy are directives given by the central bank to control the quantity and prices of financial assets/liabilities of deposit money banks (DMBs) and discount houses (Uanguta & Ikhide, 2002). These include interest rates fixing and credit ceilings. These may prove very useful in controlling price, quantity of deposit or credit and the direction of credit particularly in periods of temporary shocks. They may also be most effective and practicable in underdeveloped financial markets and in jurisdictions where the central bank lacks adequate techniques of indirect control. The downsides of the direct controls are absence of competition, inefficient use of resources and distortion of markets (Uanguta & Ikhide, 2002).
2. Indirect Instruments: Indirect Instruments of monetary policy involve controlling the price or quantity of base money (Uanguta & Ikhide, 2002). Indirect monetary policy instruments include; open market operations (OMO), monetary policy rate (MPR), reserve requirement, discount window operations and repurchase agreements. This is the current trend in monetary policy formulation and implementation because it provides a liberalised environment necessary for the efficient allocation of savings and credit in the economy (McKinnon, 1973).

2.2.2 Fiscal Policy

Fiscal policy is the use of government revenue collection (mainly taxes) and expenditure (spending) to influence the economy (O’Sullivan & Steven, 2003).

According to Okonjo-Iweala (2003), fiscal policy involves the use of taxes and changes in government expenditure to influence the level of economic activity. Fiscal and monetary policies are inextricably linked in macroeconomic management as development in one sector directly affects developments in the other. Undoubtedly, fiscal policy is central to the health of any economy, as government’s power to tax and to spend affects the disposable income of citizens and corporations, as well as the general business climate (Okonjo-Iweala, 2003).

A decrease in any of the other components of aggregate demand is expected to be compensated by government through an expansionary fiscal policy so as to maintain the same level of GDP. Such a policy naturally operates through the multiplier and reflects how shocks to one sector are transmitted throughout the economy (Froyen, 2005). Implicitly, government should increase expenditure and cut taxes to stimulate demand and increase economic growth during recession and vice versa during boom in order to tame inflationary pressures.

Expansionary fiscal policy, however, often leads to large budget deficits which tend to increase the tax burden in the long-run with adverse effects on consumption, investment and national output. Modern theorists such as Romer and Romer (2007) argue that an increase in government expenditure that raises borrowing would make economic agents increase their current savings in anticipation of an increase in the future tax burden, thus, making fiscal policy ineffective. However, budget deficits can have positive effect on output and other macroeconomic variables in the long-run if the increased expenditure is used to finance productive capital expenditure (Romer & Romer, 2007). In addition, the IS-LM postulated that fiscal expansion (contraction) is expected to raise (lower) the aggregate demand and output.

1. Government Revenue

Government revenue can be described as receipts from taxes, property income, sale of goods, voluntary transfers received from other units, and any transaction that increases the net worth of government (Ndekwu, 1988). Traditionally, government revenue is classified into tax and non-tax revenue. Tax can be defined as a compulsory levy by the government on its citizens and all other economic agents so as to extract resources for the provision of public goods. Tax also serves as a source of accountability as it creates an incentive for the citizens to hold the government accountable for its actions (and inactions). Taxation is often actively used by government as part of the broader fiscal policy to achieve the objectives of stabilization and income redistribution (Ndekwu, 1988). To achieve the former, government tends to rely on the immediate effects taxation seem to have on consumption and hence aggregate demand, and thus, employs it as a counter cyclical measure.

Taxes can be classified into direct and indirect taxes. Direct taxes are levied directly on income, wealth or profit, while indirect taxes are levied on goods and services (Rose & Karan, 1987). This classification can be viewed in terms of the burden borne by the taxpayers (Rose & Karan, 1987). While the burden of indirect taxes can be shifted to the final consumer, that of direct taxes can only be borne by the tax payer. The maximum revenue that can be generated from taxes is determined by the taxable capacity of the economy (Rose & Karan, 1987). Taxable capacity is a function of the tax base (the object defined by law as taxable), tax rate (the rate payable on the defined base) and tax administration (the effectiveness of the tax collection). The tax base and tax rate determine the amount of tax revenue, and are both intervening variables influenced by political and economic factors (Rose & Karan, 1987).

Non-tax revenues are payments, usually made for enjoying a service provided by the government. They include administrative revenues (mostly receipts from fees, licenses etc), commercial receipts (payments from water rates, education levies) and grants. Grants are usually one-way transfer from one country’s government or international organizations to another country’s government. It may also occur between a higher tier of government to a lower tier of government in the same country for the purpose of providing specific public goods or just to bridge revenue gaps (Rose & Karan, 1987).

Although, tax revenue generally tends to be the major source of revenue for most countries worldwide, Nigeria’s major source comes from sale of crude oil and gases. This made it convenient to classify revenue in terms of oil and non-oil (Rose & Karan, 1987).

1. Government Expenditure

Government expenditure constitutes outlays for the provision of public goods and services, particularly in areas where the price mechanism fails in effectively allocating resources to maximize welfare. These public goods are usually non-excludable and non-rival in consumption, thus, making it impossible for potential producers to recover cost (Ghulam, 2014).

Government expenditures can be classified into recurrent, capital and transfers. Recurrent expenditures are expenses on current goods and services that do not contribute to fixed capital, but aid day to day running of the government (Ghulam, 2014). They include: overheads, payments of salaries and wages, etc. Capital expenditure involves government acquisition of capital goods for the purpose of creating future stream of value and they include spending on infrastructure, research and development, etc. Transfer payments are expenditures on non-compensatory payments such as subsidies, social security, etc, to individuals, businesses or lower levels of government for the purpose of improving welfare and income redistribution (Ghulam, 2014).

Government expenditures are often described by their economic and functional nature so as to provide adequate information on the direction of government policy (Ghulam, 2014). The economic component defines the form of spending and it comprises; capital and recurrent expenditure (wages and salaries, overhead, interest payments, pension and gratuity) and transfers. On the other hand, the functional component comprises the allocation of government spending by sectors and it comprises expenditures on education, health, infrastructure, food, security etc. Government expenditure is expected to play three major functions in the economy. These are allocation, stabilization and distribution (Ghulam, 2014).

iii. Fiscal Deficit/Public Debt

Fiscal deficit arises from government’s expansionary fiscal policy that leads to revenue falling short of expenditure in a given fiscal year (Ghulam, 2014). The government can finance its fiscal deficits through domestic sources, which comprise the central bank, deposit money banks and the public via bond issuance. External financing can come from concessional or non-concessional aid from multilateral or bilateral creditors, including the international capital market. Expectedly, whichever mode of financing the government chooses has various implications for key macroeconomic variables (Ghulam, 2014).

The act of financing government’s fiscal deficits gives rise to public debt. Public debt is the total monetary obligations of government to both its citizens and foreigners. In Nigeria the domestic debt stock comprises treasury bills, treasury certificates, treasury bonds, ways and means advances, development and Federal Government Bonds, while external debt consist of Paris and London Club debts, Multilaterals debt, Bilateral debts, and promissory notes (Ghulam, 2014).

