DETERMINANTS OF INFLATION DYNAMICS IN NIGERIA 1995 – 2018

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TABLE OF CONTENTS

TITLE PAGE……………………………………………………………………………………………. ii

DECLARATION……………………………………………………………………………………….. iii

CERTIFICATION……………………………………………………………………………………… iv

DEDICATION……………………………………………………………………………………………. v

ACKNOWLEDGEMENT…………………………………………………………………………… vi

TABLE OF CONTENTS……………………………………………………………………………… vii

LIST OF TABLES………………………………………………………………………………………. x

LIST OF FIGURES…………………………………………………………………………………….. xi

ABSTRACT……………………………………………………………………………………………… xii

CHAPTER ONE: INTRODUCTION

CHAPTER TWO: LITERATURE REVIEW AND THEORETICAL FRAMEWORK

CHAPTER THREE: THEORETICAL FRAMEWORK AND METHODOLOGY

  1. Introduction……………………………………………………………………………………………….. 30
    1. Theoretical Framework………………………………………………………………………………… 30
    1. Model specification…………………………………………………………………………………….. 31
    1. Estimation Technique and Procedure……………………………………………………………… 34
    1. Data source and description………………………………………………………………………….. 34
    1. A Priori Expectation…………………………………………………………………………………….. 34
      1. The preliminary analysis of the data…………………………………………. 36

CHAPTER FOUR: Empirical Analysis/Presentation and Interpretation of Results

  1. Introduction……………………………………………………………………………………………….. 37
    1. Graphical illustration of the behaviors of the series and the unit root test…………….. 37
    1. Empirical results for Headline Inflation( Model 1)…………………………………………… 41
      1. Optimal Lag order and Bounds test coinigration result for model I 41
      1. The long and short run dynamics of headline inflation……………… 42
      1. Post estimation test for Headline inflation…………………………….. 45
    1. Emperical Results for Core Inflation (Model 2)……………………………………… 46
      1. Optimal Lag order and Bounds test coinigration result for model II 46
      1. The long and short run dynamics of Core inflation…………………. 47
      1. Post estimation test for Core inflation…………………………………… 49
    1. Empirical Results for Food Inflation (Model 3)………………………………………. 51
      1. Optimal Lag order and Bounds test coinigration result for model III 51
      1. The long and short run dynamics of Food inflation………………… 52
      1. Post estimation test for Food inflation………………………………….. 54

CHAPTER FIVE: SUMMARY, CONCLUSION AND POLICY RECOMMENDATION

  1. Introduction……………………………………………………………………………………… 57
    1. Summary of empirical Results…………………………………………………………….. 57
    1. Conclusion………………………………………………………………………………………. 57
    1. Policy recommendations……………………………………………………………………. 57
    1. Limitation of the study……………………………………………………………………….. 58

REFERENCE…………………………………………………………………………………………………. 59

APPENDIX……………………………………………………………………………………………………. 62

LIST OF TABLES

Table 1: A‟ Priori Expectations ………………………………………………………………………. 35

Table 2: Descriptive statistics…………………………………………………………………………. 36

Table 3a: Summary of the Unit Root Tests………………………………………………………. 39

Table 3b: Summary of Unit Root Results………………………………………………………… 40

Table 4a: Optimal Lag Length for variables in Model 1……………………………………. 41

Table 4b: Bounds Test Results for Cointegration for Model 1…………………………… 41

Table 5: ARDL Long run Estimation Results for Headline Inflation…………………… 42

Table 6: ARDL Long run Estimation Results for Headline Inflation…………………… 43

Table 7: Breusch-Godfrey Serial Correlation LM Test……………………………………… 46

Table 8: Breusch-Pagan-Godfrey Heteroskedasticity Test………………………………… 46

Table 9a: Optimal Lag Length for variables in Model 2……………………………………. 46

Table 9b: Bounds Test Results for Cointegration for Model 2…………………………… 47

Table 10: ARDL Long run Estimation Results for Core Inflation……………………….. 48

Table 11: ARDL Long run Estimation Results for Core Inflation……………………….. 49

Table 12: Breusch-Godfrey Serial Correlation LM Test……………………………………. 50

Table 13: Breusch-Pagan-Godfrey Heteroskedasticity Test……………………………… 51

Table 14a: Optimal Lag Length for variables in Model 3………………………………….. 51

Table 14b: Bounds Test Results for Cointegration for Model 2…………………………. 52

Table 15: ARDL Long run Estimation Results for Food Inflation……………………….. 52

Table 16: ARDL Long run Estimation Results for Headline Inflation………………….. 54

Table 17: Breusch-Godfrey Serial Correlation LM Test………………………………………. 55

Table 18: Breusch-Pagan-Godfrey Heteroskedasticity Test………………………………… 56

LIST OF FIGURES

Figure 1: Illustration of Keynesian theory of demand pull inflation………………………… 9

Figure 2: The demand pull theory of inflation…………………………………………………….. 10

Figure 3: Diagram depicting cost push inflation…………………………………………………… 12

Figure 4: Food Inflation 3-year monthly average trend in Nigeria…………………………… 22

Figure 5: core inflation 3-year monthly average trend in Nigeria…………………………….. 23

Figure 6: headline inflation 3-year monthly average  trend in Nigeria…………………….. 24

