CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

The prominent issues in macroeconomics revolve around three variables: unemployment, output growth and inflation. As far as inflation is concerned, the central policy question is how to keep it low and, where it is already high, how to bring it down without causing a recession. Inflation is generally understood as a sustained increase in the overall level of prices (Mankiw, 2019). It is a problem that all economies, developed and developing, have to contend with, although the larger share of its burden is borne by less developed economies, in part because high inflation falls hardest on the poor (Easterly & Fischer, 2001).

Macroeconomists and monetary policy advisers around the world are convinced that unstable prices can damage the growth of any economy. This conviction rests largely on the hypothesis advanced by Friedman (1977) in his Nobel lecture, which has been approached from two angles. The first examines the relationship between the inflation rate and inflation uncertainty, a link later formalised by Ball (1992) and often called the Friedman–Ball hypothesis. The second extends the argument by examining the link between inflation uncertainty and output growth. Friedman argued that rising inflation is associated with a higher level of inflation uncertainty, and that this uncertainty harms growth because it makes the price system less efficient at coordinating economic activity, leaving economic agents less able to decide how to use resources. He reasoned that a government's full-employment objective tends to push up the inflation rate, which in turn creates strong pressure to counter it, and that the anticipation of this pressure increases uncertainty about the future course of inflation. In short, a higher level of inflation produces greater uncertainty about the future course of government policy. When inflation is low, policy makers will try to sustain it at that level, but when inflation is high they face a trade-off between the cost of further inflation and the recession that disinflation may bring (Ball, 1992).

The literature does not speak with one voice on the direction of these effects. Cukierman and Meltzer (1986) argued for reverse causality, in which greater nominal uncertainty raises inflation because policy makers are tempted to create surprise inflation to stimulate growth. Dotsey and Sarte (2000) showed that inflation uncertainty may even raise growth, since it can induce precautionary saving. For Nigeria, however, Eregha and Ndoricimpa (2022) found that inflation uncertainty raises the level of inflation and is detrimental to output growth, supporting Friedman's hypothesis, while Bamanga et al. (2016) found that inflation causes inflation uncertainty, which is consistent with the Friedman–Ball proposition.

Data from the Central Bank of Nigeria (CBN) statistical bulletin (2010) show that inflation in Nigeria has risen and fallen in a volatile manner, with values ranging from 6.12% in 1960 to 1.7% in 1970, from 33.9% in 1975 to 10% in 1980, and from 72.8% in 1995 to 12.4% in 2009. Nigeria has experienced four major episodes of inflation above 30% since 1970 (Omotosho & Doguwa, 2012). The first was in 1975, when inflation reached about 34%. Omotosho and Doguwa (2012) attribute it to factors that included drought in northern Nigeria, which pushed up food prices, and the excessive monetisation of the large dollar inflows from the oil boom. The measures adopted in response included reducing import duties on a relatively large number of goods and raw materials, a monetary policy deliberately aimed at encouraging banks to lend more to productive sectors, and the establishment of an anti-inflation task force, which recommended the creation of a productivity, prices and incomes board. These steps explain the gradual decline in average inflation during 1976 to 1983.

In 1984, inflation reached 41% as a result of expectations of an imminent devaluation of the naira. The military regime responded with price controls, which brought the rate down to 25.5% in 1985. The expansionary budget of 1988, financed by the CBN, produced the third episode of high inflation, which ran from 1988 to 1989. Increased agricultural production helped moderate inflationary pressures in 1990, when the rate fell to 8.2%. The fourth episode, the most worrying, lasted about five years from 1992 and peaked at over 80% in 1995, driven largely by monetary growth and fiscal expansion. In response, government strengthened its stabilisation measures, entrenching monetary discipline, fiscal restraint and exchange rate stability, and inflation fell to 7.1% in 2000 from over 80% in 1995 (Omotosho & Doguwa, 2012). Olubusoye and Oyaromade (2008) similarly document that average inflation rose from about 5% in 1960–1972 to about 18% in 1973–1985 and about 31% in 1986–1995.

A background on output growth in Nigeria from 1970 to 2012 helps to show how output has fared. The Nigerian economy has had a truncated growth history. In 1960–70, Gross Domestic Product (GDP) grew by 3.1% annually. During the oil boom, roughly 1970–78, GDP grew by a remarkable 6.2% a year. In the 1980s, however, growth rates were negative. In 1988–1997, the period of structural adjustment and economic liberalisation, GDP responded to the adjustment policies and grew at a positive rate of 4%. After independence, industry and manufacturing recorded positive growth rates except in 1980–1988, when they contracted by 3.2% and 2.9% respectively. Agricultural growth was unsatisfactory in 1960–70 and 1970–1978: in the early 1960s the sector suffered from low commodity prices, while the oil boom contributed to its decline in the 1970s by drawing labour away from rural areas to the cities.

