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Rnanclallleepefting •••• Ecaaamic GrwG 10/lIgItII:All MDlllodel ApproKlo.

- Aylla Ngutsav, AIdglIIrIIa¥Id Terla • Ioremller PIlII T.

Inflation - Targeling ApproacIl to MoneUryManagement:

Is Fiscal Domlll_ R*vMt lor NigeriI?. Onwube, Onyelluc~1 • Ilwogwugn U.C.C,

Social - Economic Implication of Child labour InMaldugurl Metropolis Bomo State, Nigeria .

• Ahmed, Funmllola F., Egwu, Grace E.•

Tukur, Moha'1'med D.

_nal Perfonn-. and EcoIlOlllIcDevetopmenlIn Nlgerla.

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Use " ApproprIate TJ_1omIation In TIme sertesAaaIysIs 01 Nigeril e- PrIce Indos 01 Dairy

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Department of EconomicsEnugu State University ofScience and Technology,Enugu State, Nigeria

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Department of EconomicsPaul University, Awka,Anambra State, Nigeria

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Department of Economics andDevelopment StudiesFederal University Ndufu -AlikeIkwo, Ebonyi State, Nigeria

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Journal of Economic Studies

Volume 11 NO.1 March 2014

Published by Department 01Economics.Nnamdl Azlklwe University. Awka.

Journal of Economic StudiesVolume11 No. 1 March 2014

..,-Agricultural Financing and Performance in Nigeria: 1984 - 20 II.- Ozurumba, Benedict Anayochukwu & Chigbu, Uzoamaka Sussan 1

..,-Macroeconomic Adjustment and Economic Growth in Nigeria:Lessons ofExperience.- Kalu Christopher U. & Nwogwugwu U.C 24

..,- Financial Deepening and Economic Growth in Nigeria:AnARDLModelApproach- AyilaNgutsav,Akighir David Terfa& Iorember Paul T. .34

..,- Inflation - Targeting Approach to Monetary Management: Is Fiscal DominanceRelevant for Nigeria?- Onwube, Onyebuchi & Nwogwugwu U.C.C, 53

-or Social- Economic Implication of Child Labour in Maiduguri Metropolis Borno State,Nigeria. -Ahmed, FunmilolaF., Egwu, Grace E. & Tukur, Mohammed D 69

..,- Institutional Performance and Economic Development in Nigeria.- Ezenekwe, R.U. & Amah, Munachim 83

..,- Use of Appropriate Transformation in Time Series Analysis ofNigeria Consumer Price Index of Dairy (1990 - 20 12).- Eric L. Otuonye & Chigozie Okororie 104

INFLATION-TARGETING APPROACH TO MONETARYMANAGEMENT: IS FISCAL DOMINANCE RELEVANT FOR

NIGERIA?

By

ONVVUBE,ONYEBUCHIDepartmentof Economicsand DevelopmentStudies

Federal UniversityNdufu-AlkeIkwo, Ebonyi State NigeriaEmail:onwube.ollyebuchi@gmail.com

And

NWOGWUGWU, UCHE C.C.Departmentof Economics

NnamdiAzikiwe UniversityAwkaAnambra State, NigeriaE-mail: lIchenwofJWugwu@gmail.com

Abstract

Since the 1990's a number of countries have favoured the inflation-targeting model tomonetary management. Can Nigeria reliably adopt the inflation-targeting approach tomonetary management? The objective of the paper arises from the fact that monetaryauthorities are in a continuous search for better alternative approaches to monetarymanagement. The paper attempts to define the relationship between iriflation and majormonetary variables and the relationship between inflation andfindncial stability as well asfiscal dominance. Using a simple econometric model and secondary datafrom 1970-2008,the researchfindings indicates thatfiscal dominance existsfor Nigeria and that 'thefinancialsystem is neither strong nor stable enough tofacilitate effective transmission of monetarypolicy. The research therefore, supports the synergy between the ministry of financeresponsible for approving government expenditure and the Central Bank of Nigeria. Theresearch also suggests continuous reform of the financial system to attain a sustainabledegree of stability that will facilitate monetary policy transmissions as well as constantmonitoring (regulation/deregulation) of the interest rate and exchange rate due its volatility

as these have significant effects on inflation in the country_

Keywords: inflation-targeting, fiscal dominance, monetary management.

