Abstract
Abstract Economic theory suggests that monetary policy can be used to stabilize an economy. However, the ability of monetary policy targets—interest rates and money supply—to stabilize an economy depends on their ability to achieve price stability. Using data from 1981 to 2018 and applying the vector error correction model, this paper seeks to determine how the changes in the inflation rate affect the ability of monetary policy tools to stabilize the Nigerian economy and stimulate investment. Empirical results suggest that the impact of the interest rates on investment depends on the level of the inflation rate. The size of the effect of interest rates on investment gets weaker as the inflation rate increases suggesting that monetary policy tools, such as the monetary policy rate (MPR), that directly change the interest rates are robust stabilization tools during periods of declining inflation rates but not relevant during periods of rising inflation rates. This is attributable to low bank lending rates. Additionally, the impact of the money supply target on investment does not depend on the level of the inflation rate. This suggests that monetary policy tools, such as open market operations, that directly change the money supply can be relevant stabilization tools during economic booms and recessions. As a result, the Central Bank of Nigeria should work to deepen the scale, capacity, and efficiency of its open market operations by ensuring that most of the people can participate with minimal transaction cost and by making different financial instruments available.
Highlights
The monetary authority of a country uses its monetary policy framework to manage the value, cost, and supply of money
The size of the effect of the monetary policy rate on investment gets smaller as the inflation rate increases
Where Investment, the dependent variable, is the natural logarithm of real gross capital formation, which measures the outlays on additions to Nigeria’s fixed assets plus net changes in inventories; β is a vector containing the coefficients of the explanatory variables and the interaction terms and X is a vector containing the explanatory variables and the interaction terms between the monetary policy rate and the inflation rate, and broad money and the inflation rate. α is the intercept and Ut is the error term
Summary
The monetary authority of a country uses its monetary policy framework to manage the value, cost, and supply of money. The Central Bank of Nigeria (CBN) uses its monetary policy tools to influence the market interest rates and money supply to stabilize the economy. During economic recessions and/or falling inflation rates (deflation), the CBN adopts an expansionary monetary policy that involves the reduction of the monetary policy rate, the purchase of domestic assets on the open market, or both The idea behind these policies is to enhance the ability of the deposit money banks to advance loans and credits by decreasing the cost of borrowing and increasing the money supply. The impact of open market operations on investment does not depend on the level of the inflation rate This suggests that monetary policy tools that directly change the money supply, such as open market operations, can be a relevant stabilization tool during economic booms and recessions.
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