CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

Sound monetary policy depends on a theoretically coherent and empirically reliable model of money demand. For a central bank, a stable money demand function is what makes policy effects predictable: if the relationship between money holdings and their determinants is steady, changes in monetary instruments produce expected results, and the bank can offset disturbances that arise in the real sector. If that relationship shifts unpredictably, the money demand function becomes a source of disturbance in its own right, and the central bank loses control over the outcomes of its actions. For this reason, the stability of money demand is regarded as important for policy formulation and for liquidity management (Ujunwa et al., 2022).

A stable relationship between money demand and its determinants also supports the case for monetary targeting, a strategy in which the central bank sets the money stock it believes will deliver its macroeconomic objectives. In principle, the choice of policy target lies between a monetary aggregate and an interest rate. Where money demand is stable, a monetary aggregate is an appropriate target because the quantity of money is predictably related to income, prices and other variables that link money to the real sector. Where it is unstable, an interest rate target is generally preferable, since the velocity of money becomes unpredictable and the money stock stops being a reliable guide to economic activity.

The Central Bank of Nigeria (CBN) aims to maintain price stability in support of sustainable growth and employment. Its decisions are now communicated mainly through the Monetary Policy Rate (MPR), the corridor of standing facilities around it and other liquidity instruments. In its November 2025 communiqué, for example, the Monetary Policy Committee retained the MPR at 27.0 per cent, citing the effect of earlier tightening and the continued deceleration of headline inflation, which nonetheless remained in double digits (CBN, 2025b). Earlier in 2025, the Committee had noted with satisfaction recent exchange market reforms and the appreciation of the exchange rate that followed them (CBN, 2025a). Whatever the instrument, the effectiveness of policy still depends on how households and firms demand money in response to income, interest rates, prices and the exchange rate, and so on whether that demand is stable.

Because of its importance for policy, the demand for money is among the most heavily researched areas of macroeconomics. Recent Nigerian studies give a generally reassuring but qualified picture. El-Rasheed et al. (2017), using data for 1980 to 2014, found that real income, the domestic interest rate, inflation, the exchange rate and monetary uncertainty are cointegrated with broad money (M2), that monetary uncertainty significantly influences money demand, and that the broad money demand function remained stable over the period. Ujunwa et al. (2022) extended the standard model with a direct measure of financial innovation and tested narrow money (M1), broad money (M2) and the total monetary aggregate (M3). They found a long-run relationship between money demand and financial innovation, and stability tests indicated that money demand remained stable across all three aggregates. Adebayo (2021), covering 1980 to 2018, similarly found a cointegrating relationship between real money demand, real GDP, the real deposit interest rate and financial development, and concluded that financial development plays a key role in the long-run stability of money demand.

A stable money demand function, in turn, allows policy-driven changes in monetary aggregates to produce desired movements in targeted macroeconomic variables such as income, interest rates, prices, the exchange rate, consumption, savings and investment. It is therefore important to understand what determines the demand for money in Nigeria and whether the relationship between those determinants and the money stock remains stable over time.

1.2 Statement of the Research Problem

The stability of the money demand function is a central concern for any central bank. It is a guiding consideration in deciding how far monetary aggregates can serve as policy targets and when an alternative framework, such as one built around the policy interest rate or an inflation target, is more appropriate. Instability would imply that velocity is unpredictable, so that quantity-based targets would be poor predictors of economic activity and could mislead policy.

Existing Nigerian evidence is largely favourable to stability, but it rests on samples that end well before the present (El-Rasheed et al., 2017; Adebayo, 2021) and on specifications that treat the monetary environment as largely unchanged. Financial innovation and changes in the financial system are a long-standing reason for expecting instability (Ujunwa et al., 2022), and the recent period has brought further change. Between 2014 and 2024 Nigeria experienced episodes of exchange rate adjustment and a sharp tightening of the policy rate, which reached 27.5 per cent in early 2025 (CBN, 2025a). Whether the money demand function has remained stable through these developments is therefore an open empirical question.

This study addresses two related questions. First, is monetary targeting still relevant in the conduct of monetary policy in Nigeria? Second, is the real M2 money demand function stable enough to serve as an intermediate target? The implications of the answers for monetary policy are considerable. If M2 demand is unstable, reliance on M2 as an intermediate target could expose the CBN to serious policy errors. The study therefore re-examines the determinants and stability of money demand over a longer and more recent period, 1991 to 2024.