1. INTRODUCTION

Economic stabilization is a prime objective for every monetary authority in anygiven economy_ In achieving this, the monetary authorities bring to bear its stabilizationstrategies through its well thought out monetary policies_ The monetary authority isprimarily concerned with price stabilization but has as its overall mandate, the managementof monetary aggregates to ensure macroeconomic stability. However, as monetaryauthorities focus on price stabilization, their monetary policies are limited in their influenceover inflation in the short run even though monetary policies are generally powerful instabilizing business cycle caused by short run systemic shocks. Such shocks could beendogenous or exogenous from real sector. Bubbles in one sector of the economy couldtrigger a series of crises that can negatively affect the financial sector and destabilize theeconomy. Bernanke (2012), noted that the factors that sustained the financial crises between2007-2009 in the US and later became a global financial recession (Nigeria inclusive) werethe structural weaknesses in the financial system, in regulationand supervision.This statementhighlightstheneed forpropermonetarymanagement.

According to Batini and Yates (2003) the primary role of monetary policy is themaintenance of price stability (low levels of inflation). This of course does not rule out otherobjectives of monetary policy such as exchange rate stability, promotion of a sound/safefinancial system as well as sustainable growth and development. The monetary authority isto ensure, via its policies, internal and external balances. The achievement of this balance isparamount in the design of monetary policy as any imbalance could either result in higherinflation rate or in stagnation thus, retarding economic growth and development. In ensuringeconomic stability in Nigeria the monetary authority (central bank of Nigeria) has adoptedvarious economic management approaches (monetarily). The period between 1970 and1986, saw the operation of a fixed exchange rate regime approach to economic management.Under this regime monetary policy placed emphasis on direct monetary control.-This wasessential at the time due to the relatively underdeveloped nature of the country's money andcapital market. Between 1986 and 200 I, (the period of indirect control or market basedapproach) the approach to monetary management/economic stabilization moved from adirect approach to an indirect approach where market instruments are anchor for monetarymanagement with variations in intermediate variable instruments and the policy terms. Thiswas necessitated by a desire to eliminate the distortion and ineffectiveness in the financial

system caused by the prolonged use of administrative controls and the need to engendercompetition among banks and other operators in the financial system. Nigeria hasprogressively adopted various managerial mix to ensure that the supply of money in thesystem is consistent with the nations absorptive capacity. There is a certain level of moneysupply that is consistent with the nation's absorptive capacity. There is a certain level ofmoney supply that is consistent with an expected level of economic activity withoutnecessarily generating undue pressure on domestic prices and the exchange rate. It is thatlevel of money supply that the monetary authority wants to maintain so that there wouldn'tbe shortages or excesses leading to economic stagnation or higher inflation. To achieve thislevel of money supply different monetary management approach has been adopted bydifferent countries taking into cognizance the peculiar nature of their financial system,mstitutional capacity, available instrument and the effi, iency of policy transmission. In'~igeria, there has been movements from one approach to the other namely from the directapproach to the market based approach and various variables have been used as nominalanchor. Between 1970 and 1986, the exchange rate served as the nominal anchor forachieving stabilization in the economy.

Afterwards, following the introduction of the Structural Adjustment Program (SAP)and in line with the deregulating frame work for the economy a market based interest rateapproach was adopted. Recently there is another call to move away from the interest rate as~henominal anchor to inflation, an approach called inflation targeting (IT). Agenor (2000),noted that while only eight (8) countries adopted this approach in the 1990's, 54 countriesadopted explicit inflation target by 1998. Oluba (2008) posited that this approach known asmflation targeting (IT) was first pioneered in 1990 in New Zealand but has gained popularitym countries like Brazil, Egypt, Isreal, Spain, South Africa, South Korea, Sweden and UKamong others. Inflation targeting is an operational framework for monetary policy in whichthe attainment of price stability becomes the overriding objective of the monetary authority.The need to target inflation and ensure a low level of inflation that is consistent with growthof economic activity stems from the fact that the existing monetary targeting approach hasnot been consistent with set targets.