The contribution of agriculture to GDP, which was 63% in 1960, declined to 34% in 1988. This was not because the industrial sector expanded its share but because the agricultural sector was neglected, and it is therefore not surprising that by 1975 the country had become a net importer of basic food items. The apparent increase in the share of industry and manufacturing from 1978 to 1988 was due to activity in the mining sub-sector, especially petroleum. The economy never experienced double-digit inflation in the 1960s. By 1976, however, inflation stood at 23%; it fell to 11.8% in 1979 and then jumped to 41% in 1989 and 72.8% in 1995. By 1998 it had fallen to 9.5% from 29.0% in 1996. Between 1978 and 1986, except in 1979 and 1985, the economy continued to register negative growth, which led to high inflation, high unemployment and fiscal imbalance. The stabilisation and austerity measures of the Shagari administration (1979–83) did not arrest the deepening crisis. The balance of payments did not improve, and rising external borrowing deepened the debt overhang. The economy was plainly suffering from stagflation. Industrial capacity utilisation, which was 73.6% in 1981, declined steadily to 31% by 1989, and manufacturing growth fell from 14.6% in 1981 to 3.2% in 1989, despite the various stabilisation policies of the 1980s. The structure of the economy made it vulnerable to external shocks and policy shifts, and the problems were so severe that restructuring became inevitable.

The Structural Adjustment Programme (SAP) was consequently introduced in 1986 (Olubusoye & Oyaromade, 2008). It was intended to change and realign the pattern of aggregate domestic expenditure and production so as to reduce dependence on imports, strengthen the non-oil export base and return the economy to a path of steady and balanced growth. Unfortunately, the reform programme appeared to intensify speculative and trading activities rather than raise production. The proliferation of merchant banks and finance houses, the deregulation of interest rates, privatisation and the new industrial policy did not attract the foreign direct investment that was needed. The private sector, which was expected to be the engine of growth during adjustment, did not live up to expectations despite the favourable environment. Even after eight years of structural adjustment, and up to the present, the private sector has not been able to respond adequately to the desire for increased output, employment and stable prices.

1.2 Statement of the Problem

Rapid output growth and low inflation are the most common objectives of macroeconomic policy in both developed and developing economies. In Nigeria, the formulation and implementation of monetary policy by the CBN is aimed at maintaining price stability, in line with the achievement of sustainable growth. The growing interest in price stability as a major goal of monetary policy reflects the observation that high inflation disrupts the smooth functioning of a market economy (Fischer, 1993).

Nigeria has adopted various monetary policy routes in pursuit of its objectives. Direct controls were put in place in 1985 to combat rising inflation, which had erupted following the energy crisis of the 1970s. They operated by placing quantitative ceilings on bank credit and interest rates and limiting the freedom of banks to undertake certain activities. Direct controls were later phased out on the grounds that their effectiveness declined over time, that they distorted the allocation of bank credit, and that inflation continued to rise. The CBN then adopted open market operations (OMO) and discount window operations as indirect methods of monetary control. The indirect approach relies on the power of the monetary authorities to influence the credit operations of banks through changes in bank reserves. Since 1993, OMO has been the dominant instrument of liquidity management, with the discount rate and reserve requirements serving mainly as adjustment instruments.

High inflation is known to have many adverse effects. It imposes welfare costs on society; it impedes efficient resource allocation by obscuring the signalling role of relative price changes; it discourages saving and investment by creating uncertainty about future prices; it inhibits financial development by making intermediation more costly; it hits the poor disproportionately because they do not hold financial assets that hedge against inflation (Easterly & Fischer, 2001); it reduces a country's international competitiveness by making its exports relatively more expensive, with negative consequences for the balance of payments; and, perhaps most importantly, it reduces long-term economic growth (Fischer, 1993; Bruno & Easterly, 1998; Barro, 1996). On Friedman's argument, adequate and proper monetary policy would keep inflation under control. In the Nigerian case, however, several opinions hold sway. On one side, some groups, particularly members of government and the monetary authorities, believe that the CBN has made significant efforts to curb inflation. Against this is the view of a larger part of the population, who believe that not much has been done to combat inflation effectively since the era of deregulation.

