A TEST OF THE VALIDITY OF MILTON FRIEDMAN’S QUANTITY THEORY OF MONEY, USING NIGERIA DATA
This study test for the validity of Milton Friedman’s Quantity Theory of Money, using Nigeria Data. Variables tested against real money demand for Nigeria were real income, bonds, equities, stocks, wealth, and inflation rate. The study used annual time series spanning 47 years, a sample period from 1970- 2016. Methodically, this study models a standard money demand function and employed the use of ADF - Fisher Chi-square and Phillips-Perron test statistic to test for the unit root, the Engle-Granger single-equation to test for the cointegration and using the Autoregressive Distributed Lag (ARDL) model to dilate the impacts of the explanatory variables on the explained variable and using Pairwise Granger Causality to test for the causal effect between real demand for money and wealth. Partially consistent with theoretical postulates, this study finds that money demand function is partially stable in Nigeria for the sample period and that income; return on stock and return on equity are the most significant determinants of the demand for money. The study shows that real money demand positively responds to an increase in real income and wealth and negatively to a rise in the interest-bearing assets and inflation. It was also gathered that stock market variables can improve the performance of money demand function in Nigeria. The study recommended policies aimed at improving stock market activities and also monetary targeting as a tool to boost aggregate demand and income.
1.1 BACKGROUND OF STUDY
Money demand is certainly one of the most researched fields in economics. Literally thousands of articles have been published over the last decades that contain empirical money demand estimations for numerous countries and time periods. However, despite these considerable efforts the results of this huge literature are quite diverse. The range of the estimated income and interest-rate elasticity is wide and while some papers maintain that Money demand is stable others come to a converse conclusion. This study is however aimed at testing the validity of Milton Friedman’s Quantity Theory of Money, using Nigeria data in the determination of Money demand stability in Nigeria.
Unlike the demand for goods, Money demand is not restricted to one market but also involves other markets (Money Market, Capital Market, Commodity Market and Foreign Exchange Market), hence it has a direct bearing on monetary policy and so relevant to the study of macro-economics. The focus on the demand for money is attributed to the fact that monetary policy will only be effective if the demand for money function is stable. Stability of the demand for money is crucial in understanding the behaviour of critical macro-economic variables (Essien, Onwioduokit and Osho. 1996).
The search for a stable demand for money has been a very contentious issue since the great intellectual debates between Keynesians and Monetarists of the 1960s and 1970s, as no demand for money model set forth by any of these two schools as well as their contemporaries has withstood the test of time. The instability of the demand for money in the 1970s and in the 1980s has been attributed primarily to changes in the performance of financial markets in the area of new financial products arising out of financial innovations.
Financial innovation refers both to technological advances which facilitate access to new information, trading and means of payment and to the emergence of new financial instruments and services, new forms of organization and more developed and complete financial markets, (Odularu, 2010). According to Soludo (2009:23), Nigerian banks account for over 90 percent of financial system assets and dominate the stock market. As a result, a well-funded Banking Sector is essential in order to maintain financial system stability and confidence in the economy.
In Nigeria, the Central Bank of Nigeria (CBN) is responsible for the design and conduct of monetary policy. Over the years, the CBN has adopted a wide range of monetary policy frameworks such as exchange rate and monetary targeting frameworks in order to achieve macroeconomic objectives of price stability, economic growth and balance of payment viability as well as employment creation in its conduct of monetary policy.
According to Yusuf (2010), direct controls, political instability and pervasive government intervention in the financial system resulting in the stifling of competition and resource misallocation, necessitated the introduction of the Structural Adjustment Programme (SAP) in 1986. SAP was a comprehensive economic restructuring programme which emphasized increased reliance on market forces. In line with this orientation, financial sector reforms were initiated to enhance competition, reduce distortion in investment decisions and evolve a sound and more efficient financial system. The reforms which focused on structural changes, monetary policy, interest rate administration and foreign exchange management, encompass both financial market liberalization and institutional building in the financial sector.
According to Owoye et al, (2007), stability of the money demand function has important implications for the conduct and implementation of monetary policy. In other words, these are some of the important issues for empirical analyses because it is possible that the implementation of SAP in 1986 may have altered the stability of real money demand function. They also stressed that, after the implementation of SAP in 1986, the Nigerian economy went through some significant structural and institutional changes. These changes included the liberalization of the external trade and payment systems, substantial degree of financial deepening and innovations in the banking sector, the adoption of a managed float exchange rate system, the elimination of price and interest rate controls, changes in monetary policy, and the emphasis on market determined by indirect instruments of monetary policy. It is conceivable that these developments may have altered the relationship between money, income, prices, cash balances and other key economic variables; and this may have caused the money demand function to become structurally unstable.
During the ‘90s the growing importance of stock markets has again fed the idea that the primary source of instability is related to monetary aggregates. Moreover, the preference for liquidity in itself might be highly unstable. This could be because of wealth effects which influence non-monotonically the demand for money. It follows that the degree of instability will strongly depend not only on the fluctuations of the individual components of money demand, but also on the degree of correlation of these components with one another. Therefore, these components can significantly determine the dynamics and the stability of money demand.
Our case study focuses on the Nigerian economy, which enjoyed huge economic benefits from the oil boom of the 1970s but suffered various political coups in the 1980s. Since the effort to stabilize in a democratic dispensation, various economic programmes have been designed and implemented by successive administrations and have made significant impact on the range of existing economic relationships that determine the demand for real money balances by the average Nigerian. In this study, we draw attention to the influence of wealth on money demand in Nigerian, an area which has been scarcely investigated empirically by researchers.
