The Impact of Fiscal and Monetary Policy on the Nigerian Economy
OBJECTIVE OF THE STUDY
The broad objective of this study is to analyze the role of policy interaction in the assessment of the relative effectiveness of fiscal and monetary policy on output performance in Nigeria. Specifically, the study aims:
- To ascertain the nature of the interaction between fiscal and monetary policy in Nigeria over time.
- To analyze the transmission path of fiscal and monetary policy on economic performance
- To determine the nature of interaction between fiscal and monetary policy for various policy regimes.
- To examine the effect of regime-specific interactions on the relative effectiveness of fiscal and monetary.
Over the years, there has been a wide divergence of opinions and thoughts about the relative effectiveness of fiscal and monetary policy on the aggregate economy, which is popularly referred to as the “Great Debate”. On one hand are the fiscalists (Keynes (1936) and the Keynesian school of thought) who believe that fiscal policy is more potent than monetary policy because investment is interest-inelastic; hence the IS-curve is nearly vertical, thereby making monetary actions to cause little effect on income while fiscal actions have larger effect on income. On the other hand are the monetarists (led by Friedman (1963)) who believe that monetary policy is more potent than fiscal policy because money demand is interest-inelastic; hence LM-curve is nearly vertical, thereby making fiscal actions to have small effect on income while monetary actions exert large influence on income.
THE KEYNESIAN VIEW OF FISCAL AND MONETARY POLICY
The Keynesians posit that changes in government expenditure and taxes (otherwise known as fiscal actions) exert important influences on aggregate demand. That is, increase in government spending is a direct addition to aggregate demand while tax reduction increases disposable income, and hence increased aggregate demand (Ajayi and Ojo, 2006). On monetary policy, Keynesians hold the view that money do not matter to the economy, at least in the short-run. They believe that money supply transmission mechanism is an indirect process working through the interest rates and does not directly cause a change in income. They also view money supply as being susceptible to changes in some variables, hence not exogenous. They further argue that money supply has no effect on real variables such as output and real interest rate (money neutrality); hence pursuance of monetary target is a futile exercise (Anyanwu, 1993). The Neo- Keynesians further express their pessimism about monetary actions by asserting that monetary expansion has little or no impact on changes in interest rate, which in turn affect investment and output. They argue that monetary policy becomes relatively impotent when interest rate is very low and cannot be lowered further (the zero lower bound – ZLB) to induce investment. On the other hand, budgetary policy has significant effect on income, employment and output in the shortrun, even if no new money is created (Anyanwu, 1993). With regard to the transmission mechanism, the fiscalists believe that fiscal policy is more effective in countering shortrun cyclical fluctuations (the automatic stabilisers) due to its shorter lag (since it has a direct impact on income). However, monetary transmission is believed to be much longer and involves an indirect linkage of money supply to aggregate demand via interest rate.
THE MONETARIST VIEW OF FISCAL AND MONETARY POLICY
The monetarists assigned a causal role to money and take it as exogenous, with the belief that it is possible to control disturbances or disequilibrium in the economy by simply controlling monetary aggregates. Money exerts a strong force on aggregate demand, price level and output. Changes in the trend of monetary growth are considered the dominant determinants of trends of nominal price level and output. But the magnitude and timing of the impact of money on output depends on the level of mobilization of resources as well as the expected rate of inflation before the change in money supply (Anyanwu, 1993; Ajayi and Ojo, 2006). On the other hand, fiscal policy is viewed as complicated, more cumbersome and too rigid to execute within a short period of time, hence should not be thought of as a short-run stabilization measure. Rather, fiscal policy should be devoted to long-run equilibrium effect (Bullard, 2012). To the monetarists, the influence of fiscal actions is temporary. This is because: first, given a constant money supply, empirically, government expenditure multiplier is positive for only the first few periods and then has zero effect in the longrun. Second, without monetary expansion, government expenditure must be financed by taxes or borrowing from the private sector. In either case, there will be “crowding-out effect” since there is no net addition to purchases because resources are being transferred from private to public sector. Hence fiscal actions can only increase aggregate demand permanently if it is financed by a continual monetary expansion (Anyanwu, 1993; Ajayi and Ojo, 2006).