1. Objectives of Fiscal Policy

Fiscal policy is designed to achieve the following objectives:

1. Rapid Economic Growth and Development: The principal objective of fiscal policy is to ensure rapid economic growth and development (Kiptui, 2005). Fiscal policy is applied to mobilise financial resources which can be deployed on projects and programmes that target growth and development. Financial resources can be mobilised through effective taxation. In addition, government can prioritise it expenditure in order to enhance public savings that can be used for more productive activities (Kiptui, 2005). The government can also borrow from the private sector by implementing a tax regime that gives tax benefits to holders of government securities.

1. Efficient Allocation of Financial Resources: The Federal and State governments have made considerable efforts at achieving efficient allocation of financial resources for developmental activities which include expenditure on education, health and infrastructure (Kiptui, 2005). Therefore, fiscal policy should be designed in such a manner as to encourage production of desirable goods and discourage those goods which are socially undesirable.

iii. Reduction in Wealth and Income Inequalities: Fiscal policies are also designed to achieve equitable distribution of income and resources among different sections of the society. The direct taxes such as income tax paid by rich may be higher compared to the lower income groups. Indirect taxes imposed on semi-luxury and luxury items may also be higher as they are mostly consumed by the upper middle class and the upper class (Kiptui, 2005). The government invests a significant proportion of its tax revenue in the implementation of poverty alleviation programmes to improve the conditions of the poor in society.

1. Employment Generation: The government makes efforts to increase employment in the country through effective fiscal policy measures. Investment in infrastructure has resulted in direct and indirect employment effects (Ghulam, 2014). Lower taxes and duties on small-scale industrial (SSI) units encourage more investment and consequently generate more employment. Rural employment programmes are implemented by government to empower and reduce poverty in rural communities. Other self-employment scheme are also undertaken to provide employment to technically qualified persons.

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1. Balanced Regional Development: Another objective of fiscal policy is to bring about balanced regional development (Kiptui, 2005). There are various incentives from the government for setting up projects in backward areas such as cash subsidy, concession in taxes and duties in the form of tax holidays, finance at concessional interest rates, etc.

1. Reducing the Deficit in the Balance of Payment: Fiscal policy attempts to encourage more exports by way of fiscal measures such as tax exemptions on export earnings. Foreign exchange could also be conserved by providing fiscal benefits to import-substitution industries, imposing tariff and other duties on imports, etc (Kiptui, 2005). The foreign exchange earned by way of exports and saved by way of import substitution helps to correct balance of payments imbalance.

vii. Development of Infrastructure: Infrastructure development is important for unlocking the growth potentials of every economy. Fiscal policy measures are often designed by government for the purposes of investment in strategic national assets. In Nigeria, infrastructure gaps in critical areas such as in power have subdued the growth enhancing activities for many decades (Kiptui, 2005).

1. Instruments of Fiscal Policy

Fiscal policy instruments are:

1. Public Expenditure: Public expenditure refers to the total amount of money spent by government of a country in a period. It includes all acquisition of goods and services, and transfer payments. An increase in public expenditure during recession/depression raises the aggregate demand for goods and services and leads to a boost in income, while a reduction in public expenditure, at a time of high inflation, shrinks aggregate demand and prices (Kiptui, 2005).
2. Taxes: Taxes are financial charges and other levies imposed on an individual or legal entity by government such that failure to pay is punishable by law (Kiptui, 2005). Tax is enforced contribution imposed by the government on the governed to support governance. It is enforced because there is no “quid pro quo” associated with it. The payer does not necessarily expect something in return. Revenue obtained from taxes is, thereafter, deployed by the government to produce public goods. Reduction in taxes raises disposable income thereby increasing private consumption and investment expenditure. Reduction in tax level could be an effective measure during recession/depression. On the other hand, an increase in taxes tends to reduce disposable income thereby, limiting consumption and investment expenditure (Kiptui, 2005).

iii. Public Debt: Public debt as an instrument of fiscal policy is the borrowings by government to fund public expenditures not financed by current tax revenues. Government debts are classified mainly into two: domestic and external debt. Domestic debts are owed to lenders within the country, while external debts are owed to foreign lenders. Governments typically borrow by issuing treasury securities such as bonds, certificates and bills, or outright credit facilities from other governments, bilateral and multilateral organisations such as the World Bank and the International Monetary Fund (IMF).

2.2.3 Aggregate Demand

Aggregate demand is a macro-economic concept representing the total demand for goods and services in an economy (O’Sullivan & Steven, 2003). This value is often used as a measure of economic well-being or growth. Fiscal policy affects aggregate demand through changes in government spending and taxation. Government spending and taxation influence employment and household income, which dictate consumer spending and investment. Monetary policy impacts the money supply in an economy, which influences interest rates and the inflation rate. Also, monetary policy impacts business expansion, net exports, employment, the cost of debt and the relative cost of consumption versus saving (O’Sullivan & Steven, 2003).                                    Aggregate demand is the sum of the demand for all final goods and services in the economy. It can also be seen as the quantity of real GDP demanded at different price levels (Sexton, Fortura & Peter, 2005). Aggregate demand (AD) is calculated with the same formula for measuring an economy’s gross domestic product (GDP): AD = C + I + G + (X – M), where C = Consumer spending on goods and services; I = Investment spending on business capital goods; G = Government spending on public goods and services; X = Exports and M = Imports.

2.3 Theoretical Literature

This section presents the views of various theories regarding monetary and fiscal policies.

2.3.1 Liquidity Preference Theory

Keynes (1936) defines the rate of interest as the reward for parting with liquidity for a specified period of time. According to him, the rate of interest is determined by the demand for and supply of money.

Demand for Money: Keynes (1936) Liquidity preference means the desire of the public to hold cash. According to Keynes, there are three motives behind the desire of the public to hold liquid cash: (1) the transaction motive, (2) the precautionary motive, and (3) the speculative motive.