Under the existing approach (monetary target) which is quality-based, is focused oncontrolling money and credit. Thus the monetary authority uses both an operating target(reserve money which it can manipulate) and an intermediate target (money supplies whichit uses as a nominal anchor). The actualization of the objective of monetary targeting usingmoney supply as the nominal anchor depends on the stability of the money demandrelationship. Thus, according to Mordi (2008) monetary targeting framework presupposes

the existence of a stable and predictable relationship between the monetary aggregate an':other economic variables in the economy. In effect controlling a monetary aggregatepresupposes the existence of a stable demand for money relationship or stable velocity. Thuswhere either of them fluctuates widely, transmission mechanism becomes more complexand controlling inflation or money supply becomes difficult. Given the current monetar)target framework where the base money is the operating target and the broad money beingthe intermediate target, the same presupposition applies. Thus, a stable relationship mustexist between the two (base money and money supply) for monetary targeting to achieve itsobjective. To achieve this, the money multiplier must be relatively stable. According to theanalysis carried out by C.N Mordi (2008) over the period 1970 - 2007 the money multiplierhas been unstable and during these period monetary policy performance has been rathermixed than accurate except in 2004 where the set target for inflation didn't deviate from theoutcome and largely because fiscal expenditure didn't deviate much from the generalmacroeconomic goals.

Thus for the period under review controlling money supply has been rather difficult.Put simply monetary targeting can no longer hold for Nigeria as the ideal conditions (stablerelations between operating targets and intermediate targets) for its effectiveness does notexist. This explains the reason for the transition to inflation targeting as mentioned earlier.Inflation targeting is a monetary policy strategy whereby the monetary authority adopts anexplicit target range for inflation, makes such inflation range publicly known and focuses onits achievement as the overriding objective of monetary policy. Thus given a desired range ofinflation rate and so long as the existing inflation rate remains within the desired range themonetary authority (central bank of Nigeria) is expected to stabilize the economy.Arguments abound that Nigeria cannot transit to inflation targeting approach unless someconditions are met. Again given the pronouncement that Nigeria will transit to inflationtargeting approach to monetary management, how feasible is it? It is worthy of note thatinflation is a price based or price targeting framework. This Underscores the need for anefficient and competitive banking system. Such a system will make the transmissionmechanism or degree of pass through more effective. As it is now, Nigeria· is a developingnation and has a fmancial system that has experienced major reforms in the last six years.Moreover given the recent international financial meltdown which revealed the exposures towhich the Nigerian banking system faces can the country (monetary authority) convenientlyadopt the inflation targeting framework for monetary stabilization? What about the issue ofindependence or fiscal dominance? Will the fiscal activities of the government negate theeffort of the monetary authority to stabilize prices under an IT environment?

This article is divided into five sections beginning with section one, which discusses theintroductory aspect of monetary management and performance of monetary policy inNigeria over the period under review. Section two focuses on conceptual issues, review ofrelevant literature both empirical and theoretical on the conduct of monetary policies inNigeria. Section three covers theoretical framework and methodology, stating clearly whatmethod is applied. Section four discusses the result while section five provides the summary,conclusions and policy recommendations.

2. REVIEW OF LITERATUREMonetary management is an integral part of macroeconomic management. It refers

to the use of some combination of instrument by the monetary authority (Central Bank ofNigeria) to influence the availability and cost of credit and/or money in the domesticeconomy with a view to achieving macroeonomic balance. Inflation is a state ofdisequilibrium in the economy in which too much money chases too few goods thus, supplypersistently fails to keep pace with the expansion of demand. According to

Odusola (2007) inflation targeting is basically one of the orthodox approaches tomonetary management which involves controlling inflation through monetary policies. Theobjective is to ensure stable prices and overall macroeconomic stability. In its effort toensure internal and external balance, the apex monetary authority in Nigeria (Central Bankof Nigeria) has evolved various monetary policies over time in attempt to control the flow ofmoney in the system and thus avoid macroeconomic instability. The effect of excess moneysupply on the economy has been captured in the literature. The traditional quantity theory ofmoney states, in a crude form, that "an increase in money supply brings about aproportionate increase in prices (inflation)". 1bis theory later modified by Irving Fisher andcame to be known as Fishers equation of exchange (MY = PT) tells us that the price level(value of money) can be affected by the velocity of circulation even without increasingmoney supply. Thus economic activities can give rise to increase in prices (inflation) withconsequences on the macroeconomic objectives of price stability, full employment andsustainable growth and development. Therefore, money supply in the economy can go out ofproportion with absorptive capacity whether the monetary authority increases the moneysupply or not. To that end, controlling money supply by the monetary authority impliescontrolling the money stock and achieving this has given rise to various approaches tomonetary management.

