Optimal Monetary Policy Instrument in Setting Monetary Policy Reaction Function in Nigeria

International Journal of Research and Innovation in Social Science (IJRISS) | Volume II, Issue XI, November 2018 | ISSN 2454–6186

Optimal Monetary Policy Instrument in Setting Monetary Policy Reaction Function in Nigeria

Ibrahim Umar Bambale#, Abubakar Isah Funtua*

^#Department of Economic, Ahmadu Bello University, Zaria, Nigeria
^*Department of Economics & Development Studies, Federal University, Dutsin-Ma, Nigeria

Abstract: This paper sets out to ascertain the performance of alternative monetary policy instruments in setting monetary policy reaction function in Nigeria and, in the process identify whether setting monetary policy reaction function using the interest rate as the policy instrument is superior to setting monetary policy reaction function using the money growth rate as the policy instrument in Nigeria. To achieve this objective, the performance of the alternative specifications in setting monetary policy reaction function is considered following three types of shocks the economy is historically susceptible to for comparative purpose. This is done using a calibrated small open-economy New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model of the Nigerian Economy. Within this framework, the alternative specifications are ranked based on the results of social welfare loss. The study shows that 1.3279 is the minimum welfare loss result of setting monetary policy reaction function using the interest rate as the policy instrument, compared with 1.02 minimum welfare loss result of setting monetary policy reaction function using the money growth rate as the policy instrument. The paper concludes that using the money growth rate option is welfare superior to using the interest rate option in Nigeria. Therefore, the result suggests that Central Bank of Nigeria (CBN) should consider using money growth rate in setting monetary policy reaction function, which is consistent with anti-inflationary policies.

Keywords: Monetary policy instruments, Welfare Loss, Small open economy, DSGE

I. INTRODUCTION

For over a decade the central bank of Nigeria transited to indirect instruments in the conduct of monetary policy (2). The principal instrument used by the CBN in setting monetary policy reaction function is the Monetary Policy Rate (interest rate)(1, 3) The Monetary Policy Rate (MPR) serves as the nominal anchor that aimed at influencing the short-term overnight interest rates in the money market.
When assessing the ability of monetary policy framework to hit the announced targeted inflation rate consistently and in the process aid in reducing the output gap, then it becomes important to identify the right policy instrument to be used in setting the monetary policy reaction function (2).

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