A PREDICTIVE MODEL FOR INFLATION IN NIGERIA
1.1 Background of the Study
An economy is regarded as suffering from inflation if it is experiencing a period of continuous rising prices resulting in loss of monetary purchasing power. Consequently, inflation has been defined as a persistent or continuous rise in the general price level or, alternatively, as a persistent or continuous fall in the value of money. When the price level increases, each unit of currency buys fewer goods and services; consequently, inflation is also the erosion in the purchasing power of money, a loss of real value in the internal medium of exchange and unit of account in the economy. In an inflationary economy, it is difficult for the national currency to act as a the medium of exchange and a store of value without having an adverse effect on income distribution, output, and employment.
There is widespread agreement that high and volatile inflation can be damaging both to individual businesses as well as to consumers, hence, to the economy as a whole. Persistent inflation in goods and services can result in high social costs, too. In Nigeria, major afflictions that have persisted in the economy are inflationary trends and devaluation in the value of the naira. The problem of inflation has been with us for some time now and indeed, the rate of inflation in Nigeria has worsened.
Maintaining price stability while ensuring an adequate expansion of credit to assist economic growth have been the primary goals of monetary policy in Nigeria. The concern about inflation emanates not only from the need to maintain overall macroeconomic stability but also from the fact that inflation hits the poor particularly hard as they do not possess effective inflation hedges.
Low and stable inflation, high economic growth, and low employment rate are the three most important objectives of macroeconomic policy. Hence, governments put a significant amount of effort into monitoring and addressing trends and deviations of gross domestic product (GDP), employment and inflation compared to what is perceived to be full-capacity level. In this context, the primary goal of macroeconomic policymakers in Nigeria is achieved a sustainable, low, and predictable level of inflation. It is considered that this goal contributes towards the broader national objectives of sustainable economic growth and development. When the general level of prices is relatively stable, uncertainties of time-related activities such as investment diminish. This helps to promote full employment and strong economic growth. When price stability is achieved and maintained, monetary policymakers have done their job well (Sobel, Stroup, Macpherson, and Gwartney, 2006). Conceivably, one of the most important responsibilities of every government is fostering a healthy economy, which benefits all its citizens. The government through its ability to tax, spend and control the money supply, attempts to promote full employment, price stability, and economic growth.
According to modern central banking practices, maintaining economic stability has become one of the core objectives of Central Bank of Nigeria as in many other developing countries. The concern with maintaining price stability stems not only from the need to maintain overall macroeconomic stability, but also from the fact that price stability forms a better environment for investment, output, employment, and other vital macroeconomic indicators. Experiences of many countries over the decades, suggest that price stability promotes economic growth. Therefore, policymakers believe when inflation crosses a reasonable threshold in the economy, that it can adversely affect other macroeconomic variables and in turn undermine the steady level of the economy.
The importance of price stability is also stressed in the Maastrict agreement, which defined the framework for a single European currency, the Euro, and identified price stability as the main objective of the new European Central Bank (McEachern, 2006). When inflation is volatile from year to year, it becomes difficult for individuals and businesses to correctly predict the rate of inflation in the near future. When economic agents are able to make accurate predictions of inflation, they can anticipate what is likely to happen and take steps to protect themselves. Therefore, identifying factors that influence and drive inflation and predicting these factors accurately becomes vital for economic agents. Accurate prediction of inflation could also enable macroeconomic policymakers to conduct monetary policy effectively and efficiently to achieve the objective of price stability.
They are many measures of inflation because they are many price indices relating to different sections of the economy. Two widely known indices for which inflation rates are reported in many countries are the Consumer Price Index (CPI), which measures the rate of change in the prices of goods and services bought by consumers, and the GDP deflator, which measures prices of locally-produced goods and services. In Nigeria, raw inflation figures are reported monthly using the CPI by the National Bureau of Statistics (NBS). The CPI is an estimation of price changes for a typical basket of goods. In other words, the prices of everyday goods such as housing, food, education, clothing, and so forth, are computed from one month to the next and the difference represents the CPI. The strength of the CPI compared to other measures of inflation lies in the fact that: It is simple to compute; it has large population coverage; it includes many products and services and it is the most commonly used measure of inflation in Nigeria. Hence, the CPI is used in this study to proxy the inflation rate.