Ezekiel (2013) observed that exogenous factors affect the ability of the monetaryauthority to achieve monetary policy objectives such as price stability and due to the import

dependency of the Nigerian economy, exchange rate must be regulated to the resultant

volatility that negates the success of monetary policy management. He thus favours using

exchange rate as the nominal anchor for monetary management rather than inflation. He thus

supports the views of Aliyu and Englama (2009). They utilized a number of econometric

techniques in investigating the degree of pass-through of monetary policies under an

inflation targeting environment and observed that inflation is impassive to monetary

transmission while exchange rate has a high pass through rate. They however noted that

inflation targeting could be pursued given the right conditions.

Uchendu (2000) observed that one of the right conditions is the independence of the

central bank of Nigeria. Nnanna (2003) opined that the success of monetary policies depends

on the operating economic environment, the institutional framework adopted and the choice

of the instruments used. He also noted that fiscal dominmce, a persistent liquidity overhang,

an oligopolistic banking system and dualistic financial markets are major systemic factors

that have undermined the efficacy of monetary policy in Nigeria.

According to Nnanna (2001) fiscal expansion and the concomitant large fiscal

deficits averaging about 3.0 percent of GDP have militated against the efficacy of monetary

policy in Nigeria. Recently, more countries are adopting the inflation targeting approach to

1Il0netary management. This shows that the benefit of this approach far outweighs itsdemerits as there is no approach to monetary management that is 100% performing. In the

words of Odusola (2007) monetary management under inflation-targeting has counter

cyclical influence by reducing the volatility of inflation and output thus reducing the output­

inflation trade off. While Odusola is not against inflation-targeting approach to monetary

management he suggests the need for caution as output is reduced which has its implication

for macroeconomic stability.

Oloni and Adewara (2013) noted that autonomy and transparency of the monetary

authority means more employment for Nigeria. This suggests that for an effective monetary

policy regime fiscal dominance must be reduced to the minimum. Hugman (2007)

commented that adopting inflation targeting approach for Nigeria will be challenging due to

the latitude the authorities have to vary macroeconomic policies and therefore to

successfully practice this approach, the central bank must be prepared to tighten monetary

policies for a sustained period.

On his part, Svensson (1998) pointed out that a number off actors have motivated an

increasing adoption of inflation as nominal anchor for monetary management. These include

exchange rate volatility crises, instability of the money demand functiotl and the need to

avoid the consequent socio-economic cost of high and volatile inflation. Gladino et al (2005)

opined that the choice of inflation targeting in recent times is premised on its simplicity,maintenance of public and explicit commitment to economic management discipline,improving inflation predictability, clarifying communications, accountability andtransparency. It has been argued that making inflation target public does not just make themonetary authority responsible for their utterances but rather makes them both accountableand more transparent. Supporting the need for inflation targeting Omoye (2007) positedthat price inflation is regarded as a normal development in a growing economy as long assuch price increases are within the range oflow single digits. Inflation targeting is seen as atool for overcoming credibility problems because it mimics incentives for performancecontract and it also allows policy makers to respond more flexibly to economic shocks,Odusola (2007). According to Clifton et al (2001) inflation targeting regime provides ananchor to inflation expectations, and thus can help reduce the persistence of inflationaryshocks and improve the short-run inflation-output trade-off as observed also by Odusola(2007). Bemanke et al (I999) argued further that inflation targeting serves as a tool foranchoring the private sector's expectations for future inflation. He however, argued thatthere is the need to insure against deflation which is counter-productive. In making supportfor inflation targeting,

Mishkin and Posen (I 997) noted that inflation targeting has been highly successfulin helping countries among other things to maintain low inflation rates and that there is noevidence that inflation targeting has produced undesirable effects on the real economy inthe long run rather it has likely had the effect of improving the climate for economicgrowth. Kelecher (I 997) on his part argued that inflation targeting allows price system towork more effectively thus keeping inflation close to zero and has the advantage oflimitingthe microeconomic cost and tax distortions caused by inflation.

