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CRITICAL ANALYSIS OF THE DETERMINANT OF THE DEMAND FOR MONEY IN NIGERIA (1992-2004)

CRITICAL ANALYSIS OF THE DETERMINANT OF THE DEMAND FOR MONEY IN NIGERIA (1992-2004)

CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

Practically speaking, demand for money is the demand on the part of individuals and businesses to hold purchasing power in the form of cash and checkable deposit. Demand for money has been defined also as the amount of money balance held for certain purpose rather than putting them into immediate consumption expenditure. In the Nigerian society and other developing countries of the world today, demand for money has increasingly been a focus of economic analysis of which several studies have extensively been carried out as to what factors principally determine the demand for money in Nigeria.

There have been tremendous theoretical and empirical studies on the demand for money. Pinpointing these with the seminal work of Tomon (1972) which has led to comments and criticism through the famous “Tatoo debate” of the 1970s that demand for money is influenced by real income and interest rate. And this was criticized by the other researchers like Ojo and Teriba (1974) that poorly specified demand for money functions makes the research conducted unreliable and spurious as there is unstable demand for money function estimation.

Also the identification of the demand for money function is important as it plays an essential role in the transmission mechanism of both monetary and fiscal policy. Furthermore, the temporary stability of such identified function is also significant if monetary policy is to have a predictable effect on the ultimate objective of economic policy (Oresotu and Mordi 1992). Thus, estimation of demand for money function is important as the positive fall out of anti-inflationary stabilization policy depend on a stable demand for money function (Nwabanmwen 2002).

Even as with many other issues in economic theory, disbelief (controversy) has split the economists and policy maker into different schools of thought, namely the classical, the Keynesian, neo-classical and the monetarists.

The classicalists for instance argued that the demand for money, the medium of exchange as a simple means of carrying out transaction Jhingan (2003).

Jhingan (2003), Keynes argued that the nominal interest rate affects real money holding, although that demand for money is determined by both income and interest rate, but emphasizing that interest rate is more superior. According to this same Jhingan, Keynes argued that decision to either to hold cash, invest in bond or borrowing is pre-determined by the rate of interest.

The monetarist in their analysis however, refute Keynes’ prediction tendency that interest rate and income determine demand for money. Rather they maintained that permanent income, influence the decision to hold money, Jhingan (2003).

From this plethora of studies, it is obvious that there is no consensus among economists as to what determines or influence the demand for money. Also, it is justified that the schools of thought based their theoretical prescriptions on advanced capitalist economic system, which they practiced. This was debated as it would lead to a distortion in their workability in a developing economy like Nigeria.

Ojo (1974) argued that in a developing country like Nigeria characterized by underdeveloped money markets and financial assets, the choice facing an individual is more between money and physical assets rather than between money and financial assets, with inflation as the opportunity cost.

In spite of the controversies among the economists, the analysis of the demand and the supply of money still play tremendous role in the economic policy both in the developed and developing economies.

1.2 STATEMENT OF PROBLEM

The general hypotheses are that the demand for money is influenced by the permanent real income, rate of inflation, and domestic lending interest rate.

The problems which motivate this study could be summarized as follows:

  • Real income is a significant factor influencing demand for money function.
  • Domestic lending interest rate is responsible to the demand for money.
  • Inflation rate is a significant factor determining the demand for money within the context of import dependent economy and underdeveloped financial markets like Nigeria.

Given these, it is thus, the aim of the study to reconcile the differences among economists as to what determines the demand for money in the Nigerian context.

1.3 OBJECTIVE OF THE STUDY

The objective of the study is to critically analyze within the context of an import-dependent economy and developing economy like Nigeria, the factors that influenced the demand for money. This would go a long way to verify the following bothering issues.

  • Whether the same set of factors that determine the demand for money in developed world are prevalent in the Nigeria economy.
  • Other significant factors or variables that determine the demand for money in the Nigeria economy could be probably shown also.

1.4 RESEARCH HYPOTHESIS

The cardinal hypothesis for this work is that interest rate and permanent real income to mention but a few are significant determinants of the demand for money and the supply of money in the less developed countries like Nigeria.

  • Is there any significant positive relationship between the level of real income (GDP) and demand for money?
  • Is there any significant positive relationship between domestic lending interest rate and demand for money?
  • Is there any significant negative relationship between the rate of inflation and the demand for money?

1.5 SCOPE OF STUDY

Using annual data, the study will cover a period of 13 years of Nigeria economy measuring from 1992 to 2004. It is believed that this length of time will have a unique advantage of measuring a real result in knowing how efficacious the variable used are.

1.6 LIMITATION OF THE STUDY

Limitation is anything that can act as a barrier to the successful completion of any project work. This research work was hampered by the following factors.

  • Time factor: The time given to the researcher for the completion of this work was short. Thus, the researcher sacrificed a lot to combine the project with normal academic work and he had to put extra effort for the completion of the work.
  • Finance: Finance constraints have always been a barrier towards the completion of any project work. As a result of the economic hardship, the researcher did not have enough money with which to carry out the research and yet feed properly.

1.7    DEFINITION OF BASIC TERMS

The terminologies employed in this research work are presented and defined below.

  • Market or nominal interest rate: This can be defined as the interest rate computed from the money values of a borrowing or lending arrangement, such as a savings account; the interest unadjusted for expected inflation.
  • Real interest rate: This is defined as the nominal interest rate minus the expected rate of interest.
  • Expected inflation rate: This is defined as the rate of inflation that consumers and businesses expected to exist over a relevant future period, such as coming year.
  • Liquidity Preference Theory: This is defined as a theory stating that the interest rate is determined by the interaction of real money demand and supply, interest rate changes are due to real money demand or supply changes which produce changes in real economic activity.
  • Real money demand: This is the demand on the part of individual and businesses to hold purchasing power in the form of cash and checkable deposits.
  • Transactions demand: This is money demand that arises from the desire of businesses and consumers to facilitate exchange with the use of money.
  • Precautionary demand: Money demand that arises from the desire of businesses and consumers to hold money in order to facilitate unexpected purchases (to meet unforeseen events).
  • Speculative demand: Money demand arising from uncertainty of future interest rates and the fact that people can substitute between holding money and holding bonds.
  • Quantity theory of money; A hypothesis suggesting a predictive positive relationship between the money supply and the price level, specifically, that money supply changes cause price level changes.
  • Equation of exchange: An identity used to derive the quantity theory of money; MV = PQ.
  • Income velocity: The average number of times that a unit of money (Naira) is used, or changes hands, in purchasing nominal GNP.
  • Neutrality of money: A proposition stating that, in the long-run, the relative prices of goods and services are not affected by the changes in the money supply.

 

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