In November 2014, the presidency, acting through the CBN, put into effect a monetary policy aimed at devaluing the naira, which had varying effects on all sectors of the economy. The cost of manufacturing rose, domestic prices of goods began to climb, and those engaged in foreign trade faced higher costs. Low- and middle-income earners, who make up the majority of the population, prefer to buy goods and services now rather than save for future consumption, for fear of future income erosion. It is because of this kind of uncertainty that financial institutions find it hard to persuade citizens to save more of their current earnings for future consumption and investment. The problem motivating this study therefore concerns how inflation and its uncertainty affect the economic decisions of Nigerians, especially their spending and saving habits, and how this in turn affects output growth in Nigeria.

1.3 Research Questions

From the statement of the problem, the following research questions arise:

1. Has there been any significant relationship between inflation, inflation uncertainty and output growth?
2. What is the causal relationship between inflation uncertainty and output growth?
3. What is the causal relationship between inflation and output growth?
4. What is the causal relationship between inflation and inflation uncertainty?

1.4 Objectives of the Study

The specific objectives of this study include:

1. To investigate the relationship between inflation, inflation uncertainty and output growth.
2. To ascertain the direction of causality between inflation uncertainty and output growth.
3. To ascertain the direction of causality between inflation and output growth.
4. To determine the direction of causality between inflation and inflation uncertainty.

1.5 Research Hypotheses

The hypotheses are stated in their null form, while their alternatives are implied:

H01: There is no significant relationship between inflation, inflation uncertainty and output growth.

H02: There is no causal relationship between inflation uncertainty and output growth.

H03: There is no causal relationship between inflation and output growth.

H04: There is no causal relationship between inflation and inflation uncertainty.

1.6 Significance of the Study

The macroeconomic environment of every country needs to be forward-looking and stable if sustainable growth is to be achieved. This study will provide insight into the actual efficiency of monetary policy in managing inflation over the years, and into how policy can better serve price stability, output growth and investment than it has done in the past. It is intended to guide monetary policy advisers on the course of action most likely to create an economic environment that is not highly volatile and is friendly to investment (Eregha & Ndoricimpa, 2022). It will also help government in its growth planning, because its findings will show how much government can afford to spend to support production, boost employment and raise output without worsening inflation.

The study will also be valuable to investors. Every investor in a foreign economic environment wants assurance of profit, and information on the output gap and the purchasing power of an economy is therefore especially useful. Investors and portfolio managers will benefit because the study shows how responsive the economy is likely to be to their investment, in terms of demand for output, and how profitable their ventures may turn out to be. Finally, the findings will consolidate the existing literature and stimulate further debate that may point to areas for further research.

References

Ball, L. (1992). Why does high inflation raise inflation uncertainty? Journal of Monetary Economics, 29(3), 371–388.

Bamanga, M. A., Musa, U., Salihu, A., Udoette, U. S., Adejo, V. T., Edem, O. N., Bukar, H., & Udechukwu-Peterclaver, C. T. (2016). Inflation and inflation uncertainty in Nigeria: A test of the Friedman's hypothesis. CBN Journal of Applied Statistics, 7(1a), 147–169.

Barro, R. J. (1996). Inflation and growth. Federal Reserve Bank of St. Louis Review, 78(3), 153–169.

Bruno, M., & Easterly, W. (1998). Inflation crises and long-run growth. Journal of Monetary Economics, 41(1), 3–26.

Central Bank of Nigeria. (2010). Statistical bulletin. Central Bank of Nigeria.

Cukierman, A., & Meltzer, A. H. (1986). A theory of ambiguity, credibility, and inflation under discretion and asymmetric information. Econometrica, 54(5), 1099–1128.

Dotsey, M., & Sarte, P. D. (2000). Inflation uncertainty and growth in a simple monetary model. Journal of Monetary Economics, 45(3), 631–655.

Easterly, W., & Fischer, S. (2001). Inflation and the poor. Journal of Money, Credit and Banking, 33(2), 160–178.

Eregha, P. B., & Ndoricimpa, A. (2022). Inflation, output growth and their uncertainties: Some multivariate GARCH-M evidence for Nigeria. Journal of Social and Economic Development, 24(1), 197–210. https://doi.org/10.1007/s40847-022-00177-1

Fischer, S. (1993). The role of macroeconomic factors in growth. Journal of Monetary Economics, 32(3), 485–512.

Friedman, M. (1977). Nobel lecture: Inflation and unemployment. Journal of Political Economy, 85(3), 451–472.

Mankiw, N. G. (2019). Macroeconomics (10th ed.). Worth Publishers.

Olubusoye, O. E., & Oyaromade, R. (2008). Modelling the inflation process in Nigeria (AERC Research Paper 182). African Economic Research Consortium.

Omotosho, B. S., & Doguwa, S. I. (2012). Understanding the dynamics of inflation volatility in Nigeria: A GARCH perspective. CBN Journal of Applied Statistics, 3(2).