PROPOSAL ON THE IMPACT OF MONETARY POLICY ON BALANCE OF PAYMENT IN NIGERIA

Abstract

This research work is centered on the impact of Monetary Policy on Balance of Payment in Nigeria with the scope being from 1970 to 2006.

The Central Bank of Nigeria (CBN) monetary policy instruments were discussed and the IS-LM framework of an open economy was also discussed including the CBN monetary policy guideline from 1970 to date which is the major channel through which the Central Bank’s activities are based on.  The ordinary least square estimator (OLS) was the analysis adopted and from analysis and result obtained it indicates a negative impact of monetary policy on balance of payment.  However, recommendations were made with respect to the CBN’s to adopt the Charles Soludo new exchange rate proposal 2007 and to shift emphasis to non-oil sectors of the economy in order to have a viable balance of payment.

INTRODUCTION

The monetary approach to balance of payments explains the elimination of payments disequilibrium in terms of factors bringing the demand and supply of money into equality.  It treats the supply of money as endogenous by assuming a feedback from the balance of payments through changes in international reserve to changes in the monetary liabilities of the central bank and government. One important question of monetary policy is the extent to which the monetary authority of an open economy can affect the price level or the other arguments of the demand for money, such as the level of real output and the interest rate.  If it were the case that these could not be changed, then any increase in monetary liabilities of the authority would be met by an equal and offsetting outflow of international reserve (or an equi-proportionate rise in the price of home goods and foreign exchange), and one would have to argue that monetary policy had no influence on the real response of the system. A second purpose of this research work is to clarify the effects of external shocks on the balance of payments.  The simple monetarist model may provide an incorrect answer to the question.  “What is the impact effect of an increase in particular world prices on the balance of payments of a small country?”  The simple model (monetarist model) tells us that the balance of payments will temporarily improve as the higher prices produce an increase in the demand for stock of money.  But we shall see that the answer is far more complex – indeed the effects on balance of payments depends on whether it is import or export prices that have risen and on a more traditional consideration of elasticity of demand (George and James, 1978). The monetary approach focuses on the supply and demand of money and the money supply process.  The monetary approach hypothesizes that the balance of payment and exchange rate movement result from changes in money supply and demand.  Consider what happens if the Central Bank domestic currency money supply exceeds money demand.  There is pressure for the domestic currency to depreciate.  The Central Bank must sell foreign exchange reserve until money is equal to money demand.  There has been no net impact on the monetary base and money supply as the change in foreign exchange reserve offset the change in domestic currency.  However, a balance of payment deficit as foreign exchange reserve is less than zero.  Flexible exchange rate regime, the foreign exchange reserve component of monetary base does will adjust to eliminate my monetary disequilibrium.

If money supply exceeds money demand, now the domestic currency must depreciate to balance money supply and money demand.  The monetary approach postulates that changes in a nation’s balance of payment or exchange rate are a monetary phenomenon (Nankai University Fan Xiaoyun, 2004). We now want to gain a fuller understanding of the wide variety of international transactions which create a demand for and generate a supply of a given currency.  The spectrum of international trade (balance of payment) and financial transaction is reflected in the “United States” international balance of payments.  A nation’s balance of payment statement attempts to record all the transactions which take place between its residents (including individuals businesses and governmental units) and the residents of all foreign nations.  These transactions include merchandise exports and imports, tourist expenditures, purchases and sales of shipping and insurance services, interest and dividends received or paid abroad, and so forth.  Stated differently, the Nigeria’s balance of payment, shows the balance between all payments Nigeria receives from foreign countries and all the payments which we make to them (Mcconnel, 1987).