1.3 Objectives of the Study

The main objective is to examine the determinants of the demand for money in Nigeria and to determine its stability. The specific objectives are to:

1. evaluate how income, the interest rate, the inflation rate, the exchange rate and the foreign interest rate affect the quantity of money demanded in Nigeria;
2. examine the long-run cointegrating relationship between the money demand function and the selected variables: real income, interest rate, inflation rate, exchange rate and foreign interest rate; and
3. study the short-run dynamics of the money demand function so as to capture both short-term deviations and long-run expectations.

1.4 Research Questions

1. To what extent do income, the interest rate, the inflation rate, the exchange rate and the foreign interest rate affect the quantity of money demanded in Nigeria?
2. How strong is the long-run cointegrating relationship among real income, the interest rate, the inflation rate, the exchange rate and the foreign interest rate?
3. How quickly do short-run deviations adjust back toward long-run equilibrium?

1.5 Hypotheses of the Study

The hypotheses are stated in null form:

1. H01: Income, the interest rate, the inflation rate, the exchange rate and the foreign interest rate have no significant effect on the quantity of money demanded in Nigeria.
2. H02: There is no cointegration between the money demand function and the selected macroeconomic variables (real income, interest rate, inflation rate, exchange rate and foreign interest rate).
3. H03: The speed of adjustment of short-run deviations toward long-run equilibrium is not statistically significant.

1.6 Scope of the Research

The study covers the period 1991 to 2024 and uses the autoregressive distributed lag (ARDL) approach to cointegration and the error correction model. The starting year is retained because 1991 is when the Banks and Other Financial Institutions Act and the Central Bank of Nigeria Decree No. 24 were promulgated, replacing the CBN Act of 1958 and the Banking Act of 1969 to strengthen the powers of the Central Bank. The end year has been extended from 2014 to 2024 so that the analysis includes the most recent episodes of exchange rate adjustment and monetary tightening.

1.7 Significance of the Study

Academia. The level and stability of money demand continue to attract academic attention because understanding them informs the design of monetary policy. By covering a longer and more recent period than earlier studies, this study provides updated reference points on the behaviour of money demand in Nigeria and a basis for further research.

Policymakers. Analysis of the money demand function helps monetary authorities anticipate the demand for money and set appropriate rates of monetary growth. The results will help the CBN identify the variables that matter most for money demand and so support its efforts to maintain monetary and price stability.

Monetary economists. A stable money demand function lets monetary authorities bring about predictable changes in targeted variables such as income, interest rates and prices. The study has implications for how monetary policy should be conducted and adds to a literature that is still comparatively thin for Nigeria.

1.8 Operational Definitions of Terms

Monetary targeting: A strategy in which a central bank sets the money stock expected to deliver its desired macroeconomic objectives.

Stability of money demand: A condition in which the quantity of money is predictably related to the key variables that link money to the real sector.

Determinants: The variables that drive the long-run demand for money in Nigeria, here real income, the interest rate, the inflation rate, the exchange rate and the foreign interest rate.

Short-run dynamics: The quarter-to-quarter or year-to-year movements in real money balances that arise from temporary shocks to desired money holdings.

REFERENCES

Adebayo, D. B. (2021). Reconsidering the stability of money demand in Nigeria [Master's thesis, Eastern Mediterranean University]. https://i-rep.emu.edu.tr/items/5e286089-6b05-4a94-8952-cc59d5a32e4a

Central Bank of Nigeria. (2025a). Monetary policy communiqué No. 156 (20 February 2025). https://www.cbn.gov.ng/Out/2025/CCD/Central_Bank_of_Nigeria_Comminique_No.156_20_February_2025.pdf

Central Bank of Nigeria. (2025b). Monetary policy communiqué No. 160 (25 November 2025). https://www.cbn.gov.ng/Out/2025/CCD/MPC%20Communique%20No.%20160%20%20November%2025%202025.pdf

El-Rasheed, S., Abdullah, H., & Dahalan, J. (2017). Monetary uncertainty and demand for money stability in Nigeria: An autoregressive distributed lag approach. International Journal of Economics and Financial Issues, 7(1), 601–607.

Ujunwa, A., Onah, E., Ujunwa, A. I., Okoyeuzu, C. R., & Kalu, E. U. (2022). Financial innovation and the stability of money demand in Nigeria. African Development Review, 34(2), 215–231. https://doi.org/10.1111/1467-8268.12631