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DETERMINANTS OF DEMAND FOR MONEY AND ITS STABILITY IN NIGERIA (1991-2014)

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CHAPTER ONE

INTRODUCTION

1.1     Background to the Study

A sound monetary policy formulation presupposes theoretically coherent and empirically robust model of money demand. To monetary authorities, the stability of the money demand function is necessary for understanding how the formulation and implementation of an effective monetary policy is crucial in offsetting the fluctuations that may arise from the real sector of the economy. If the relationship between the demand for money and its determinants shift around unpredictably, the central bank loses the ability to derive results from the implementation of its policies. In such a case, variations in the money demand function is an independent source of disturbance to the economy. (Bhatta, 2013,p.1).

The identification of a stable relationship between the demand for money and its determinants provides empirical evidence that  monetary targeting is an appropriate framework for economic stabilization policy (Rutayisire [as cited in Bhatta, 2013, p.1). Monetary targeting is an attempt by central banks to describe or determine the optimum money stock that will yield the desired macroeconomic objectives. Theoretically, the choice of target is normally between the stock of monetary aggregates and interest rates. Poole; and McCallum (as cited in Owoye and Onafowara, 2007, p.1) expressed that whenever the money demand function is unstable, interest rate is generally the preferred target, otherwise, the money stock remains the appropriate target.

The primary objective of the Central Bank of Nigeria (CBN), in its conduct of monetary policy, is to maintain a stable price level that supports sustainable economic growth and employment (Owoye and Onafowora, 2007,p.1). The CBN has relied on setting predetermined growth rates for the broad money (M2) as a tool for achieving price stability. This is based on the belief that inflation cannot be sustained over the long-term, if it is not accommodated by excessive growth in money supply (Doguwa, Olowofeso, Uyaebo, Adamu and Bada, 2014, p.16). In the conduct and implementation of monetary policy, the assumption that the money demand function is stable is very important, because, the money demand function is used both as a means of identifying medium term growth targets for money supply and as a way of manipulating the interest rate and reserve money for the purpose of controlling both the inflation rate and the total liquidity in the economy (Owoye and Onafowora, 2007, p.1).

Given the importance attached to money demand in the success or failure of monetary policy, it is not surprising that the demand for money is one of the most controversial and heavily researched areas in macroeconomics. If the central bank relies on control of monetary aggregates as its policy instruments, Cameron (as cited in Bhatta, 2013), states that:

it must believe in a known and reliable connection between changes in that aggregate and changes in the arguments of the money demand function in order for its policy to have predictable effects on those arguments. If instead the central bank relies on interest rates as targets and adjusts the monetary aggregate through daily reserve management to whatever level is required to hit them, instability of the demand for money could make the required reserve changes both large and unpredictable. In such a case, disorderly financial markets might well result. (p.2).

Laumas and Mehru (as cited in Ogunsakin and Awe, 2014, p.2) stipulated that the stability of money demand is crucial for the understanding of the monetary policy transmission mechanism. It is crucial because a stable money demand function means that the quantity of money is predictably related to a set of key variables that link money to the real sector of the economy. A stable money demand function always require appropriate instruments and intermediate targets of monetary policy. It enables a policy driven change in monetary aggregates so that the desired values of targeted macroeconomic variables such as fiscal policy, exchange rate, stock market, consumption expenditure, savings and investments, imports, exports, inflation and interest rates are ensured (Sober, 2013, p.32). Therefore, it is important to have knowledge of the determinants of money demand in order to ensure a stable relationship exists between these determinants and the money stock.

 

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