According to (Afolabi, 1990), the need for balance of payment includes living on account of the import of a country, and this will act as a signal for domestic policies. Telling us a country’s export composition and the extent to which the country depend on certain commodities for its foreign exchange earning, showing whether a country is having a deficit or a surplus in its trade transactions with the rest of the world, provision of a basis for comparison of trade relation among countries and financial integrity whether it is at a deficit or surplus position in the balance of payments which can be used to know if a country is aid-worthy or credit worthy, provision of historical data on import and export overtime which could be used for planning and also providing statistics for the net foreign investment component of the national income. Campbell McConnel (1987) in his work said whether a country’s balance of payment is at a deficit or surpluses; if it is good or bad is dependent in firstly, the event causing them and secondly, their persistence through time.  For example, the large payments deficits imposed upon the United States and other oil-importing nations by OPEC’s dramatic run-up of oil prices in 1973 – 1974 and 1979 – 1980 were very disruptive in that they forced the United States to invoke a variety of policies to curtail oil imports.  Similarly, any nation’s official reserve are limited.  Therefore, persistence or long-term payments deficits which must be finance by drawing dawn those reserves, would ultimately cause reserve to be depleted.  In the case the nation would have to undertake specific policies to correct its balance of payments. These policies might entail painful macroeconomic adjustment, the use of trade barriers and similar restrictions, or changing the international value of its currency. In view of this lingering problem, the government has introduced many policies so as to reduce or eliminate the pressure on balance of payments, some of these policies according to Stephen and Osagie (1985) are viz.  Exchange control, foreign exchange budgeting, cutting down government expenditure abroad, import restriction through tourists production and deflation policy though the use of a combination of monetary and fiscal policies etc.

According to the CBN briefs (2004), the impact of government policies as it relates to management of external debts are to outline strategies of increasing foreign exchange earnings thereby reducing the need for external borrowing to determine the criteria for borrowing from external sources and the type of project for which external loans may be obtained.  The impact of the exchange control policy is the reduction of imports by making import difficult to obtain the necessary foreign currency on invisible items such as remittance by foreigners and limit the outflow of capital account by imposing restriction on foreign investors.

To keep the value of money stable, its quantity and cost has to be controlled and maintenance of relative price stability and a healthy balance of payment position that monetary policy comes in to play an important role. Monetary policy refers to the attempt to achieve the  national economic goals of full employment without inflation, rapid economic growth and balance of payments equilibrium through the control of the economy’s supply of money and credit.  Since the rate of interest is the cost of credit, monetary policy includes the control of money supply (through the control of high-powered reserves) and the rate of interest.  In a wider sense, monetary policy may also be taken to include attempts to influence the external values of a nation’s currency, i.e. exchange rate management (in a regime of floating exchange rate) (Iyoha, 2002).

Because of the impact monetary policy has on financing conditions in the economy (not just the costs, but also the availability of credit or banks’ willingness to assume specific risks) but also because of its influence on expectations about economic activity and inflation, monetary policy can affect the prices of goods, asset prices, exchange rates as well as consumption and investment (Oesterreichische National Bank, 2002).

There are some disagreements in the usage of monetary policy.  These disagreements include, how effective is the use of monetary policy as a tool of economic management?  What is the channel through which monetary policy can actually work?  Since monetary policy cannot be used to pursue all goals simultaneously, hence, which goal or goals should be targeted first before other?  What technique should be used in the conduct of monetary policy?  What is the influence of monetary and fiscal policy can be used to correct the persistence or sharply negative balance of payment?  This leads us to why we are carrying out the research work, the impact of monetary policy on balance of payment.

THEORETICAL REVIEW

Monetary policy is an important level of power.  It entails the management of net export, money supply, inflation, exchange rate and interest rate in the economy in order to attain the desired levels of broad macroeconomic objectives.  These broad objectives are price stability, sustainable economic growth, thigh level of employment and balance of payment equilibrium.  The attainment of these objectives is not often simultaneous.  They exist conflicts between them in general, monetary policy refers to a combination of measures (policies) designed to regulate the value, volume and cost of money in the system consistent with expected level of economic activities.  There is however, disagreement among experts as to what variable monetary policy should be used as a level to control the economy.  Ajayi (1981) pointed out the set of key variables monetary policy operated upon to manoeuvre the economy.  These are commercial banks deposits, the quality of money, interest rates total bank credit etc.

The stock of money offers itself as the most attractive candidate of the degree of ambiguity that can arise from the use of others.  It is also the method this is more under the grip of the central bank, this is by means tantamount to saying that the central bank determines the money stock.  It has a better and closer control subject to possible slippage arising from the non-bank public and bank portfolio adjustment Ajayi, 1994).

The traditional IS-LM framework states that an increase in money supply, which shifts the LM curve outward will depress interest rate which in turn persuades restoring increase investment spending.  Other interest-sensitive component of aggregate demand will also rise, thus causing real output to rise.  The extent of the increase in output will depend on the slope of the demand function for money (Beeketh and Morris, 1992).