1. Transactions Motive: The transactions motive relates to the demand for money or the need of cash for the current transactions of individual and business exchanges. Individuals hold cash in order to bridge the gap between the receipt of income and its expenditure. This is called the income motive Keynes (1936). The businessmen also need to hold ready cash in order to meet their current needs like payments for raw materials, transport, wages etc. This is called the business motive.
2. Precautionary Motive: Precautionary motive for holding money refers to the desire to hold cash balances for unforeseen contingencies. Individuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies. Similarly, businessmen keep cash in reserve to tide over unfavourable conditions or to gain from unexpected deals. Keynes (1936) holds that the transaction and precautionary motives are relatively interest inelastic, but are highly income elastic. The amount of money held under these two motives (M₁) is a function (L₁) of the level of income (Y) and is expressed as M₁ = L₁ (Y)

iii. Speculative Motive: The speculative motive relates to the desire to hold one’s resources in liquid form to take advantage of future changes in the rate of interest or bond prices. Bond prices and the rate of interest are inversely related to each other. If bond prices are expected to rise, i.e., the rate of interest is expected to fall, people will buy bonds to sell when the price later actually rises. If, however, bond prices are expected to fall, i.e., the rate of interest is expected to rise, people will sell bonds to avoid losses.                                                                            According to Keynes (1936), the higher the rate of interest, the lower the speculative demand for money, and lower the rate of interest, the higher the speculative demand for money. Algebraically, Keynes expressed the speculative demand for money as

M₂ = L₂ (r)  ……………………………………………………………………………..1

Where, L₂ is the speculative demand for money, and r is the rate of interest. Geometrically, it is a smooth curve which slopes downward from left to right. Now, if the total liquid money is denoted by M, the transactions plus precautionary motives by M₁ and the speculative motive by M₂, then M = M₁ + M₂. Since M₁ = L₁ (Y) and M₂ = L₂ (r), the total liquidity preference function is expressed as M = L (Y, r) (Keynes, 1936).

Supply of Money: The supply of money refers to the total quantity of money in the country. Though the supply of money is a function of the rate of interest to a certain degree, yet it is considered to be fixed by the monetary authorities. Hence the supply curve of money is taken as perfectly inelastic represented by a vertical straight line (Keynes, 1936).

1. Determination of the Rate of Interest: Like the price of any product, the rate of interest is determined at the level where the demand for money equals the supply of money. In following figure 1, the vertical line QM represents the supply of money and L the total demand for money curve. Both the curve intersects at E₂ where the equilibrium rate of interest OR is established.

If there is any deviation from this equilibrium position an adjustment will take place through the rate of interest, and equilibrium E₂ will be re-established (Mckinnon, 1973). At the point E₁ the supply of money OM is greater than the demand for money OM₁. Consequently, the rate of interest will start declining from OR₁ till the equilibrium rate of interest OR is reached. Similarly at OR₂ level of interest rate, the demand for money OM₂ is greater than the supply of money OM. As a result, the rate of interest OR₂ will start rising till it reaches the equilibrium rate OR (Mckinnon, 1973).                                                                                                                                              It may be noted that, if the supply of money is increased by the monetary authorities, but the liquidity preference curve L remains the same, the rate of interest will fall. If the demand for money increases and the liquidity preference curve sifts upward, given the supply of money, the rate of interest will rise (Mckinnon, 1973).

Criticisms: Keynes theory of interest has been criticized on the following grounds:

1. It has been pointed out that the rate of interest is not purely a monetary phenomenon. Real forces like productivity of capital and thriftiness or saving by the people also play an important role in the determination of the rate of interest (Mckinnon, 1973).
2. Liquidity preference is not the only factor governing the rate of interest. There are several other factors which influence the rate of interest by affecting the demand for and supply of investible funds (Mckinnon, 1973).

iii. The liquidity preference theory does not explain the existence of different rates of interest prevailing in the market at the same time (Mckinnon, 1973).

1. Keynes ignores saving or waiting as a means or source of investible fund. To part with liquidity without there being any saving is meaningless (Mckinnon, 1973).
2. The Keynesian theory only explains interest in the short-run. It gives no clue to the rates of interest in the long run (Mckinnon, 1973).
3. Keynes theory of interest, like the classical and loanable funds theories, is indeterminate. We cannot know how much money will be available for the speculative demand for money unless we know how much the transaction demand for money is (Mckinnon, 1973).

2.3.2 IS-LM Framework

The role of monetary variables in the Keynesian model was first pointed out by (Hicks, 1937). The IS-LM model is the basic model of aggregate demand that incorporates the money market as well as the goods market (Hicks, 1937). It lays particular stress on the channels through which monetary and fiscal policy affect the economy. The IS-LM model is a standard tool of macroeconomic that demonstrates the relationship between interest rates and real output in the goods and services market and the money market (Hicks, 1937). The intersection of the IS and LM curves is the “General Equilibrium” where there is simultaneous equilibrium in both markets (Hicks, 1937).

a. Equilibrium in a Closed Economy

The general equilibrium model of the economy comprises of the two parts. The first part brings together the determinants of equilibrium in the real sector or the goods market of the economy (Hicks, 1937). The second part brings together the determinants of equilibrium in the money market or the monetary sector of the economy. The equilibrium in the real sector is defined in terms of the equality between the aggregate saving and aggregate investment corresponding to that aggregate real income where aggregate saving equals the aggregate Investment (S=I), the aggregate demand for goods just equals the aggregate supply of goods in the economy, i.e. C+I=Y thus, the economy’s real sector is in equilibrium (Hicks, 1937). The equilibrium of the economy’s money market requires equality between the total supply of money and the total demand for money. The equality between the total supply of and demand for money furnishes us with the equilibrium rate of interest. Thus, the monetary sector of the economy will be in equilibrium at that rate of interest corresponding to which the total demand for money equals the total supply of money, i.e. where M_d=M_s (Hicks, 1937).

The equilibrium aggregate income corresponding to which the aggregate saving equals the aggregate investment, i.e., S=I, partly depends, on the conditions in the monetary sector. Similarly the equilibrium rate of interest at which the total demand for money and the total supply of money are in equilibrium, i.e., M_d=M_s, partly depends on the conditions in the real sector or the goods market (Hicks, 1937).

b. Goods Market Equilibrium: IS Curve

The goods market includes trade in all goods and services that the economy produces at a particular point in time. If the real commodity markets are in equilibrium, the investment demand for internal and external funds and the internal and external supply of saving, both in real terms, must also be equal to each other. This equilibrium condition in the commodity markets may be summarized in an IS schedule (Hicks, 1937). The IS curve is the schedule of combinations of the interest rate and level of income such that the goods market is in equilibrium. The goods market is in equilibrium whenever the quantity of goods and services demanded equals the quantity supplied, or when injections into the system equal leakages. (Hicks, 1937) increases in the interest rate reduce aggregate demand by reducing investment spending. Thus, at higher interest rates, the level of income at which the goods market is in equilibrium is lower. The IS curve relates different equilibrium level of national income with various rates of interest. The IS curve is negatively sloped because an increase in the interest rate reduces planned investment spending and therefore reduces aggregate demand, thus reducing the equilibrium level of income(Hicks, 1937).

