CHAPTER ONE1.0 INTRODUCTION1.1 BACKGROUND OF THE STUDYFor most economies, the objectives of monetary policy include price stability,maintenance of balance of payments equilibrium, promotion of employment andoutput growth, sustainable development. These objectives are necessary for theattainment of internal and external balance, and the promotion of long runeconomic growth. The importance of price stability derives from the harmfuleffect of price volatility which undermines the objectives. This is indeed a generalconsensus that domestic price fluctuations undermines the role of monetaryvalues as a store of value, and frustrate investments and growth.Ajayi and Ojo (1981) and fisher (1993), empirical states on inflation,growth and productivity have confirmed the long run inverse relationshipbetween inflation and growth. When decomposed into its components, that isgrowth due to capital accumulation, productivity growth, and the growth rate ofthe labour force, the negative association between inflation and growth has beentraced to the strong negative relationship between it and capital accumulation aswell as productivity growth respectively. The importance of these empiricalfindings is that stable prices are essential for growth due to capital accumulation,productivity growth, and the growth rate of the labour force, the negativeassociation between inflation and growth has been traced to the strong negativerelationship between it and capital accumulation as well as productivity growthrespectively. The importance of these empirical findings is that stable prices areessential for growth. The success of monetary policy depends on the operatingeconomic environment, the institutional framework adopted, and theimplementation of monetary policy is the responsibility of the central bank ofNigeria (CBN). The mandates of the CBN as specified by the CBN Act of 1958include; Issuance of legal tender currency. Maintaining external reserves to safeguard the international value of thecurrency. Promoting monetary stability and a sound financial system. Acting as banker and financial adviser to the federal government.However, the current monetary policy framework focuses on the maintenance ofprice stability while the promotion of growth and employment are the secondarygoals of monetary policy. The performance of monetary policy depends on somelegal framework upon which it operates. The legal framework are quantitativegeneral or indirect and second, qualitative selective or direct. The effect effectsthe level of aggregate demand through the supply of money, cost of money andavailability of credit. Out of the two types of instruments, the first categoryinclude bank are variations, open market operation, and required reserve ratio.They are meant to regulate the overall level of credit in the economy throughcommercial banks. The selective credit control aims at controlling specific types ofcredit. This includes changing margin requirement and regulation of consumer’scredit (M.L Jhingan, 2003).In any economy, the conducts of both policies are normally rooted throughbanking institutions that play in the intermediation process. The role of bringinglenders and borrowers together through this process the central bank plays a veryimportant role in determining the price of money (Ebhodaghe, 1996). Therefore,monetary policy is important in its own right from the past view of monetaryeconomists and policy maker’s interns of its impacts on the economy. Of all toolsavailable to government for directing the cause of the economy, monetarypolicies have proven to be the most visible instrument for achieving medium termstabilization objectives (CBN guideline 2002). Indeed monetary policy formulationand implementation emerged as a critical government responsibility so that theeconomy does not go astray. Policies are made not only for their own sake ratherfor achieving some desired goals over a given period of time.Generally, the primary objectives of monetary policy is concerned with theapplication of expansionary monetary policy measures during economic recessionand contractionary monetary policy controls money supply because it is believedthat its rate of growth has an effect on inflation. The basic aim of monetarypolicies is not to aggregate themselves but the aggregate in the real sectors of theeconomy such as, level of capital price stabilization and economic development.Policies are designed in order to change the trend of some monetary variables inparticular direction so as to induce the desired behavioral change in the monetarypolicy. The central bank’s role is to conduct appropriate monetary policy that isconsistent with the main economic objectives that will help the growth of grossdomestic product (GDP), sustainable inflation are and stable balance of paymentposition. This is done by putting in place the direct or indirect monetary approachso as to control monetary trends. In this regards the CBN determines the amountof money to be supplied that is consistent with the nation’s macro-economicobjectives and manipulate the monetary instrument at its disposal in order toachieve the stated objectives. Monetary policy influences the macrocosmicobjectives because it is believed that there occurs a relationship between the realvariables. Monetary policy affects all aspects of our economic and financialdecisions whether to buy a car, build a house, start up a business or to expand theexisting ones, whether to send one’s child to school or to make the child learntrade. Money supply or monetary policy tries to influence the performance of theeconomy as reflected in key macro-economic indicators like inflation, GDP andemployment. It works by affecting aggregate demand across