comparative analysis between monetary and fiscal policies

CHAPTER ONE

INTRODUCTION

1.1 Overview

The existence of a set of policies that can alter a given state of an economy to a desired state is assumed in the theory of economic policy. Regulatory policies are therefore made, to affect economic behaviour in particular directions that the economic policy-maker may desire from time to time (Ndekwu 1999). Macroeconomic policy is basically classified into two broad categories namely: monetary and fiscal policies. The policy itself depends on economic theory which is based on several assumptions because we are in the world of uncertainty. Therefore, Nigeria is not exceptional because government had been performing a lot of roles in influencing her economic activities since the creation of the country in 1960. Both fiscal and monetary policy are formulated to achieve certain macroeconomic objectives such as full employment, price stability which is the same as low and stable inflation and balance of payments equilibrium.

However, some economists regarded monetary policy as all monetary decisions irrespective of whether their aims are monetary or not, and all non-monetary decisions and measures designed to control the value, supply and cost of money in an economy in consonance with the level of economic activities (Ubogu, 1985).

On the other hand, fiscal policy is a policy through which the government uses its expenditures and revenue programmes to produce effects and avoid undesirable effects on national income, production and employment. Its main variables are government taxes (source of revenue to the government), expenditures and borrowing (supplementary tool of fiscal policy) (Smithies, 1949).

Considering that fiscal and monetary policies have the same objectives and are designed within the same broad national economy policy framework the harmonization of both policies for effective economic management seems quite natural, logical and simple. However, experience in the past three decades has shown that the Nigerian economy has been mismanaged (Ojo 1995) particularly; the poor performance of monetary policy has been attributed to the lack of coordination with fiscal policy.

For several years, Nigeria has been making serious and conscious effort to achieve the acceptable macroeconomic goals such as high of economic growth, full employment, low and stable inflation rate and balance of payments equilibrium in order to achieve a rapid socio-economic development of the country. Economic literatures support the fact that the achievement of these policy objectives is basically restrained by (i) the activity of the economic structure (ii) the policy structures as well as built-in stabilizers (iii) the Transmission mechanisms of the policy; and the (iv) the policy response features of economic variables in a nation of interest (Polaoamina, 1986). Yet, the interplay of fiscal and monetary measure and interventions has become a notable mechanism which successive government always attempt to use in order to attain the specified macroeconomic goals and objectives. Both policies are generally evaluated by how successful they are in achieving these macroeconomic goals - full employment, stable price level, high output growth rates and balance of payment equilibrium. However, the comparative effect of monetary and fiscal policies on the level of economic activities has been the principal of much debate since the 1960s. Monetarists have advocated the use of monetary policy while fiscalists believed that fiscal policy was more efficacious.

These broad policy goals are achievable through the application of either policy or monetary policy or by simultaneous use of the two as mutually complementary economic policies. The fact that both monetary and fiscal action, individually and collectively influence the level of economic activity remains undisputed among economist. However, the degree of relative superiority of one of these policy measures over the other in affecting economic activity has been a bone of contention among economists and policymakers alike.

1.2 Statement of the Problem

Before Keynesian view, the classical economists accorded prominence to the relative superiority of monetary policy. However, the publication of pioneering work by John Maynard Keynes titled “General Theory of Employment, Interest and Money” in 1936 swept away the time-long faith in the supremacy of monetary over fiscal measure and this scenario marked the commencement of “Keynesian revolution’ with its emphasis on fiscalism. Owing to this, fiscal policy was considered as relatively more potent and reliable policy instruments for economic stabilization.

Later on, a strong reaction and opposition came from Milton Friedman and his colleagues who gave birth to the “Monetarist Counter Revolution”. The monetarist challenged the fiscalists to a scientific test to ascertain the comparative relevance of fiscal and monetary actions in the stabilization of an economy. In addition, Friedman supported his view by the following statement:

“Monetary policy is effective and fiscal policy is ineffective in controlling inflation; fiscal restraint, measured by full employment surplus or deficits for example can have little effect in reducing the rate of inflation unless it is accompanied by a reduction in the rate of monetary expansion”. Monetarists claimed that instead of having two instruments, i.e. monetary and fiscal policies to control the rate of price changes, only the monetary policy is efficacious.

However, many studies have been performed as a way of resolving the controversy; most of empirical and theoretical works were centered on the experiences of advanced nations. Little attention if any has been devoted to the economies of developing countries in which Nigeria includes. Therefore, the study is an attempt to fill or bridge the gap and evaluate scientifically the comparative strength and dependability of these two instruments.

1.3 Objectives of the Study

The overall objective of the study is to examine the relative effectiveness of monetary and fiscal policy in Nigeria and to suggest the means through which both policies will achieve the macroeconomic goals in the future. The specific ones are as follows:

 To carry out a comparative analysis between monetary and fiscal policies.

To suggest ways by which monetary and fiscal policies can be made more effective.

1.4 Methodology of the Study

Data used for the study are mainly secondary data. They are sourced from journals, textbooks and internet search.

Based on literature, establishment of the relative effectiveness of monetary and fiscal actions in influencing economic activity of any nation can be handled in two ways: first, their effects are measurable within the context of a well specified and statistically estimated structural model. The second method is the single equation or reduced form approach. This reduces the entire economic structure to a single equation that explains the way in which the exogenous variables determine the values of endogenous variables (GDP). On the basis of this, some measures of economic activity will be regressed on the measures of monetary and fiscal actions excluding the specification of the mechanism of transmission.

For the purpose of the study, the single equation or reduced form approach will be adopted by using Gross Domestic Product (GDP) as the measure of economic activity, and recurrent government expenditure to depict the measure of fiscal action due to lack of available data. However, fiscal action’s measures include government spending on goods and services, changes in government tax, government revenue, budget deficits and surpluses. Current government expenditures entail outlays of all the three tiers of government for compensation of employees, purchase of good and services from the sectors of economy, military equipment and other purchase from abroad.

On the other hand, the variable denoting monetary policy or action is the money stock widely defined as M2 which consists of currency held by non-bank public plus demand and time deposits.

1.5 Scope of the Study

The study is restricted to Nigerian data from period of 1980 to 2010 to run regression using the two policies as explanatory variables in model one and gross domestic product as a dependent variable in model two. Due to non-availability of data, 2010 is taken as the end year.

1.6 Plan of the Study

The study is structured into five chapters. Chapter one is the introduction. In chapter two, background to the study is examined in detail. Chapter three and four are the analytical framework and empirical analysis respectively. Chapter five consists of summary, conclusion, recommendations and limitations of the study.

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