                                             Figure 2: IS Curve

The IS curve relates different equilibrium levels of national income with various rates of Interest. The goods market is in equilibrium whenever the quantities of goods and services demanded and supplied are equal. The IS curve describes equilibrium points in the goods market (Hicks, 1937). The combinations of aggregate output and interest rate for which aggregate output produced equal aggregate demand.

c. Factors Causing a Shift in IS Curve

The IS curve shifts whenever a change in autonomous factors occurs that is unrelated to the interest rate. The IS curve is shifted by changes in autonomous spending. An increase in autonomous spending, including an increase in government purchases, shifts the IS curve out to the right (Hicks, 1937).

d. Money Market Equilibrium: LM Curve

The LM curve shows combinations of interest rates and levels of output such that money demand equals money supply (Hicks, 1937). Money is demanded for transactions and speculative purposes. The transaction demand for money consists of the active working balances held for the purpose of making business payments as they become due. The transaction demand for money is positively related to the level of national income. The speculative demand for money arises from the desire to hold money balances instead of interest- bearing securities. However, the higher the rate of Interest, the smaller is the quantity of money demanded for speculative or liquidity purposes because the cost of holding inactive money balances is greater (Hicks, 1937).

The condition for monetary equilibrium is that the demand for money is equal to the supply of money. The supply of money is assumed by some monetary theorists to be exogenously determined by the central bank. When the money market is in equilibrium, the demand for money and the supply of money are equal to each other and may be shown as an LM schedule (Hicks, 1937). This LM schedule relates different rates of interest and different levels of national income where the demand and supply of money are in equilibrium (Hicks, 1937).

The LM curve is positively sloped. Given the fixed money supply, an increase in the level of income, which increases the quantity of money demanded, has to be accompanied by an increase in the interest rate. This reduces the quantity of money demanded and there by maintains money market equilibrium (Hicks, 1937).

                                    Figure 3: LM Curve

The LM curve relates the level of income with the rate of interest which is determined by money market equilibrium corresponding to different levels of demand for money. The money market is in equilibrium whenever the quantity of money demanded for transactions and speculative purposes is equal to the given supply of money (Hicks, 1937). The LM curve describes the equilibrium points in the market for money- the combinations of aggregate output and interest rate for which the quantity of money demanded equals the quantity of money supplied (Hicks, 1937).

e. Factors Causing a Shift in LM Curve

The LM curve is shifted by changes in the money supply. An increase in the money supply shifts the LM curve to the right. Only two factors can cause the LM curve to shift. Autonomous changes in money demand and changes in the money supply (Hicks, 1937). The LM curve shifts to the left if there is an increase in the money demand function which raises the quantity of money demanded at the given interest rate and income level. On the other hand, the LM curve shifts to the right if there is a decrease in the money demand function which lowers the amount of money demanded at given levels of interest rate (Hicks, 1937)

f. Using the IS- LM Model to Analyze Fiscal Policy

We can use the IS- LM model to look at the impact of fiscal policy: Government decisions on taxation and spending. Economists refer to increase in government purchases or cuts in taxes as expansionary fiscal policy. Cuts in government purchases and increases in taxes are referred to as contractionary fiscal policy. An increase in government purchases or a cut in taxes increases expenditure on goods and services, which in turn increases the production of goods and services. This is reflected in a shift out of the IS curve (Hicks, 1937).

Figure 4: IS-LM Model to Analyze Fiscal Policy

Consider the impact of expansionary fiscal policy initially the economy is in equilibrium at an interest rate of I₀ and an output level of Y₀. This implies that spending on goods and services equals the production of goods and services while the demand for money equals the supply of money. Consider the impact of contractionary fiscal policy, we know that this would decrease expenditure on goods and services and therefore shift the IS curve in. The decrease in government purchases decreases expenditure on goods and service, which in turn decreases the production of goods and services. This is reflected in a shift in of the IS curve. At the original interest rate I₀ output is now much lower and as a result the demand for money is also less than the money supply. Equilibrium can only be restored if there is a decrease in the interest rate. So we end up at a point i.e. I₂ and Y₂ (Hicks, 1937).

g. Using the IS-LM Model to Analyze Monetary Policy

Monetary policy affects the economy, first, by affecting the interest rate and then by affecting aggregate demand. An increase in the money supply reduces the interest rate, increases investment spending and aggregate demand, and thus increases equilibrium output.

                             Figure 5: IS-LM Model to Analyze Monetary Policy

An expansionary monetary policy, i.e., it increases the money supply; we showed that this would cause the LM curve to shift to the right. This causes GDP to rise and interest rates to fall in the economy. Intuitively, expansionary monetary policy has a positive impact on Y because the increase in money supply causes interest rates to fall in order to restore money market equilibrium on the goods market side, the lower interest rates result in increased investment spending which in turn increases Y (Hicks, 1937).                                                                            The opposite would be true for contractionary monetary policy. The decrease in money supply causes interest rates to rise in order to restore money market equilibrium on the goods market side, the higher interest rates result in decreased investment spending, which in turn lowers Y (Hicks, 1937).

The question of the monetary- fiscal policy mix arises because expansionary monetary policy reduces the interest rate while expansionary fiscal policy increases the interest rate. Accordingly, expansionary fiscal policy increases output while reducing the level of investment, expansionary monetary policy increases output. Governments have to choose the mix in accordance with their objectives for economic growth, or increasing consumption, or from the view point of their beliefs about the desirable size of the government. This study therefore is base on the monetary and fiscal policies in IS-LM framework (Hicks, 1937).

2.4 Structure of Nigeria’s Fiscal Sector

2.4.1 Structure of Government

The structures of government in Nigeria are the Federal, State and Local governments and also parastatals and agencies which provide services with funding from the government treasuries (CBN, 2010). The lower tiers of government consist of 36 states and 774 local governments. The 1999 federal constitution created the exclusive and concurrent legislative lists that apportion responsibilities for legislation among the federal, state and local governments. The items on the exclusive list can be legislated upon by the federal government, while the concurrent list may be legislated by both federal and state governments. A third list, the residual list which contains matters not expressly treated in the first two lists is the exclusive preserve of the states and local governments (CBN, 2010). The public sector produces public goods and services possessing the basic characteristics of non-appropriability, non-rivalry and non-excludability in consumption. These characteristics render efficient allocation of resources in a market economy ineffective, thus, providing the rationale for public intervention in order to ensure efficient allocation of resources, income redistribution and the attainment of stabilization objectives. The CBN (2010) opines that the tiers of government in Nigeria support the fiscal relations that facilitate the achievement of macroeconomic objectives of price stability, full employment, economic growth and balance of payment equilibrium (CBN, 2010).

2.4.2 Fiscal Federalism

It is generally believed that the devolution of certain public responsibilities to lower tiers of government still remains the best approach to the effective provision of public goods and services (Odoko & Nnanna, 2007). This has led to an overwhelming support for the federal system of government (often taken, albeit erroneously, to be synonymous with democracy) in recent times. Simply put, federalism is a system of government where revenue and expenditure functions as well as the appropriate fiscal instruments for carrying out these functions are divided among the various levels of government. Thus, revenue generating and spending responsibilities, intergovernmental transfer and the administrative aspects of fiscal decentralization are, in fact, the real issues involved in the so-called fiscal federalism (Odoko & Nnanna, 2007).