the economy, that is,individuals’ and firms’ willingness and stability to spend on goods and services. Indoing this, monetary policy has two fundamental goals to promote maximumsustainable output and employment and to maintain sustainable price level in theeconomy. The job of stabilizing output in the short run and promoting pricestability in the long run involves several steps first, the central bank tries toestimate how the economy is doing now and how it is likely to do in the mediumterm, then, it compares this estimates to its goals for the output and the pricelevel, if there is a gap between the estimates and the goals, the CBN have todecide on how forcefully and swiftly to act to close the gap. Estimate of thecurrent economic conditions are not as even as the most up-to-date data on keyvariables like employment, growth, productivity etc, largely reflect condition inthe past. So to get a reasonable estimate of the current and medium termeconomic conditions, the central bank tries to find out what the most relevanteconomic developments are such as government spending, economic conditionsabroad, financial conditions at home and abroad and the use of new technologiesthat boos productivity. These developments are the incorporated in an economicmodel to see how the economy is likely to evolve over time. In doing this, thecentral bank is confronted with some unexpected development such as the NigerDeltacrisis that disturbed the oil production and slowed down the revenuegeneration by the government they therefore, have to build uncertainties intotheir model. Uncertainty seems to be problem at every part of the monetarypolicy process there is yet no set of policy and procedures that policy makers canuse to deal with all situations that may arise. Instead, policy makers must decidehow to precede by analysis the issue is far from being settled. Indeed, the centralbank spends a great deal of time and effort in researching into the various waysto deal with different kinds of situation. Since these issues are not likely to beresolved very soon, the central bank is likely to continue to look at everything.Nigeria did not have any stable macroeconomic policy enforcement before andduring the inflammation of structural adjustment programme (SAP). The terms oftrade deteriorated for most of the period between 1980 to 1985 and someprevious years before the 1980. The consumer price index (CPI) growth rate wason the average of 17.1% between 1980 and 1985 and though this fell to about5.0% in 1986 and 1987, if again started to rise from 1988, peaking at 47.5% in1989. It has remained consistently high in the 1990s reading an all time high of54.7% in 1994. The current account reported as surpluses between 1989 and1993 after a fairly long period of deficit between 1981 and 1988 (there was amoderate surplus in 1984 and 1985 due to the austerity measures embarkedupon by the federal government under the then military administration of generalBabangida). Domestic savings as a ratio of GDP, which stood at an average of27.7% between 1970 and1980, started to fall in 1981. Between 1981 and 1986, itstood at 13.8% the instrument ratio has followed the same pattern although,reporting slightly lower figures. Fiscal deficit has been chronic and is financed byborrowing from the banking system. The share of commercial banks in totalfinancial assets has shown a structural shift from about 57.7% in 1986 to 36.4% in1993, the major gainer has been the central bank whose share has increased from33.1% to 46.4% during the same period. It is doubtful if the structural adjustmentprogramme has improved competitiveness in the system as the three largestbanks still amount put a third of total deposits. One major feature of banking inthe period of deregulation is the occurrence of large distress in the bankingsystem. Close to 42 banks were severely distressed in the system in the systemwith 45 percent of loans classified as non-performing loans (CBN 1994). Theperformance of major monetary and commercial banks ratios did not show anyappreciable improvement during reforms. For example, total loan and advancesmeasured as a ratio of GDP declined from 25.6 percent in 1986 to 14.3 percent in1990. The aggregate domestic credit, GDP ratio which peaked at 50.3 percent in1986, reduced by half in 1993 (24.5%) with credit to government commanding alarger proportion. The ratio of both narrow money MI save trend. From a hightrend of 19.2 percent in 1981, MI/GDP ratio phi-meted to 11.5 percent in 1993and M2/GDP ratio from 30.6 to 20.1 percent following the same pattern severelynegative before the liberalization exercise the deregulation exercise in 1987 yieldinterest rate that were mildly negative to positive in the period 1987-1990. Butwith pressure on prices thereafter real interest rates have turned severelynegative, again for the period of 1991 to 1994. It can be observed that mostmacro-economic aggregates have become severely unstable in recent times it isin this environment that indirect monetary control was initiated in 1993. Much ofdifficulty in achieving the objectives of SAP resulted largely from failure to achievefiscal balance and the consequent reliance on borrowing from the central bank tofinance the fiscal deficits. This has adversely affected both the market for foreignexchange, money and goods and the expected role of market in allocatingresources efficiently. The extent to which open market operations in governmentbills can help to successful manage the excess liquidity in the system which iscreated by government borrowing from the central bank is one of that whileshould be of interest given the enormity of this problem in the attainment ofstabilization goals in the economy.