Odusola (2006) pointed out that the main motivation for inflation targeting is thedirect benefit of price stability for economic efficiency and growth. The report by JEC(2005) of the US congress noted some of the benefits of publicly declared inflation'targetsto include stabilization of economic markets such as the commodity market, the exchangerate markets and the money and capital markets. Despite these positive remarks aboutinflation targeting there are criticisms that has been leveled against this approach resultingfrom the reality of the economies that have practiced the approach.

Apart from the criticism there are also challenges that developing economies withemerging markets face in adopting inflation target approach to monetary management.According to Esptein (2005) inflation targeting has not fully addressed serious ills of theeconomy such as poverty, employment and inequality. Arguments also exist that this

approach brings about a lot of trade-offs with the achieving of price stability butsimultaneously asset price bubbles and fInancial instability (Borio and White 2002; Fildaro,2004; Odusola, 2006). Hugman (2007) highlighted, the challenges for Nigeria in thesewords: the Central Bank of Nigeria must recognize that the move to inflation-targeting mustbe gradual, carefully planned within a coherent overarching framework and done incomplete coordination with other key economic management agencies without which suchannouncements may not have the desired impact on prices as encountered in severalemerging markets".

Odusola (2007) noted that inflation targeting approach relegates the macroeconomicgoals of employment creation and economic growth to the background. Thus for a countrylike Nigeria with a great need for growth and employment creation care must be exercised toavoid such a trade off. Also, the success of inflation target approach lies on adherence toadequate coordination of monetary and fiscal policies (Odusola, 2007). Despite thesearguments for and against inflation-targeting and the challenges associated with it, thenumber of countries adopting it has been on the rise since its inception (Agenor, 2000; Oluba,2008). Since monetary management is an indispensable aspect of macroeconomicmanagement, monetary authorities are in constant search of better alternative approaches tomonetary management. Without monetary management, emerging and developedeconomies cannot contain the distortions that result from excess domestic liquidity. Toachieve price stability the Central Bank of Nigeria (the apex monetary authority in thecountry) has evolved various monetary management policies. These policies have had theirchallenges and dismal outcome over the years and that has put the monetary authority inconstant search, as it is around the globe, of a better alternative approach to achieving pricestability and thus avoiding the attendant macroeconomic instability it engenders. Isinflation-targeting an option? The fear is that the system is not adequately prepared to adoptthis approach. As a price-based approach the efficacy is contingent on stable and efficientfInancial system, the absence of fIscal dominance and the proper coordination of monetaryand fiscal policies which the country is yet to achieve.

3. METHODOLOGY, THEORETICAL FRAMEWORK AND MODELSPECIFICATION

A basic concept in this research is the concept of inflation-targeting framework. Asposited by Silkos (1999), inflation-targeting is a strategy in which the monetary authorityadopts a numerical target (preferably single digit) for inflation and commits to achieving thetarget. Thus the monetary authority adopts an explicit target range, makes the target public

and focus on keeping the inflation rate within that range. This paper aims at determiniT'" thefeasibility of implementing monetary policy rules under an inflation targeting envinThe argument is that inflation is price based and the transmission mechanism f,based variables requires an efficient and stable fmancial system.

The major reforms in the financial system beginning with consolidation to L.

concept of corporate governance and risk management is indicative of the fact that thenation is working to establish the appropriate environment for the inflation targetingapproach to monetary management. Theoretically, the basis for this approach stems fromthe generalization of the monetarist approach to inflation which states that inflation is"always and always a money matter". According to the Neoclassical economist (IrvingFisher) a change in the value of money can be brought about by changes in the velocity ofcirculation of money without necessarily changing the money supply. This argument iscaptured in his famous equation of exchange which is a modification of the traditionalquantity theory of money.