In Nigeria, the structure of fiscal federalism involves spending and revenue generating powers assigned to the three tiers of government, namely the Federal, State and Local governments. Within this arrangement, the constitution provides that all revenues accruing to the federation account (a common pool) mainly from crude oil and gas sales, taxes and royalties as well as non-recurring receipts are to be shared among the three tiers of government based on a sharing formula approved by the National Assembly. In the same vein, the constitution assigned various powers, exclusive and/or concurrent, to each tier of government to raise revenue and legislate on expenditure. More often than not, however, certain gaps created by geographical and economic forces necessitate inter-governmental transfers from higher to lower tiers of government in order to bridge such gaps (Odoko & Nnanna, 2007).

2.4.3 Monetary and Fiscal Policies Practice in Nigeria

The over dependence on oil has turned Nigeria from revenue generating country to a revenue sharing country. This has led to problems of fiscal discipline at all levels of government (Ezeoha & Uche, 2006). Given the underdeveloped nature of the country’s securities market, it is not surprising that monetary policy have consistently been ineffective in this environment of fiscal dominance. Given the fact that both monetary and fiscal policies impact on economic growth and development, it is not surprising that they are entwined (Ezeoha & Uche, 2006). Fiscal and monetary policies are inextricably linked in macroeconomic management as development in one sector directly affects developments in the other. Undoubtedly, fiscal policy is central to the health of any economy, as government’s power to tax and to spend affects the disposable income of citizens and corporations, as well as the general business climate (Ezeoha & Uche, 2006).

In this regard, the interrelationship between fiscal spending and private sector performance is of paramount importance (Okonjo-Iweala, 2003). On one hand, Government expenditure can provide an impulse for private sector growth, while on the other, it can be harmful if it results in budget deficits and leads to competition for scarce financial resources from the banking sector as the government seeks to finance the deficit. In such circumstances, the crowding out of the private sector by the Government sector can outweigh any short-term benefits of an expansionary fiscal policy. The key to all these therefore lies in striking a good balance in fiscal management. Having enough expenditure outlays to meet the needs of Government and support growth, but not so much as to deny the private sector the resources it needs to invest and develop (Okonjo-Iweala, 2003). Furthermore, Government fiscal recklessness resulting in deficit financing can also cause inflation, which contradicts the fundamental monetary policy objective of price stability. This has the potentials of destabilizing the macroeconomic environment thereby retarding economic productivity and development (Okonjo-Iweala, 2003).

There is no doubt that the failure of government fiscal policies, rather than the failure of monetary policies, is the main reason why most of the past developmental programmes undertaken by the Government have come to naught (Ezeoha & Uche, 2006). This is so despite the fact that the conventional theory tends to suggest that a central bank uses monetary policy instruments to predominantly influence the general price level. This broadly translates into the monetary theory of the price level, which implies monetary dominance in the determination of the price level. In reality however, fiscal policy is sometimes dominant. This is especially so in countries with underdeveloped securities markets which essentially limit the ability of a central bank to effectively develop and use monetary policy instruments (Okonjo-Iweala, 2003).

This has been explicitly explained by Oyejide (2003) thus, “In principle fiscal dominance occurs when fiscal policy is set exogenously to monetary policy in an environment where there is a limit to the amount of government debt that can be held by the public. Hence if the inter-temporal budget constraint must be satisfied, fiscal deficits would have to be magnetized, sooner or later. In fact when the size of the financial system is small relative to the size of the fiscal deficits, a central bank may have no choice but to magnetize the deficits (Oyejide, 2003). Thus, in countries with shallow financial systems, monetary policy is the reverse side of the coin of fiscal policy and can only play an accommodative role. In such low income countries, government securities markets are underdeveloped and central banks do not hold sufficient amounts of tangible securities and the central bank’s lack of suitable and adequate instruments of monetary control constitutes one of the factors that induce fiscal dominance (Oyejide, 2003). Where fiscal dominance applies, the country’s economic policy is only as good as its fiscal policy and institutionalized central bank independence may not necessarily bring about an independent monetary policy” (Oyejide, 2003).

There is no doubt that Nigeria clearly meets all the requirements for fiscal dominance. In fact, concerns about the fiscal dominance nature of the country, especially the underdeveloped securities market predates the advent of central banking in Nigeria (Oyejide, 2003).  Monetary activities in the country have been based on the control of inflation and the need to create a stable macroeconomic environment. Government has, in their desperate measure to control inflation undertaken monetary policies that have had disastrous long-term consequences (Uche, 2001).   However, it led to a major loss of confidence in the Naira and damaged its ability to serve as a regional currency for West Africa (Uche, 2001). This was because huge Naira reserves held outside the country, especially in the West African sub-region, were essentially demonetized in the process (Uche, 2001). The failure of the monetary policy variants to engender the stable macroeconomic environment necessary for economic growth and development in the face of fiscal dominance led to the adoption of The Structural Adjustment Programme (SAP) in 1986.

Undoubtedly, the most important factor that has impacted on both the level and character of fiscal policy in the country is the advent of oil as the main stay of our economy. Over dependence on oil resources and the volatility of the oil market has been transmitted to the rest of the economy. This has been explained by Baunsgaard (2003) thus: “With about 75 percent of revenue from oil and gas, fiscal policy in Nigeria has been heavily influenced by oil driven volatility impacting both revenue and expenditure. Since 1970, both revenue and expenditure have been very volatile while increasing over time (Baunsgaard, 2003). In periods with high oil prices, such as in 1979- 82, 1991-92, and more recently in 2000-02, revenue and expenditure have increased sharply. This has typically been followed by the scaling back of expenditure as oil prices subsequently decline, though at times with a lag. The implications of such boom-bust fiscal policies include the transmission of oil volatility to the rest of the economy as well as disruptions to the stable provision of government services (Baunsgaard, 2003). This has added to the failure over the years of public spending, neither facilitating the diversification and growth of the non-oil sector nor reducing poverty” (Baunsgaard, 2003).

Aside from the negative impact of the transmission of oil volatility to the rest of the economy, the enormous oil windfalls have helped alter the country’s revenue allocation formula by facilitating the change in focus from revenue generation to revenue sharing. The implication of this is that Nigeria has essentially become a rentier state where sharing of assets is based not on economic justification but political control (Baunsgaard, 2003). The consequence has been the development and growth of an unproductive civil service, proliferation of local governments, states and government agencies and institutions with doubtful productivity value (Ezeoha & Uche, 2006).           Monetary policy affects interest rates and the available quantity of loanable funds, which in turn affects several components of aggregate demand (Baunsgaard, 2003). Tight or contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand. Business investment will decline because it is less attractive for firms to borrow money, and even firms that have money will notice that, with higher interest rates, it is relatively more attractive to put those funds in a financial investment than to make an investment in physical capital. In addition, higher interest rates will discourage consumer borrowing for big-ticket items like houses and cars. Conversely, loose or expansionary monetary policy that leads to lower interest rates and a higher quantity of loanable funds will tend to increase business investment and consumer borrowing for big-ticket items (Baunsgaard, 2003). If the economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP. Figure 2(a) illustrates this situation. This example uses a short-run upward-sloping Keynesian aggregate supply curve (AS). The original equilibrium during a recession of (Er) occurs at an output level of 600. An expansionary monetary policy will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate demand curve (AD₀) to shift right to AD₁, so that the new equilibrium (Ep) occurs at the potential GDP level of 700.

