The paper aimed to construct a monetary conditions index (MCI) for Nigeria to aid the evaluation of the stance of monetary policy. Quarterly data for 91-day treasury bill rate (TBR), real exchange rate (RER), inflation rate (INF), real private sector credit (RCP), and real gross domestic product (RGDP), covering the period 2000Q1 to 2014Q1, were utilised. The period coincided with key reforms in the money and foreign exchange markets, culminating in the adoption of a new monetary policy framework in 2006.
Following some econometric diagnostic tests, an aggregate demand function was estimated using the Johansen co-integration technique. The resultant long-run coefficients were applied to the deviations of the MCI component variables to derive the monetary conditions indices.
The narrow and broad MCIs suggested a relatively tight monetary environment with the broad MCI being more volatile, compared with the narrow MCI due to the inclusion of the credit component, which reflects the continual swings in banking system liquidity.
Our findings revealed that the exchange rate is a strong channel of monetary policy transmission mechanism in Nigeria, and thus very crucial in the conduct of monetary policy.
Mmanagement, the other being fiscal policy. Both policy tools are used to guide an economy towards a level of output (Gross Domestic Product) that is optimal with regard to employment.
Central banks as the monetary authority of countries formulate and implement monetary policy by controlling money supply through several mechanisms. Compared with fiscal policy, monetary policy has proved to be a more flexible and powerful instrument for achieving economic stabilisation objectives, in the short to medium term, because it can be adjusted quickly, when need be, in response to macroeconomic developments.
Recent events surrounding the global financial crisis have amply demonstrated the uses and abuses of monetary policy in open economies. In particular, the use of quantitative easing to restart growth shows that monetary policy can adopt unconventional strategies (buying or selling private securities) when conventional strategies (buying or selling government securities) are unable to achieve stabilisation objectives. Mishkin (1995), Monetary Policy Committee (BOE) (1999), and Kuttner and Mosser (2002) identified six (6) channels of transmission of monetary policy, namely: the interest rate; the wealth effect; the exchange rate; the monetarist (relative asset price changes); the narrow credit (bank lending); and the broad credit (balance sheet) channels. Through these six channels changes in overnight interest rate by the central bank affect the level of aggregate demand and the inflation rate, ultimately. The six channels are commonly compressed into three: interest rate, exchange rate and credit channels due to the significant effect of monetary policy on these three variables, particularly in the short-run. Monetary policy actions, operating through these channels, generate an overall monetary condition in an economy beyond what a central bank’s policy rate would suggest. A Monetary Conditions Index (MCI) is an index number, relative to a base period, calculated from a linear combination of two or all of these three economy-wide financial variables relevant to monetary policy. It is a summary statistic of the monetary condition in an economy. In all cases, the variables include short-term interest rate and exchange rate. MCI calculated using only the interest and exchange rates is termed a narrow MCI, while that calculated using all the three variables is termed broad MCI. The purpose of calculating the index is to provide information on the economy, inflation and the general monetary environment in a country to guide monetary policy. A change in the index indicates the stance of monetary policy: how ‘tight’ or ‘loose’ monetary conditions in an economy are relative to the reference or base period. The use of MCI began with the Bank of Canada in the early 1990s. The Bank used it as a short-run operational target of monetary policy. Other monetary authorities in New Zealand, Turkey, the United Kingdom and Australia, some international organisation’s (such as the OECD) and large business corporations, especially banks have also adopted the technique of MCI as decision-making tool. Calculation of MCI is done within a model in which the GDP or inflation path is dependent on two or all the three monetary policy variables: interest rate, exchange rate and volume of credit to the economy.
MCI serves as an indicator of monetary policy stance. Also some major central banks, including the Bank of Canada, its counterparts in New Zealand, Australia, Norway, Sweden and the European Central Bank, have at one time or the other, used MCI as operational target. The International Monetary Fund (IMF), Goldman Sachs, JP Morgan, Deutsche Bank and Merrill Lynch also calculate MCIs and use them to appraise the monetary conditions in different countries. Although various institutions use the index for varying reasons, there is monetary authority that has embraced it explicitly to serve as a policy rule. The indicator usually provide supplementary information to certain central banks to enable them identify divergence between actual monetary conditions and the desired stance of policy. The objective of this paper is to rejuvenate the estimation of MCI for Nigeria and to test the outcome in order to enhance the efficiency of monetary policy in Nigeria. This paper would extend earlier efforts by Oleka and Masha (2003) and Yaaba (2013) in the estimation of monetary conditions index for Nigeria. It is believed that, the construction and maintenance of MCI for Nigeria could be used by the central bank and other policy makers to evaluate the stance of monetary policy. A good MCI could also be useful in the following ways: (i) provide additional insights on monetary conditions; (ii) serve as potent indicator under a multiple indicator approach such that the contribution of each of the channels of monetary policy transmission to the general monetary condition (beyond the overnight interest rate and or exchange rate) can be evaluated; (iii) provide policy makers with necessary flexibility to respond more appropriately to local and foreign financial markets dynamics; (iv) allow monetary policy authorities the chance to continuously rebalance priorities between output growth and price stability in a flexible and time variant manner depending on the underlying macroeconomic and financial conditions evident in the MCI; (v) help to determine which of the variables (determinants) is more important in influencing monetary condition in a given period; (vi) serve as a leading indicator of price movement and economic activity; (vii) complement the money demand function, which lacks precision; (viii) guide monetary policy decisions, using forecasts of MCI through the forecast of its determinants.