Figure 7: Trend of financial Deepening in Nigeria……………………………………………….. 24

Figure 8: Money supply 3-year average monthly trend in Nigeria…………………………… 25

Figure 9: Real GDP 3-year monthly average trend in Nigeria………………………………… 26

Figure 10: Interest rate 3-year monthly average trend in Nigeria……………………………… 26

Figure 11: GDP Per capita 3-year monthly average trend in Nigeria………………………… 27

Figure 12: Oil price 3-year monthly average trend in Nigeria………………………………….. 28

Figure 13a.Monthly Trends of Headline, Core, Food Inflation, and Fiscal deficit in Nigeria (1995M01- 2018M12)……………………………………………………………………………………………………… 37

Figure 13b.Monthly Trends of Real GDP, Agricultural output, Food importation, Oil price, Money supply, and Official Effective Exchange Rate in Nigeria (1995M01-2018M12)……………….. 38

Figure 14: CUSUMQ test for Headline Inflation Model in Nigeria (1995M01-2018M12).45 Figure 15: CUSUMQ test for Core Inflation Model in Nigeria (1995M01-2018M12)……………. 50

Figure 16: CUSUMQ test for Food Inflation Model in Nigeria (1995M01-2018M12)            55

Abstract

This study examines empirical determinants of inflation dynamics in Nigeria between 1995 and 2018 fiscal years. It employed monthly data that were sourced from the Central bank of Nigerian Statistical Bulletin, 2018 edition. Several studies have examined inflation determinants in Nigeria for several periods, but the empirical findings of some of these studies are mixed in terms of the different forms of inflation. Headline inflation, which is the most, reported inflation in Newspapers often include all forms of commodities prices, hence it tends to be overblown. Thus, the volatile commodity prices such s energy which are more volatile need to be separated. Thus, this study accounted for headline, core, and food inflation Nigeria for this period. After testing for the time series properties of the variables, the study found that they were fractionally integrated [order zero (I (0) and I (1)]. Therefore an Autoregressive Distributed lag model (ARDL) specification of Pesaran and Shin (2011) was utilized for the analysis. The study found that exchange rate and real GDP were consistent determinants of all the three forms of inflation. For the short run estimated results across the entire three models, money supply was noted to be a significant determinant of inflation rates. The study therefore recommends that since Nigeria is an import dependent country in consumer goods and technology, instability in exchange rate will lead to further depreciation of naira which will fuel inflation, and that a stable exchange rate policy to reduce inflation, concerted efforts to be directed toward output stabilization through minimizing government expenditure and investment in productive sectors are necessary.

CHAPTER ONE

INTRODUCTION

      Preamble

The struggle to achieve price stability is one of the major macroeconomic challenges that the Nigerian government has always been plagued with. This problem is what we refer to as inflation. Inflation is defined as a continuous, persistent and appreciable rise in the general price level of goods and services without a corresponding increase in output. By definition, inflation is a persistent and appreciable rise in the general level of prices (Jhingan, 2002).This also points out to the fact that not every rise in price is inflation, the main characteristic of inflation is that it is persistent and affects almost every commodity. Thus, inflation is generally seen as a continuing rise in prices as measured by an index such as the Consumer Price Index (CPI) or by the implicit price deflator for Gross National Product.

There are various methods which can be used in measuring inflation the most widely used is the Consumer Price Index(CPI) which measures the changes in the prices of consumer goods and services purchased by household over a period of time. It is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. Inflation is also measured with the aid of the wholesale price index (WPI) which is a price index that is used to estimate the average change in price of goods in the wholesale market. Another method is through the GNP deflator which is a measure of the price levels of all final goods and services produced in a particular economy within a specified period of time.

Inflation is also characterized by a rise in exchange rate when compared to the currency of other countries. Nigeria has experienced this devaluation of money in past years as the exchange rate of the naira has continuously increased comparatively with comparison to the dollar. In 1981  the exchange rate was N1 to $1. By 1995 it had increased toN25 to $1, this increase slowly escalated to N101 to $1 in 2000 and by 2014 it had reached a staggering amount of N158 to $1.

