CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND OF THE STUDY
Some recent studies have found cross-country evidence supporting the view that long -term growth is adversely affected by inflation (Kormendi and Meguire 1985; Fischer 1983, 1991, 1993; De Gregorio 1993; Gylfason 1991; Roubini and Sala-i-Martin 1992; Grier and Tullock 1989; Levine and Zervos 1992). Countries (especially in Latin America) that have experienced high inflation rates, have also witnessed lower long-term growth (Cardoso and Fishlow 1989; De Gregorio 1992a, 1992b). This literature is part of the endogenous growth literature, which tries to determine the causes of differences in growth rates in different countries. There is now considerable evidence that investment is one of the most important determinants of long-term growth (Barro 1991; Levine and Renelt 1992). It has often been suggested that a stable macroeconomic environment promotes growth by providing a more conducive environment for private investment. This issue has been directly addressed in the growth literature in the work by Fischer 1991, 1993; Easterly and Rebelo 1993; Frenkel and Khan 1990; and Bleaney 1996. Among the reasons why high inflation is likely to be adverse for growth are: economies that are not fully adjusted to a given rate of inflation usually suffer from relative price distortions caused by inflation. Nominal interest rates are often controlled, and hence real interest rates become negative and volatile, discouraging savings. Depreciation of exchange rates lag behind inflation, resulting in variability in real appreciations and exchange rates; real tax collections do not keep up with inflation, because collections are based on nominal incomes of an earlier year (the Tanzi effect) and public utility prices are not raised in line with inflation. For both reasons, the fiscal problem is intensified by inflation, and public savings may be reduced. This may adversely affect public investment and high inflation is unstable. There is uncertainty about future rates of inflation, which reduces the efficiency of investment and discourages potential investors.
The effect of macroeconomic instability on growth comes largely from the effect of uncertainty on private investment. Multi-country panel data studies on investment report that measures of macroeconomic instability, like the variability in the real exchange rate or the rate of inflation, have an adverse impact on investment (Serven and Solimano 1992). In a study of 17 countries, Cordon (1990) finds that although there are outliers, evidence generally supports the view that high growth is associated with low inflation. This is suggested both by cross-country evidence and comparison over time for countries where the rate of growth has fallen in relation to an increased as the rate of inflation.
Fischer (1993) examines the role of macroeconomic factors in growth. He found evidence that growth is negatively associated with inflation and positively associated with good fiscal performance and undistorted foreign exchange markets. Growth may be linked to uncertainty and macroeconomic instability where temporary uncertainty about the macro-economy causes potential investors to wait for its resolution, thereby reducing the investment rate (Pindyck and Solimano 1993). Uncertainty and macroeconomic stability are, however, difficult to quantify. Fischer suggests that, since there are no good arguments for very high rates of inflation, a government that is producing high inflation is a government that has lost control. The inflation rate thus serves as an indicator of macroeconomic stability and the overall ability of the government to manage the economy.
Fischer found support for the view that a stable macroeconomic environment, meaning a reasonably low rate of inflation, a small budget deficit and an undistorted foreign exchange market, is conducive to sustained economic growth. He presents a growth accounting framework in which he identifies the main channels through which inflation reduces growth. He suggests that the variability of inflation might serve as a more direct indicator of the uncertainty of the macroeconomic environment. However, he finds it difficult to separate the level of inflation from the uncertainty about inflation, in terms of their effect on growth. This is because the inflation rate and its variance are highly correlated in cross-country data. Evidence is in favour of the view that macroeconomic stability, as measured by the inverse of the inflation rate and the indicators of macroeconomic trends, is associated with higher growth.
A good number of factors have been identified as the causes of inflation in Nigeria, which according to Nwankwo (1981) they includes excess demands, rising cost of production, limiting outputs and increasing money supply. People’s immediate concern is with how their income holds up with changes in their expenses. Businesses care about how the prices of their product do in relation to their cost. Also government battle with polices to keep inflation rate at the barest minimum and ensure effective and efficient administration.
In terms of geography, there are very few studies on the impact of inflation on investment in this part of the world, hence this study fill this gap in terms of geography. Given government recent wooing of international investor into the country, the need to examine the impact of inflation on investment becomes imperative. The Central Bank of Nigeria main policy objective is to maintain stable price of goods and services. This study thus examines the impact of inflation on investment.