Figure 6: Expansionary or Contractionary Monetary Policy

                Source: Ezeoha and Uche, 2006

(a) The economy is originally in a recession with the equilibrium output and price level shown at (Er). Expansionary monetary policy will reduce interest rates and shift aggregate demand to the right from AD₀ to AD₁, leading to the new equilibrium (Ep) at the potential GDP level of output with a relatively small rise in the price level. (b) The economy is originally producing above the potential GDP level of output at the equilibrium (Ei) and is experiencing pressures for an inflationary rise in the price level. Contractionary monetary policy will shift aggregate demand to the left from AD₀ to AD₁, thus leading to a new equilibrium (Ep) at the potential GDP level of output (Baunsgaard, 2003).                                                                                                                              Conversely, if an economy is producing at a quantity of output above its potential GDP, a contractionary monetary policy can reduce the inflationary pressures for a rising price level. In Figure 6 (b), the original equilibrium (Ei) occurs at an output of 750, which is above potential GDP. A contractionary monetary policy will raise interest rates, discourage borrowing for investment and consumption spending, and cause the original demand curve (AD₀) to shift left to AD₁, so that the new equilibrium (Ep) occurs at the potential GDP level of 700. These examples suggest that monetary policy should be countercyclical; that is, it should act to counterbalance the business cycles of economic downturns and upswings (Baunsgaard, 2003). Monetary policy should be loosened when a recession has caused unemployment to increase and tightened when inflation threatens. Of course, countercyclical policy does pose a danger of overreaction. If loose monetary policy seeking to end a recession goes too far, it may push aggregate demand so far to the right that it triggers inflation. If tight monetary policy seeking to reduce inflation goes too far, it may push aggregate demand so far to the left that a recession begins. Figure 7 (a) summarizes the chain of effects that connect loose and tight monetary policy to changes in output and the price level.

                        Figure 7: The Pathways of Monetary Policy

                        Source: Ezeoha and Uche, 2006

(a) In expansionary monetary policy the central bank causes the supply of money and loanable funds to increase, which lowers the interest rate, stimulating additional borrowing for investment and consumption, and shifting aggregate demand right. The result is a higher price level and, at least in the short run, higher real GDP (Ezeoha & Uche, 2006). (b) In contractionary monetary policy, the central bank causes the supply of money and credit in the economy to decrease, which raises the interest rate, discouraging borrowing for investment and consumption, and shifting aggregate demand left. The result is a lower price level and, at least in the short run, lowers real GDP (Ezeoha & Uche, 2006).

2.4.4 Monetary Policy influence on Aggregate Demand

In the short run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services. In the long run, shifts in aggregate demand affect the overall price level but do not affect output. Policymakers who influence aggregate demand can potentially mitigate the severity of economic fluctuations. When desired spending changes, aggregate demand shifts, causing short-run fluctuations in output and employment. Monetary and fiscal policies are sometimes used to offset those shifts and stabilize the economy. The aggregate demand curve slopes downward for three reasons: the wealth effect, the interest-rate effect and the exchange-rate effect (Ezeoha & Uche, 2006).

1. Wealth Effect

A higher price level decreases the real value of money and makes consumers less wealthy, which discourages them to spend more. This decrease in consumer spending means smaller quantities of goods and services demanded. Keynes (1936) developed the theory of liquidity preference in order to explain what factors determine the economy’s interest rate. According to the theory, the interest rate adjusts to balance the supply and demand for money. Liquidity preference theory attempts to explain both nominal and real rates by holding constant the rate of inflation.

Money Supply; The money supply is controlled by the Central Bank through:

1. Open-market operations
2. Changing the reserve requirements

• Changing the discount rate

Because it is fixed by the central bank, the quantity of money supplied does not depend on the interest rate. The fixed money supply is represented by a vertical supply curve (Bemanke & Alan, 1998).

Money Demand: Money demand is determined by several factors. According to the theory of liquidity preference, one of the most important factors is the interest rate. People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services (Bemanke & Alan, 1998). The opportunity cost of holding money is the interest that could be earned on interest-earning assets. An increase in the interest rate raises the opportunity cost of holding money. As a result, the quantity of money demanded is reduced (Bemanke & Alan, 1998).

Equilibrium in the Money Market: According to the theory of liquidity preference; the interest rate adjusts to balance the supply and demand for money. There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded equals the quantity of money supplied. Assume the following about the economy:

1. The price level is stuck at some level.
2. For any given price level, the interest rate adjusts to balance the supply and demand for money.

iii. The level of output responds to the aggregate demand for goods and services.

            Figure 8: Equilibrium in the Money Market

            Source: Bemanke and Alan, 1998

The price level is one determinant of the quantity of money demanded. A higher price level increases the quantity of money demanded for any given interest rate. Higher money demand leads to a higher interest rate. The quantity of goods and services demanded falls. The end result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded (Bemanke & Alan, 1998).

            Figure 9 (a): The Money Market

            Source: Bemanke and Alan, 1998

  Figure 9 (b): The Aggregate Demand Curve

  Source: Bemanke and Alan, 1998

1. Interest Rate Effect

A higher price level increases the real interest rate and makes borrowing more expensive, which discourages spending on investment goods. This decrease in investment spending means a smaller quantity of goods and services demanded (Bemanke & Alan, 1998).

1. Exchange-Rate Effect

A lower price level in Nigeria causes interest rates to fall and the real exchange rate to depreciate, which stimulates Nigerian net exports. The increase in net export spending means a larger quantity of goods and services demanded (Bemanke & Alan, 1998).

Figure 10(a): Monetary Injection (The Money Market)

Source: Bemanke and Alan, 1998

Figure 10 (b): Monetary Injection (The Aggregate Demand Curve)

Source: Bemanke and Alan, 1998

When the central bank increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded at any given price level, shifting aggregate- demand to the right. When the central bank decreases the money supply, it raises the interest rate and reduces the quantity of goods and services demanded at any given price level, shifting aggregate- demand to the left (Bemanke & Alan, 1998).

1. Role of Interest-Rate Targets in CBN Policy

Monetary policy can be described either in terms of the money supply or in terms of the interest rate. Changes in monetary policy can be viewed either in terms of a changing target for the interest rate or in terms of a change in the money supply. A target for the monetary policy rate affects the money market equilibrium, which influences aggregate demand (Bemanke & Alan, 1998).