The trends of inflation rates in Nigeria reflect the monetization of oil revenue which has led to an increase in money supply. Since the early 1970s, inflation rates in Nigeria have been extremely unstable with the high inflationary change in excess of 30 percent. This is evident from the high correlation between money supply growth and high inflations due to the fact that the real economic growth is less in terms of money growth. Sokpo et al. (2017) discussed four

expected negative effects of inflation as outlined by Mankiw (2010). First is the distortion of the inflation tax on the amount of money people hold. In this case an increase in inflation rates results is an increase in the nominal interest rates which in turn causes real money balances to fall. Because individuals now hold lower money balances on average, they would need to make frequent trips to the bank in order to withdraw money which would be a form of inconvenience on the individual.

Secondly, it is conceived that the cost of changing money (inflation) is the menu cost whereby higher inflation causes firms to frequently change their prices as they incur these costs. Thirdly, there is possibility of unfair tax treatments because some taxes are not adjusted to account for inflation, such as the capital gains tax. Lastly, there is relative price distortions that firms facing menu cost are plagued with. Different firms change their prices at different times, leading to relative price distortions that usually cause microeconomic inefficiencies in the allocation of resources.

It has been observed that inflation can have positive effects on an economy when it ranges from 3 to 6 per cent (Anfofum et al, 2015). In case, such mild inflation brings about a boost in investment and production which subsequently leads to a growth in wages and consumption. However if the rate of inflation is in the double digit range, it poses a threat as it has negative effects on the economy. This high inflation rate affects the purchasing power of the economies currency, which would then result in uncertainty in value of loss and gains, borrowers and lenders, buyers and sellers (Abdul et al, 2007). In addition high levels of inflation create a level of doubt in individuals which dampens their willingness towards savings and investments. High inflation decreases the real rate of returns on financial assets which is what leads to a decline in savings, and as a result of this decline in savings, investment rate also reduces leading to a decline in economic growth. These dynamic effects of high inflation rate deteriorate the gains from growth thereby leaving the poor worse off causing an upsurge in the income gap between the rich and the poor, even though high inflation rate affects both the rich and the poor.

While it is acknowledged that high inflation distorts the rate of economic development, the poor in developing countries suffer the most, especially when it comes to food inflation. It has been noted that the poor who are low income earners that spend at least 75% of the income they possess on food items.

In macroeconomics, efforts at reducing or achieving price stability are one of the goals of developing and developed economies. Incessant rise in food prices which is generally termed as food inflation has been the trend in Nigeria over the years now. This study therefore examines the determinants of both food and core inflation.

  • BACKGROUND TO THE STUDY

Nigeria is often referred to as the giant of Africa, a nation richly blessed with numerous natural resources, however the problem of inflation in Nigeria is one that can be traced back to the discovery of oil in Nigeria in the late 1950‟s. Since then Nigeria has moved from agriculture being the main sector of the economy to oil exploration. The Nigerian economy has also become fully dependent on oil as its main source of revenue and because of this overdependence on the oil sector it has in turn made other sectors such as education, transportation, agriculture telecommunication to depend on the oil sector.

There are four remarkable episodes of inflation in Nigeria. The first observed period of inflationary increase in Nigeria was from 1974 to 1976 where inflation increased by 30 per cent. The reason for this include political instability, a drought in the northern part of Nigeria which resulted in high cost of agricultural produce, increased monetization of oil revenue.

The second episode of rising inflation was between 1983 and 1985.This time, the inflation rate increased to 40 per cent. This period experienced very minimal economic growth because the Nigerian government debt had increased above 70 per cent while the excess was around 41 to

43 per cent and the government was under intense pressure from debtors to accept the International Monetary Fund (IMF) conditionality‟s to devalue the domestic currency.

The third period lasted from 1987 to 1989. During this time the inflation rate was a little over 35 per cent, there was a noticeable fiscal expansion in the budget of 1988 which put high inflationary pressure on the economy. Also during this period, there was a drastic contraction in monetary policy as well as the debt for equity swap conversion method adopted by the Nigerian government both of which also accounted for the inflationary change in this period. The fourth period is set from 1987 to 2000. The inflation during this period was caused by deficit expansion which resulted in a70 per cent increase in the money supply which affected domestic credit to the private sector of the economy (CBN, 2006).

Similarly, the National Bureau of Statistics, (NBS, 2018) recently revealed that food inflation has tremendously increased monthly. According to NBS, food inflation increased from 13.16% to 13.31% in august, 2018. This was as a result of rises in prices of food items such as potatoes, milk, bread, cereal, fish, yams, vegetables, fruits, and meat. Other rises in price include basic human needs like education price which rose from 9.83% to 9.92% in September, 2018 and health which increased marginally from 9.64% to 9.65%. In the service industry, prices of services rendered in eateries and hotels increased from 9.38% in august to 9.39% in September. Cost of communication also increased from 6.32% to 6.79%.