The equatioo of exchange is illustrated below as:MV=PT

Making P the subject of theformular we have:

PT=MV 2

P=MV 3

T

P=v/tM 4

Let v/t rep-esent the coefficient of money multiplier and be represented as <1, thus:

P=aM 5

Equation (5) can be written as

P = f(a.,M) 6

IfP, th: rcice level represents inflation th:n Equation (6) can be written as:

Inf= f(a, M) 7

Equation 7 is a non-stochastic relationship which looks quite simple yet provides an ins::

into the behaviour of prices (inflation) given changes in the value of (velocity of circular:.

of money) and M (money supply). Thus the equation indicates that inflation is affected ~

money supply and the velocity of circulation of money. If money supply M is constant Ddthe value of (velocity of circulation of money) changes the result will be a change in ~

inflation level in the same direction. Theoretical literature and empirical studies have show!.

that inflation is caused by not by money supply alone but a number of factors. It follows tha:

to keep inflation low means to keep an 'economic eye' on the factors that generate

inflationary situations. Such factors may include monetary aggregates like exchange rate­

interest rate and other factors like the financial sector and fiscal dominance proxied b~

government expenditure. Thus the focus is on inflation and to measure the effect of a stable

financial system and fiscal dominance on inflation in an inflation targeting environment the

appropriate inflation model in its non-stochastic form is represented below with its aprior

signs:

inf = a+ 131ir + I3zexr+ I3:Jss+ rVd 8+ + +

Where Inf is inflation, ir is the rate of in1erest, exr is the exchange rate fSs, is financial system

stability measured by commercial bank's loan to deposit ratio and fd is fiscal dominance. Thus the

effect of fiscal dominance and stable fmancial system en inflation can be anal)Ud using a oouble log

stochastic ecommetric relationship of the form.

lninf= a + 1311nir+I32lnexr+ I3Jlnfss+ I\lnfd + f.l 9

In all, the variables employed are five (5). To avoid spurious result all the variables were

logged to reduce them to the same unit. Also there apriori expectations are indicated below.

The variable fss representing financial system stability is expected to be inversely related to

inflation. This is expected as an efficient and stable fmancial system to enhance the rate of

pass through of monetary policies in order to keep inflation from rising above the set target.

Thus where inflation is high, given the financial system, is an indication that financial system

is not efficient enough as to allow the monetary policy management have a 'pass through' to

maintain a low level of inflation consistent with economic growth activities. The other

variables such as interest rate, exchange rate and government fiscal expenditure are expected

to have a positive relationship as the case may be. Interest rate rises during inflation only

because lenders are willing to lend at high rate of inte~est to make up for the loss in nn" .rate of interest and borrowers hope to gain through goods purchased at higherWhere this does not hold, interest rate may be sticky downwards. Governmerexpenditure can only lead to higher inflation when such expenditures are geared tctransfer payments rather than capital projects that will impact on output. When SUCh

expenditures are on the real sector where goods and services are produced inflation is likelyto remain sticky or stable. High exchange rate leads to inflation where the monetaryauthority is not effective in ensuring that the objective of increasing exchange rate, which isto aid domestic production, in realized.

4. DISCUSSION OF RESULT

Table I presents the unit root test based on the Augmentf,d Dickey-Fuller testcriteria, indicating the order of integration of the univariate time series. To ensure thereliability of the result, unit root test was carried out on the univariate time series todetermine the stationarity of the variables. The result of the unit root test indicates that thevariables were stationary at first difference which implies an order one integration i.e 1(1).[SeeAppendix I]

TESTING THE REsmUAL OF THE MODEL

To establish a long run relationship between the dependent and independent variables theresidual of the model was estimated and subjected to unit root test. The result indicated thatthe estimated residual was stationary at level. This implies that the residual is integrated atorder zero supporting the cointegrated status of the variables. The result is presented below:u,=0.0023 +0.2108,-101709"1t =0.0221 1.2746 -4.8830s.e = 0.1065 0.1654 0.2398