THE FISCAL THEORY OF PRICE LEVEL(FTPL) DETERMINATION
The fiscal theory of the price level (FTPL) (as propounded by Leeper, 1991; Sims, 1994; and Woodford, 1994, 1995 and 2001) describes fiscal and monetary policy rules that determine the price level basically through government debt and fiscal policy alone, while monetary policy plays a passive role. In FTPL, monetary policy alone does not provide the nominal anchor for an economy; rather, it should be the pairing of a particular monetary policy with a particular fiscal policy that should determine the path of the price level. The FTPL assumes that government commits to a fixed and exogenous present value of primary fiscal balance. Leeper (1991) termed this special case of price-level determining fiscal policy an “active fiscal policy” while Woodford (1995) called it a ‘Non-Ricardian’ fiscal regime. The main intuition of the FTPL is that, when current and future fiscal policies are set without concern about sustainability, the general price level will rise so as to satisfy the present value budget constraint (Lima, Maka and Pumar, 2011). Although modern monetarist view recognizes the fact both fiscal policy must be selected in an appropriate way for price stability to be guaranteed, however this view holds that active monetary policy will automatically compel the fiscal authority to choose an appropriate fiscal policy. The FTPL also opposes the modern monetarist view in this respect by arguing that unless special steps are taken to ensure that appropriate fiscal policies are taken, the primary objective of price stability may not be achieved irrespective of how active the monetary policy might be (Christiano and Fitzgerald, 2000).
CHAPTER THREE: METHODOLOGY
THEORETICAL FRAMEWORK: THE NEW KEYNESIAN MODEL
One of the tools widely employed by economists around the globe to analyse the relative effectiveness of fiscal and monetary policy, as well as the interaction between them, is the Keynesian model (Branson, 1989; Anyanwu, 1993; Mishkin, 2004; Mankiw, 2005; Ajayi and Ojo, 2006). The “traditional Keynesian model” utilizes the Hicksian IS-LM framework to analyse the economy’s equilibrium income and interest rate derived simultaneously from the goods and money market. The IS equation, which is derived from the entities of the aggregate demand function, depicts an inverse relationship between income and interest rate in the goods market; hence it is downward slope. On the other hand, the LM curve, as derived from the liquidity preference theory, shows a direct relationship between income and interest rate in the money market. The economy equilibrium income and interest rate is established at the point where the IS curve intersect the LM curve. The effect of fiscal actions on the economy is transmitted through the IS curve, since fiscal variables are direct addition to aggregate expenditure; whereas, the effect of monetary actions on the economy is transmitted through the LM curve with exogenous monetary aggregate.
However, the tradition Keynesian model has been criticized severally on many grounds. The Neo-Classicals believe that the models has failed on grand scale due to the fact that it lacks strong microeconomic foundation of a rational optimizing agents; no provision for expectation which is critical to the optimization problems of the agents; the assumption of sticky price which contradicts the Classicals’ market clearing price; and the inability of the model to provide explanation to the persistent business cycle (the supply-side of the economy).
The New Keynesian (NK) Model was developed partly as a response to the criticisms of the traditional Keynesian model. The NK theory was introduced by Micheal Parkin in 1982 with other early contributors like Stanley Fischer, Edmund Phelps and John Taylor (Mankiw and Romer, 1991). The New Keynesians relax some of the extreme assumptions (Mankiw termed this the “Dubious Assumptions”) of the traditional Keynesians such as: adaptive expectation, unconstrained expectation, bounded rationality and structural impediments. The NK is built on two key assumptions of rational expectations and microeconomic foundations involving the intertemporal optimization choice of the agent. However, the sticky prices assumption is being maintained in the NK model. It is believed that prices are sticky due to contracts and imperfect competition.
PRESENTATION AND ANALYSIS OF RESULTS
RESULTS OF THE PRE-ESTIMATIONTESTS
In accordance with the objective of this study and the estimation procedure earlier discussed, the estimated results are hereby presented and analysed as follows. First, the variables of interest are subjected to unit-roots test, using the Augmented Dickey-Fuller (ADF) and the Phillip-Peron (PP) tests as summarized below:
CONCLUSION AND POLICY RECOMMENDATION
The interactions between fiscal and monetary policy has become one of the most debated issues in the field of macroeconomics in the last two decades, especially after the global financial crisis in 2008. Although, prior to these period, the debate on the relative effectiveness of these two policies has become a household issue among economists, the recent discussion on policy interaction has taking a further step to investigate what could make such policies to become responsive to various macroeconomic shocks, how they effects changes in the macroeconomic environment and how they collectively adjust to each other’s shock in order to influence a particular macroeconomic target.
In this study, the relevant literatures relating to the debates on fiscal-monetary interaction and effectiveness are reviewed. The literatures on relative effectiveness of both policies are first considered, both from the Keynesians and Monetarist perspectives. Then, the theories of policy interactions are reviewed, with more emphasis on the fiscal theory of price level determination (FTPL) and the theory of “strategic interactions”. Various empirical studies, with different methodologies adopted, are also reviewed extensively.