1.2 Statement of Research Problem
Inflation is viewed as being undesirable because of some serious economic and social effects. Regrettably, in Nigeria, we are now reaching levels of inflation that seem to be highly volatile and which poses a much greater threat to the economy. Despite efforts by the government to curb the inflationary trend in Nigeria, inflation continues to cause serious distortion in real income redistribution, impact negatively on the growth rate of the living standard of most Nigerians, especially fixed income earners, for example, pensioners and beneficiaries, whose incomes are usually not adjusted upwards fast enough to compensate for the effect of continually rising prices. Producers are confronted with higher unit costs of production, low capacity utilization, and outright shop closure. The high cost of production has reduced output which affects the unit cost. Consumers bear the burden of higher prices which diminishes the value of their disposable income. The workers tend to demand higher wages even without a corresponding increase in the marginal productivity of labor. The average propensity to save and invest is continuously on the decline thereby stagnating economic growth.
Nigeria has a long history of high and variable inflation. According to Folorunso and Abiola (2000), a general increase in the price level was first noticed in the 1970s. This was propelled by fiscal dominance and severe macroeconomic imbalances brought about by a sharp increase in government revenue from crude oil exports. The government injected massive public expenditure into the economy through the enormous post-war reconstruction of the early 1970s and expenditure on gigantic capital projects embarked upon by all governments under the Third National Development Plan. This increased the entire currency in circulation with the financial sector having to contend with a serious liquidity crisis due to deposit runs. During the sample period (1995-2015), inflation reached an all-time high of 73% in 1995 easing off to 17.9% in 2005. The inflation rate further declined to its historical low of 5.3% in 2007. However, from 2008, signs of appreciation in the inflation rate became obvious averaging 9.7% in 2015 (see Table 1.1) Insert Table.
Inflation in Nigeria has been linked to rapid growth in the money supply caused mostly by large deficit budgeting by the federal government over the years. These deficits are financed by printing money through the Ways and Means Advances of the Central Bank of Nigeria (Folorunso et al, 2000). During the period under review, 1995-2015, money supply, broadly defined, has been on the increase. Money supply (M2)was N291.5 billion (1995), N2,767.9 billion (2005) N11,154.8 billion (2010), and N19,142.5 billion in 2015 (see table 1.1).
In an attempt to identify the determinants of inflation in Nigeria, money growth, income, and exchange rate movements have remained the focal issues. Indeed, most studies have concluded that excess domestic demand, generated by expansionary fiscal and monetary policies have been the key factors underlying inflation in Nigeria (Akinnifesi, 1984; Darat, 1985 and Ikhide, 1993). Others have tended to stress structural factors such as rapid exchange rate depreciation, agricultural supply bottlenecks, fragmentation between supply and demand in and between different sectors of the economy and inadequate food supply (Adeyeye and Fakiyesi, 1980; Asogu, 1991; Aigbokhan, 1991).
The question that agitates the mind after considering issues raised in this section concern factors that determine inflation in Nigeria. Relatedly, is there an economically interpretable and the statistically valid functional relationship between the inflation rate and its suspected causative factors in the Nigerian economy? It is hoped that this the research will yield a theoretically plausible and statistically robust model which could be used in predicting inflation rates in Nigeria. This it is believed will aid sound macroeconomic policy formulation and implementation in order to achieve the objective of price stability.
Table 1.1: Inflation Rate and some other macroeconomic indicators in Nigeria (1995-2015)
Money Supply (Nm)
Official Exchange Rate (N1)