2.4.5 Fiscal Policy influence on Aggregate Demand

Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes (Bemanke & Alan, 1998). Fiscal policy influences saving, investment, and growth in the long run. In the short run, fiscal policy primarily affects the aggregate demand. When policymakers change the money supply or taxes, the effect on aggregate demand is indirect through the spending decisions of firms or households (Bemanke & Alan, 1998). When the government alters its own purchases of goods or services, it shifts the aggregate-demand curve directly. There are two macroeconomic effects from the change in government purchases:

1. The multiplier effect
2. The crowding-out effect

Government purchases are said to have a multiplier effect on aggregate demand. Each Naira spent by the government can raise the aggregate demand for goods and services by more than a Naira (Bemanke & Alan, 1998). The multiplier effect refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

Figure 11: The Multiplier Effect

Source: Bemanke and Alan, 1998

The formula for the multiplier is: Multiplier = 1/(1 – MPC). An important number in this formula is the marginal propensity to consume (MPC).It is the fraction of extra income that a household consumes rather than saves (Bemanke & Alan, 1998).

If the MPC = 3/4, then the multiplier will be:

Multiplier = 1/(1 – 3/4) = 4

In this case, a N20 billion increases in government spending generates N80 billions of increased demand for goods and services. A larger MPC means a larger multiplier in an economy. The multiplier effect is not restricted to changes in government spending (Bemanke & Alan, 1998).

1. Crowding-out Effect

Fiscal policy may not affect the economy as strongly as predicted by the multiplier. An increase in government purchases causes the interest rate to rise. A higher interest rate reduces investment spending. This reduction in demand that results when a fiscal expansion raises the interest rate are called the crowding-out effect. The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand (Bemanke & Alan, 1998).

Figure 12: (a ) Crowding-out Effect (The Money Market)

Source: Bemanke and Alan, 1998

Figure 12: (b) Crowding-out Effect (The Shift in Aggregate Demand)

Source: Bemanke and Alan, 1998

When the government increases its purchases by N20 billion, the aggregate demand for goods and services could raise by more or less than N20 billion, depending on whether the multiplier effect or the crowding-out effect is larger. When the government cuts personal income taxes, it increases households’ take-home pay. Households save some of this additional income.  Households also spend some of it on consumer goods. Increased household spending shifts the aggregate-demand curve to the right (Bemanke & Alan, 1998). The size of the shift in aggregate demand resulting from a tax change is affected by the multiplier and crowding-out effects. It is also determined by the households’ perceptions about the permanency of the tax change (Bemanke & Alan, 1998)

1. Active Stabilization

Active Stabilization: The government should avoid being the cause of economic fluctuations. The government should respond to changes in the private economy in order to stabilize aggregate demand. Some economists argue that monetary and fiscal policy destabilizes the economy. Monetary and fiscal policy affects the economy with a substantial lag. They suggest the economy should be left to deal with the short-run fluctuations on its own (Bemanke & Alan, 1998).

1. Automatic Stabilizers

Automatic stabilizers are changes in fiscal policy that stimulates aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. Automatic stabilizers include the tax system and some forms of government spending, such as unemployment benefits (Bemanke & Alan, 1998).

2.4.6 Monetary Policy Transmission Mechanism

The monetary transmission mechanism describes how policy-induced changes in the nominal money stock or the short-term nominal interest rate impact on real variables such as aggregate output and employment. Mishkin (1995) in his work “Symposium on the Monetary Transmission Mechanism” identifies four (4) channels of monetary transmission as: interest rate channel, credit channel, exchange rate channel and other Assets Price effects channel. Monetary transmission mechanism due to its complexity and the various erroneous misconceptions associated with it would be better appreciated if the various channels are well elucidated in relation to some key assumptions (Mishkin, 1995). We assume that: The liabilities of the Central bank of Nigeria include both components of the monetary base: currency and bank reserves. This explains the fulcrum of the CBN’s ability to controls the monetary base. It should be noted that monetary policy actions typically begin when the CBN changes the monetary base through an open market operation, purchasing government bonds in order to increase the monetary base or selling securities to decrease the monetary base. If these policy-induced movements in the monetary base are to have any impact beyond their immediate effects on the central bank’s balance sheet, other agents must lack the ability to offset them exactly by changing the quantity or composition of their own liabilities (Mishkin, 1995).                                                                                              Therefore, it is safe for any model of the monetary transmission mechanism must assume that there exist no privately-issued securities that substitute perfectly for the components of the monetary base. The channels of monetary policy transmission mechanism are explained below:

1. Interest Rate Channel: The interest rate channel of monetary policy transmission has been described by Ogunkola and Abubakar (2008) as the standard Keynesian channel of monetary transmission which operates within the IS-LM framework and has been replicated by Taylor (1995); Mishkin (1995), Cotarelli and Kourelllis (1994); and Clarida, Gali and Gertler (2000); The interest rate channel was clearly defined in Keynes’ General Theory (Keynes, 1936; see also Uanguta & Ikhide, 2002). Negative monetary shocks limit the banking system’s ability to sell deposits. Demand for bonds increases while demand for money decreases. If prices are not fully adjustable, real money balances will decline, pushing up interest rates, and raising the cost of capital, investment spending declines, reducing both aggregate demand and output. The monetary transmission mechanism under this view works through the liability side of bank balance sheets. There are two necessary conditions for the money channel to work. First, banks cannot perfectly shield transaction balances from changes in reserves. Second, there is no close substitute for money in the conduct of transactions in the economy. Mishkin (1995) observes that the traditional Keynesian view of how monetary tightening is transmitted to the real economy can be represented by a schematic diagram as:

MP↓ → I_R ↑ → INV ↓ → Y ↓

Where indicated a contractionary monetary policy leading to a rise in real interest rate (I_R ↑), which in turn raises the cost of capital; thereby causing a decline in investment spending (INV ↓).This process also lead to a decline in aggregate demand and eventually a fall in output (Y ↓). ↓denotes a decrease or a fall and ↑ represent an increase or a rise. In asserting the importance of the interest rate channel in the transmission mechanism, Taylor (1995) argues that financial market prices are key components of how monetary policy affects real activities, in which case a contractionary monetary policy raises short-term interest rates.

Since prices and wages are assumed to be rigid downwards, real long-term interest rates increase as well (Mishkin, 1995). These higher real long-term rates lead to a decline in real investment, real consumption, and thereby on real GDP. In the long run, after wages and prices of goods begin to adjust, real GDP returns to normal. In an economy with high inflation, the interest rate channel is incapacitated as it loses strength due to inflationary volatility (Uanguta & Ikhide, 2002). If inflation becomes volatile, its certainty equivalent will exceed its expected value by a volatility premium. Hence, a high real interest rate is not associated with contractionary monetary policy if the volatility premium is also high. Conversely, a lower inflation strengthens the efficiency of the interest rate channel because low inflation means less volatile interest rate (Uanguta & Ikhide, 2002). The interest rate referred to in the above schematic diagram is real interest rate. This implies that, in real terms, the changes in market interest rates, may affect the costs of financing investments, thereby causing a change in investment spending which affect aggregate demand and hence output (Uanguta & Ikhide, 2002).