Conversely, the effect of an increase in money demand is to raise interest rates.  This arise because such increase in cash balance would have to be financed by sales of bonds and other interest earning substitutes to holding money thus a rising up the rate of return on money.  This increase in interest rate is expected to discourage investors from making additional borrowing for further investment.  The return on real investment would also fall making investment unattractive.  The end result is a fall in output.  Again, the extent of output fall is a function of money supply curve or slope.  The more elastic it is, the smaller will be contraction in output and vice versa (Beeketh and Morris 1992

The balance of payment also depends on money supply, the money stock. Holding everything also constant, a higher level of money supply would lead to an increase of household expenditure and thus an increase of imports and a decline in balance of payments position (George Bort and James Hanson, 1971).

An increase in the price of export would raise household’s income.  So would a rise in the price of the domestic good since Y > Yh (Yh = household income).  Assume that the household expects such increase income to be temporary and holds real consumption constant.  This assumption implies that household engage in short-run hoarding or saving of money in the face of the expectation that real income will fall to its original level at a later date.  Thus the holding of money as a shock absorber will be positively related to price of Y and price of exports.  Import price may also affect hoarding, though the direction of the relation is ambiguous.  It is also reasonable to assume that the demand for money as a shock absorber is negatively related to the amount of money so held (George Borts and James Hanson, 1971).

According to Heckscher-Ohlin (1985) model “trade result from the fact different countries have different factor endowment” that is, countries that are rich in capital will export capital intensive goods.  Specifically, trace arises from inter-country differences in marginal opportunity cost.  The theory went further to say that inequalities in inter-country marginal opportunity costs arise from three sources.  International differences in relative factors supplies i.e. relative factor endowments; cross-country differences in production function and inter-country differences in the pattern of demand.  They believe this to be so because, in their view, differences in relative factor endowments are the most important single cause of international differences in price structure.  International dealings between countries make it necessary for them to make payments to one another, while the balance of payment shows the relationship between one country’s total payments to all countries and its total receipts from them.  The chief payments and receipts arise from trade in goods payment having to be made for import and being received from the sales of exports.

When the value of visible exports exceeds the value of the visible imports then there is a favourable balance of trade.  On the other hand if visible exports are less than visible imports there is an unfavourable balance of trade.  When the visible exports equal visible imports then there is a balance of trade.  If it should be borne in the mind that the balance trade or trade balance is only a part of current account of balance of payment.  A favourable balance of trade does not necessarily men that she receives more of invisible import (i.e. services) than she is receiving from invisible exports (Heckseher – Ohlin, 1985).

Inflation is a sustained rise in the average price of standard basket of goods and services, that is, the general price level.  An increase in aggregate spending, by stimulating imports will put pressure on the external sector.  Conversely, if monetary expansion fails to keep pace with the growth in output, this slack would exert a recessionary impact on growth, this does not mean excessive demand pressure alone are to blame for inflation.  Inflation can also be due to non-factors on the supply side.    Also arising from the foregoing is the link between inflation on the one hand and markets interest rates and the exchange rate on the other.  Persistent inflation generates expectation about the course of future prices and put an upward bias on market interest rates as leaders seeks to protect the real value of their funds.  Furthermore, rising domestic inflation relative to those of trading partners puts downward pressure on the value of the domestic currency in terms of foreign currency (CBN, 2000).

 STATEMENT OF THE PROBLEM

Because of the impact monetary policy has on financial condition (Balance of payment) in the economy (not just the cost, but also the availability of credit or bank’s willingness to assume specific risk) but also because of its influence on expectations about economic activity and inflation, monetary policy can affect the prices of goods, assets prices, exchange rate as well as consumption and investment (Oesterreichische National Bank, 2002).

Every monetary policy impulse (e.g. an interest rate change by the Central Bank, change in the monetary base resulting from changes in minimum reserve rate) has a lagged impact on the economy.  Moreover, it is uncertain how exactly monetary policy impulses are transited to the price level or how real variable develop in the short and medium term.

The difficulty of the analysis is to adjust the effect of the individuals channels for external factors e.g. supply and demand shocks, technical progress or structural change may be superimposed on the effect of central bank measures, and it is difficult to isolate monetary policy effects on various variables for analytical purposes.  Moreover, the time lag in the reaction of the real sector to monetary measures renders the analysis more difficult.  Hence monetary policy must be forward looking (Oesterreichische National Bank, 2002). It is in view of this that the researcher intend to investigate the impact of monetary policy on balance of payment.

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