Further reports show that the annual urban inflation increased from 11.67% in august 2018 to 11.7% during the month of September 2018, while the rural inflation rate increased from 10.84% in august 2018 to 10.92 in September 2018. The highest increases however were accounted for in the cost of fuels and lubricants, vehicle spare parts, tobacco, furniture, hospital services, carpets, dental services and other floor coverings (NBS, 2018). To contribute to knowledge therefore, this study seeks to examine the trends and determinants of inflation in view of recent data.

  • STATEMENT OF THE PROBLEM

It has become evident and ultimately pressing within the past years that the growth dynamics of output in Nigeria has not been inclusive. It is characterized with diverse problems. After the collapse of the oil boom, the nigerian currency(naira) was continiously overvalued which resulted in major economic changes in the production and consumption pattern as the economy was highly dependent on import which ultimately led to a significant deficit in the balance of payment and as a result loans were taken to help finance these deficits. A good example is the Paris Club loan which was ($5.39billion) in 1983 and rose to ($21.6billion) in 1999 (CBN 2001). The World Poverty Clock (2018) revealed that Nigeria has overtaken India as a country where the most extreme poor people live in the world. According to this report, 86.9 million Nigerians were living in extreme poverty and that with the pace of increasing population; Nigeria was projected to be the world‟s third largest poor country by 2050.

The probability that at least half the population of the country would beat the threshold of extreme poverty as anticipated by the United Nations by 2030 seems to be getting narrowed daily with raising inflation rate. Although inflation is relative in nature, but is pathetic to note that within a short span of time between July 2018 and September 2018, core inflation has risen

from 11.23% to 11.28%, all in the space of two months. This brought to an end the eighteen uninterrupted months of inflation decline recorded from about 17.78% in February 2017 to 11.14% in august 2018 (CBN, 2018).

Again, valid empirical evidences that will support appropriate policy for reducing inflation in Nigeria have been emphasized in several researches; however, some of the studies on the determinants of inflation in the context of Nigeria did not comprehensively address the nature of inflation in total. Thus, there seems to be a vague knowledge on the determinants of all forms of inflation. Also, the theory is not cleared about major determinants of inflation generally. Therefore, this study seeks to address empirical questions on inflation predicting parameters in Nigeria. Some of these questions are outlined in section 1.3.

  • RESEARCH QUESTIONS

The questions of this research aim at finding an appropriate way to analyze the problem of inflation in Nigeria, conduct a full study into the determinants, and understand why. The study proposes the following questions.

  • Are monetary policy variables such as money supply, interest rate significant in predicting inflation in Nigeria?
  • How significant is fiscal deficit in determining inflation trend in Nigeria?
  • Do oil price affect inflation in Nigeria?
  • Is the output level in the country (GDP) propels increased inflation trend in Nigeria? This study beams its searchlight in the direction of addressing these questions empirically in Nigeria to be able to draw out their relevance policy implications for Nigeria.
    • OBJECTIVES OF THE STUDY

The major objective of this study is to analyze the determinants of the dynamics of inflation in Nigeria. Specifically, the study will:

  1. Examine the trend of inflation in Nigeria
    1. Estimate the impact of monetary policy variables on the behaviour of inflation in Nigeria
    1. Estimate the impact of fiscal deficit on inflation in Nigeria
    1. Examine the relationship between oil price and inflation in Nigeria
    1. Analyse the impact of real output (real GDP) on inflation in Nigeria.

              JUSTIFICATION FOR THE STUDY

The incessant upsurge in the rate of inflation in Nigeria like any other developing countries in the world has prompted various research studies to examine the determinants of inflation. In fact, the literature has evidences of empirical evidences of various factors that determine inflation. However, there are inconclusive findings on what determines inflation in Nigeria. For instance, Fakiyesi (1996), Egwaikhide et al (1994), Ajayi (1988), Okoye, Modebe, et al (2016), and Iya and Aminu (2014) among other examine effects of monetary expansion, exchange rate, trade openness, output growth, and interest rate on inflation in Nigeria respectively. The major area of contribution to knowledge in this study is that it accounts for all forms of inflation such as headline, core inflation, and food inflation. In addition, Nigerian economy is a net oil exporter, and so, it would be evidence that oil price will play a significant role in shaping the dynamics of inflation Nigeria, but there is little or no existing study that have accounted for oil price alongside with other macroeconomic variables in determining inflation predictors in Nigeria. This study therefore fills these observed gaps in the literature.

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