1.2: Statement of Research Problem
Our case study focuses on the Nigerian economy, which enjoyed huge economic benefits from the oil boom of since the 1970s but suffered various political crises due to political instability and economic distortions through to the late 90’s and early 2000. Since the effort to stabilize in a democratic dispensation, various economic programmes have been designed and implemented by successive administrations and have made significant impact on the range of existing economic relationships that determine the demand for real money balances by the average Nigerian. In this study, we draw attention to the influence of wealth on money demand in Nigerian, an area which has been scarcely investigated empirically by researchers.
Furthermore, the recent economic recession in Nigeria, especially as it affects commodity prices, has trickle-down effects on the economy, this is capable of causing money demand function in Nigeria to be unstable with adverse effects on the potency of monetary policy in Nigeria.
Economists from previous empirical studies argued on the most appropriate choice of moneyness for Central Bank Nigeria intermediate monetary target, M1 or M2. Some believed that function of the narrow money, M1 is more stable and more appropriate than the broad money, M2. However, In Friedman’s analysis, broad money function is a better choice for money demand analysis. The Central Bank of Nigeria Now use M2 as an intermediate monetary policy target, yet, some economists question the stability of M2, hence, questioned the justification for its choice by CBN. But this study looks at factors affecting demand for real cash balances and provides empirical evidence on real money demand in Nigeria.
1.3: Aim and Objectives of the Study
The aim of this study is to test empirically if demand for real money balances function in Nigerian economy is consistent with the Milton Friedman’s theory of demand for real money balances for any economy. The study examines the role of real income, bonds, equity, stock, interest rates, inflation and past level of real money demand in the money demand function as the appropriate measure of opportunity cost of holding money.
This study also aims to achieve the following general objectives;
1. Measure the long run effects of the determinants of money demand on real cash balances; while observing the significance and degree of impact of wealth on money demand,
2. Empirically investigate the causal effect of wealth on real money demand.
3. Investigate the relationship on the stability of real money demand function and its implications for the conduct and implementation of monetary policy.
1.4: Research Questions
1. What is the usefulness of Milton Friedman’s Quantity Theory of Money on the real money demand function in the Nigerian Economy?
2. Are they relationships among the variables in Friedman’s Quantity theory and the demand for money in Nigeria? What is the effect of wealth in the demand for money function in Nigeria?
3. How does the demand for money functions, affect monetary policy?
1.5: Statement of Hypotheses
This study is a test of the validity of Milton Friedman’s Restatement of the Quantity Theory of Money, using Nigeria data. Ultimately, this study tests;
Ho: Null Hypothesis: Friedman’s Quantity Theory of Money components which include; (income, wealth, returns on other assets and inflation) are not relevant in explaining the money demand function in Nigeria.
H1: Alternative Hypothesis: Friedman’s Quantity Theory of Money components are relevant in explaining money demand function in Nigeria.
Consequently, the study considered the hypotheses for each of the variables determining the trend of Money demand as postulated by Friedman (1956).
Ho: Null Hypothesis: Variations in each explanatory variable, especially wealth is statistically insignificant in defining the money demand stability in Nigeria.
H1: Alternative Hypothesis: Variations in each explanatory variable is statistically significant in defining the money demand stability in Nigeria.
Ho: Null Hypothesis: Demand for money functions do not affect monetary policy
Hi: Alternative Hypothesis: Demand for money functions do affect monetary policy
All tests were conducted at 5% level of statistical significance, i.e. 95% confidence level, to infer the rejection or acceptance of the null hypothesis.
1.6: Significance of Study
The recent economic recession in Nigeria, especially as it affects commodity prices, has trickle-down effects on the economy, and having much stronger effects on consumable goods and the financial system. The Central Bank of Nigeria is faced with the challenge of achieving a strong and stable financial system and to ensure the consolidation of financial institutions in Nigeria. Furthermore, it is imperative to adopt an effective monetary policy, which will follow a smooth transmission to target key macroeconomic variables, to bring about stability in the economy.
The justification for this study stems from the fact that despite the avalanche of literature on the money demand function in Nigeria, very few studies have focused on the impact of wealth in the demand for money function. The other short coming in earlier studies on this subject matter is in part related to methodology. Most of the studies adopted the traditional Ordinary Least Squares (OLS) method of analysis. This study fills that gap by estimating a money demand function for Nigeria and by assessing the relationship between real money demand (RM2) and its determinants in accordance with Milton Friedman’s demand for money theory, using the Autoregressive Distributed Lag (ARDL).
This study also provides a guide for policy formulation and implementation on how the money demand function plays a vital role in influencing macroeconomic aggregates, especially with regard to the formation and transmission mechanism of monetary policy. Consequently, this study provides explanation through empirical estimation of money demand functions, concentrating on Friedman’s theory of explaining demand function.
1.7: Scope and Limitations of Study
This study test for the validity of Milton Friedman’s Quantity Theory of Money, using Nigeria data between real money balances (demand for money), using the Milton Friedman’s money demand function and real income, bonds, equities, stocks, interest rates, and inflation rate in Nigeria. The study used annual time series spanning 49 years, a sample period from 1970-2016. The study will therefore, not focus much attention on other attempts to explain or define factors that determine money demand stability in any economy.
1.8: Organisation of Study
The study is divided into five chapters; the first chapter gives a background and scope of the study, stating the significance and objectives of the study. The second chapter looks into various concepts and review of existing and related literature on the topic, while the third chapter presents the theoretical framework and methodology and outlines the model specification. The fourth chapter explains the analytical and estimation technique and discusses the empirical results of the study and the fifth chapter presents the summary, recommendations and conclusion of the study..