R'=0.51 %; DW=2.0659; F.stat= 16.750From the result in table 2[see appendix 1] it is obvious that fiscal dominance is true forNigeria. That is to say governrilent expenditure has inflationary implication on the .economy and can jeopardize the effort of the monetary authority to maintain a price levelthat is compatible with the nation's absorptive capacity. The coefficient of the fiscaldominance variable shows a positive and high correlation between governmentexpenditure and inflation in Nigeria. Moreover, the t-statistic has a value of 3.0881indicating that government expenditure is a significant explainer of inflation in Nigeria. Tocapture a strong and stable fmancial system, which is a basic requirement for adopting the

inflation-targeting model of monetary management, financial system stability proxied byloan to deposit ratio of commercial banks was used. The variable denoted as fss indicated avery strong relationship statistically and supported the apriori expectation of a negativerelationship. This confirms the notion that a weak fmancial system cannot facilitate thenecessary transmission mechanism for effecting monetary policies in order to achievemonetary objectives. The result also showed that interest rate has a positive correlation withinflation in Nigeria. The correlation is high with a value of 1.7639 and a t-statistic value of4.0980. This indicates that interest rate manipulation by the Central Bank must be done inline with monetary policy objectives so as to avoid distortions in the system. However,exchange rate showed a negative but high correlation value with inflation. Recall that highexchange rate implies high cost of importation and where this discourages importation,imported inflation becomes nearly impossible. But if importers could defy the highexchange rate due to weakness in financial supervision and import goods and services atinflated prices, domestic inflation rises. Also high exchange rate implies adevaluation/depreciation of the naira this makes domestic production cheaper and keepsprices low, all things being equal. Thus to keep prices low exchange rate can be manipulatedin line with the overall macroeconomic policy of the country. The coefficient ofdetermination of (R' = 43.47%) indicates that there are other factors not captured in thisrelationship that impact on the level of inflation in Nigeria. This may include smuggling, :"419" activities, internet fraud, electioneering among others. Nevertheless the resultiindicates that fiscal dominance, financial system stability, exchange rate and interest rate areimportant variables to keep in mind when working at sustaining a price level that iscompatible with the nation's absorptive capacity under an inflation-targeting environment.The F-statistic is 6.1542 indicating a well specified model.

5. POLICY IMPLICATIONSANDCONCLUSION

In summary we can conclude that fiscal dominance is a contributory factor to theinflationary pressure in Nigeria as such government fiscal activities must be in consonancewith monetary policy thrust. This implies that the Ministry of Finance must not be isolatedfrom the apex monetary authority (Central Bank of Nigeria). The two agencies must work inharmony so that fiscal expenditures do not impact negatively on monetary objectives andpolicy thrust.

The financial system must be strengthened. The result indicated that a spongfmancial system has an effective transmission mechanism. To this end reforms on thefinancial system must be carried out on clearly defined objectives that have the overall

interest of the nation's economy. Since the "Great Recession" which began in 2007, the

Nigerian financial system has not been competitively impressive as market capi~tionand All Share Index has not improved significantly. This is a cause for conceri'i andsuggests that financial reforms must be on-going given that no monetary policy lasts fordecades and no fmancial system anywhere in the world is immune to external shocks.Interest rate must be low enough to encourage borrowing for investment withoutdiscouraging the act of savings. Higher level of savings implies high levels of investmentbut the connection between them is the interest rate.

Lastly the success of exchange rate as an instrument for controlling inflation depends onthe ability of the monetary authority to keep a close tab on its volatility and the facts aboutthe economy in terms of domestic production, importation, elasticity of demand amongothers. The monetary authority must have the necessary information to effectively manageexchange rate volatility.

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AppendixTable 1 AUGMENTED DICKEY-FULLER UNIT ROOT TEST

VARIABLES LEVELI"DlFF.2'" DlFFCRITICAL VALUEORDEROF

INTEGRATION

LNINF

-3.7369-6.5768---3.53481(1)

LNEXR

-2.2768-4.8882---3.53481(1)

LNIR

-1.9693-8.6027---3.53481(1)

LNFSS

-3.1294-6.1566---3.53481(1)

LNFD

-21724-7.1241---3.53481(1)

Computed by author using eviews

Table 2. Estimated Relatimship

D.W. statIsltc -1.9979R - 0.4347, F. statIstIC 6.1542,

Variables CoefficiertsSTDErrort-StatisticProbability==1

C

0.88763.34560.26530.7925~Lnexr-0.98990.2491-3.97420.0004

Lnir

1.76390.43044.09800.0003

Lnfss

-1.86690.7182-2.59920.0140

Lnfd

0.62750.20323.08810.0041"

-