This study analyzes the interaction of fiscal and monetary policy within the Nigerian macroeconomic setting, and how such interaction influences the relative effectiveness of both policies over the sample period and at various policy regimes (non-monetary autonomy and monetary autonomy regimes). This analysis is founded on the New-Keynesian framework which is built on the assumptions of rational expectations, sticky-price and the intertemporal optimization choice of the agents. The New-Keynesian model is then estimated using the Sims (1980) VAR approach. To capture the objectives of the study, two different sets of the VAR model are estimated. First, the General VAR model is estimated over the entire sample period (1970-2011) in order to ascertain the nature of the interaction between fiscal and monetary policy, and how key macroeconomic performance indicators respond to these policies over the period. Then, the Regime-Specific VAR models are estimated so as to analyse the nature of interactions between these policies at various regimes (1970-1993 and 1994-2011), and how these regime-specific interactions influence the relative effectiveness of both policies.
From the results of the analysis conducted, it is found that there exist significant interactions between fiscal and monetary policy over time and at various policy regimes, which is in accordance with Okafor’s (2013) study. Precisely, there seems to fiscal dominance over the period and at various policy regimes. The two policies tend to be counteractive during the direct monetary control period, while evidence is found in favour of accommodativeness (complementarity), at some points, during the indirect monetary control period, which supports the findings of Chuku (2010). Also, the study finds evidence in support of the FTPL in Nigeria. Evidence obtained from the overall sample and the no-autonomy period seems to play along the non-Ricardian regime, while no such evidence is found for the monetary-autonomy period.
Finally, the study is able to investigate the cause of the discrepancies among previous studies on the Nigerian economy with regards to the relative effectiveness of fiscal and monetary policy. In line with the Killick’s (1981) criteria for evaluating policies, this study finds evidence in favour of relative fiscal effectiveness. This might not be unconnected to the dominance of fiscal policy for most part of the study period which inhibited the performance of the monetary policy, as well as the prominent presence of the government in the day-to-day performance of the economy.
One of the significant conclusions made in this study is that there tends to be fiscal dominance in the Nigerian economy, and this has constrained the performance of monetary policy for most of the period. In order to ease the excessive influence of fiscal actions on monetary policy, the financial/monetary system of the economy must be further strengthened to complement the CBN autonomy and credibility. Also, the fiscal authority, while setting monetary commitments for the Central Bank when necessary, must also commit itself appropriately by playing to the rule of the game. This will not only enhance monetary effectiveness but also enhance the credibility of monetary policy emanating from the CBN.
Similarly, the study reveals that, for most part of period, fiscal and monetary policies tend to counteract each other, which thereby inhibited their relative effectiveness. In order to effectively address this menace, there is a need for proper coordination of both policies. Both fiscal and monetary authorities must cordial operate and set macroeconomic targets based on chosen policy variables.
Furthermore, both fiscal and monetary authorities need to properly cordially coordinate their respective policy instruments in order to address the menace of inflation Nigeria, as evidence from the study reveals that neither of the policies is strong enough to influence this menace. The fiscal authority also needs to constantly check its spending, especially the non-productive spending, which leaks, unabatedly, into the economy and induce inflation.
More so, policy makers must take caution when assigning targets to policy instruments. Comparative evidence from this study and other studies on Nigeria, and other foreign studies, reveals that the choice of policy instruments could significantly alter obtainable outcomes. Thus, the effect of a one percent change in interest rate may not be the same as that of a one percent change in money supply, even though both of them are monetary policy instruments and can be used to achieve similar objectives. This applies also to fiscal instruments.
In conclusion, it is recommended that the national statistical bodies should do more to constantly update the nation’s statistical database in order to further reduce the variations among studies on this topic, so that reliable estimates could be obtained and valid forecast made. This has immense implications on the conduct and performance of fiscal and monetary policy in the country. For instance, a reliable estimate and forecast of inflation will enable agents to make appropriate decisions on inflation expectation, which may ease tension on policy conduct and performance.
VALUE ADDED BY THE RESEARCH
With regards to the analysis of fiscal and monetary policy interaction and effectiveness in Nigeria, this study is novel in the sense that it builds the foundation of its analysis on the New- Keynesian theory which allows for interaction and effectiveness of policy rules. The study’s ingenuity can also be seen in the construction of a regime-specific VAR model to capture policy interactions at various regimes, which is the first of its kind among Nigerian studies.
SUGGESTIONS FOR FUTURE RESEARCH
The debate on the interactions and effectiveness is still on-going. Researchers interested in this line of debate may improve on this study by considering Nigeria as a small-open economy that responds significantly to external shocks which may be captured with exchange rate shock, import-share or degree of openness. Interested researcher may also decide to calibrate the equations of the NK model and then simulate them with the respective policy rules. Rather than estimating a VAR model for the NK framework, alternatively, interested researcher may estimate a DSGE model.
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