1. Credit Channel: The credit channel consists of a set of factors that amplify and propagate the conventional interest rate effects. This implies that, the credit channel is an enhancement mechanism, not a truly independent or parallel channel (Uanguta & Ikhide, 2002). The presence of asymmetric information and costly enforcement of contract have informed the emergence of two channels of monetary transmission mechanism within the credit channel viz: the Bank lending (the narrow credit) and the Balance Sheet channels (Uanguta & Ikhide, 2002).

The bank lending channel is pivoted on the theoretical assumption that banks play a special role in the financial system because they issue bank deposits that contribute to the broad monetary aggregates and also by holding assets and bank loans that are suitable for different types of borrowers. According to Mishkin (1995), contractionary monetary policy that decreases bank reserves and bank deposits exert impact through its effect on these borrowers. The CBN can regulate the availability of banks loans in two ways: First, the CBN can raise reserves requirements with the ultimate intention of reducing both the total volume of commercial bank assets and the proportion of commercial banks earning assets to total assets. Second, the CBN can conduct open market sales of treasury bills and government development stock (Uanguta & Ikhide, 2002). This is aimed at reducing commercial banks’ reserves-as depositors will substitute commercial banks deposits with more attractive alternative financial assets. This channel can be represented schematically as:

MP↓ → BD ↓ → BCL ↓ → INV ↓ → Y ↓

Where MP↓ denotes contractionary monetary policy

BD ↓ Denotes decrease in bank deposits

BCL ↓ denotes decrease in bank loans

INV ↓denotes decrease in investment

Y ↓ denote a decrease or a fall in output.

Based on this microcosm, a contractionary monetary policy lowers the network of firms and so leads to lower investment spending and aggregate demand because of the increase in adverse selection and moral hazard. The balance sheet channel is based on the theoretical prediction that the external finance premium facing a borrower should depend on borrower’s financial position (Uanguta & Ikhide, 2002). The balance sheet channel of monetary policy arises because the shifts in policy affect not only market interest rates but also the financial positions of borrowers, both directly and indirectly. A tight monetary policy directly weakens borrowers’ balance sheets in at least two ways. First, rising interest rates directly increase interest expenses, reducing net cash flows and weakening the borrower’s financial position. Second, rising interest rates are also typically associated with declining asset prices, which among other things shrink the value of the borrower’s collateral. Indirect effect of tight monetary policy on net cash flows and collateral values is from deterioration in consumers’ expenditure (Uanguta & Ikhide, 2002). The firm’s revenues will decline while its various fixed or quasi-fixed costs do not adjust in the short run. The financing gap, therefore, erodes the firm’s net worth and credit worthiness over time. The balance sheet channel operates through the network of business firms (Bernanke & Blinder 1988, 1992). A drastic reduction in the network of business firms raises the adverse selection and eventually leads to a decrease in the tempo of lending to finance investment spending (Romer & Romer, 1990).

iii. Exchange Rate Channel: This channel of monetary transmission mechanism focuses on the link between net private capital inflows and monetary policy after financial reforms leading to liberalization. According to Taylor (1995) and Obstfeld and Rogoff (1995), the exchange rate channel works through the aggregate demand as well as the aggregate supply effects which is more effective under the flexible exchange rate regime. This channel of monetary policy involves interest rate effects. Mishkin (1995) presents the schematic diagram for the monetary transmission mechanism operating through the exchange rate channel as:

MP↓ → I_R ↑ → ER ↑ → NX ↓ → Y ↓

Where ↓ (↑) denote a decrease (an increase) or a fall (a rise).

MP↓ denotes contractionary monetary policy,

I_R ↑ denotes increase in interest rate (real),

ER ↑ denotes increase in exchange rate,

NX ↓ denotes decrease in net export and

Y ↓denotes a fall in output

When domestic real interest rates rise (I_R ↑), domestic deposits become more attractive relative to deposits denominated in foreign currencies, thus leading to a rise in the value of the domestic currency relative to other currencies and deposits this gives rise to an increase in exchange rate (ER ↑), thereby causing a fall in both net exports (NX ↓) and output (Y ↓) (Bernanke & Blinder 1988, 1992).

1. Other Assets Price Effect (Equity Price Channel): Two sub-channels are involved in the equity price channels that are important to the monetary transmission mechanism. These include the Tobin q theory of investment and wealth effects on consumption. These two sub-channels are based on the monetarists’ paradigm. In Tobin q theory, Tobin (1969) defines q as the market value of firms divided by the replacement cost of capital. The theory provides a mechanism through which monetary policy affects the economy through its effects on the valuation of equities. This is represented schematically as:

M ↓ → Pe ↓ → q ↓ → I ↓ → Y ↓

Where ↓ (↑) denotes decrease (increase)

M↓ denotes contractionary monetary policy

Pe↓ denotes decrease in prices of equity

q↓ denotes divided by the replacement cost of capital.

I ↓denotes a fall in investment and

Y↓ denotes a decrease in output.

The rise in interest rates as a result of the contractionary monetary policy makes bonds more attractive relative to equities, thereby causing the price of equities to fall (Bernanke & Blinder 1988, 1992). The major intuition drawn from the above analysis are that, lower equity prices (Pe ↓) will lead to a lower q (q↓) and therefore a lower investment spending (I↓) culminating into one of the sub-channels of the other assets prices channel of monetary transmission mechanism. The other sub-channel found in the channel of monetary transmission through other assets prices channel is the wealth effect on consumption. The wealth channel was modeled on the life-cycle hypothesis of consumption developed by Modigliani (1971), in which households’ wealth is a principal determinant of consumption spending. A major component of financial wealth is common stocks. The link to monetary policy emanates from the relationship between interest rates and asset prices (especially common stocks). When stock prices fall, the value of financial wealth decreases, thereby decreasing the lifetime resources of consumers, hence consumption is expected to fall (Ahmad, 2008).

Therefore, a contractionary monetary policy leads to a decline in stock prices (Pe↓) resulting into another sub channel of transmission mechanism in the other assets prices channel. This can be presented schematically as: –

M ↓ → Pe ↓ →wealth ↓ → consumption ↓ → Y ↓

↓ (↑) denote decrease (an increase)

→ denotes transmission effect

M↓ denotes contractionary monetary policy

Pe ↓ denotes equity prices

Where ↓ denotes decrease in financial wealth ↓ leading to a fall in consumption (consumption ↓) and Y ↓ denotes decrease in output. But an increase in consumption increases aggregate demand and output, and hence results into an increase in the general price level (Ahmad, 2008).