Monetary Policy Transmission Mechanism in an Estimated Dynamic Stochastic
General Equilibrium (DSGE) for the Nigerian Economy
by
Adebiyi, Michael Adebayo, PhD
Central Bank of Nigeria, Nigeria
E-mail mikebiyi@yahoo.com or maadebiyi@cbn.gov..org
Tel: 234-0946235913 or 234-8073356300
&
Charles N.O. Mordi
Central Bank of Nigeria
E-mail cnomordi@cbn.gov.ng
Tel: 08037851373
Keywords: DSGE Model, Monetary Policy Transmission Mechanism, Nigeria
JEL Classification Numbers: E52, C22, C51
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EXTENDED INTRODUCTION
Substantial research work has been conducted in the area of monetary policy
transmission mechanism (MPTM) in many countries focusing on the empirical
analysis of how monetary policy shock affects output, prices, exchange rates, as
well as other key economic variables (Christiano, Eichenbaum, and Evans, 2000;
Kim and Roubini, 2000; Peersman and Smets, 2003; Saxegaard, 2006; Ceng,
2006; Chmielewski, 2005; Al-Mashat and Billmeier, 2007; Agha et. al., 2005; Mayes
2004 and Goeltom, 2008; Taylor, 1995; Mohanty and Turner, 2008 and Bernanke
and Gertler, 1995).
Using different methodologies covering different periods, the summary of the
findings is as follows: first, that excess liquidity in the sub-Saharan African
weakens the MPTM and thus hinder the ability of monetary authorities to
influence demand conditions in the economy; second, that low inflation is
associated with higher openness in the South African economy; third, that an
exogenous increase in the short-term interest rate tends to be followed by a
decline in prices and appreciation in the nominal exchange rate in Kenya, but
has insignificant impact on output; fourth, that banks tend to reduce credit
supply after a monetary tightening
and less capitalised banks are more
vulnerable to react to a monetary tightening in Poland; fifth, that the exchange
rate channel continues to play an important role in the transmission of the
monetary policy in Egypt; sixth, that the role of bank lending is prominent
because of the dominance of the banking sector; seventh, that firms’ balance
sheet variables are very important determinants of the firms’ investment in
Indonesia and that small firms are more sensitive to balance sheet changes than
large firms; eighth, that expected inflation is determined predominantly by the
exchange rate, past inflation, and the interest rate in Indonesia; and lastly, that
interest rate channel plays a dominant role in the transmission process in a
developed financial system.
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In Nigeria, past studies on the channels of MPTM included, among others, Oke
(1995), Uchendu (1994), Ojo (2000), Adebiyi (2006) and CBN (2008). The main
empirical results of these papers are that (i) the interest rate channel of
monetary policy appears to be weak in Nigeria; (ii) the credit and exchange
rate channels are very pronounced; (iii) expectation channel plays a very
limited role in transmitting monetary shocks to the economy; and (iv) the
dominance of the channels of MPTM is influenced by regime shifts and structural
breaks in Nigeria.
Thus, the identification of the dominance of the channels of MPTM, which is
critical to the proper design, management, and implementation of monetary
policy, has not been clearly addressed in the Nigerian financial system. Until
recently, the monetary authority in Nigeria was confronted with the enormous
challenges of conducting monetary policy in the face of unclear directions and
speed. Identifying the channels of transmission of monetary policy is important
because they determine the most effective set of policy instruments, the timing
of policy changes, and hence the main challenges that central banks face in
decision making. Since there are lags in the transmission mechanism (i.e.
between monetary policy initiatives and their impact), the chain of events
emanating from a change in central bank policy rate or base money needs to
be studied and analyzed.
The knowledge of these intricate links between
economic variables will ensure that correct policy measures are taken to
produce specific outcomes in the future.
The focus of this study is to empirically investigate the monetary policy
transmission mechanism in Nigeria using DSGE model. Specifically, the paper
intends to examine credit rate, interest and exchange rates channels of
monetary policy transmission with the objective of exploring their strengths,
speed of transmission and ultimately determining the more dominant channel.
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The paper also attempts to forecast output and price based on the baseline
model developed. The outcome of the study is expected to guide policy
choices for a more effective monetary management.
The rest of the paper will be structured as follows. Section 2 will briefly describe
the appraisal of monetary policy in Nigeria, while Section 3 will discuss basic
structure of DSGE models. Section 4 will focus on the microfoundation of a DSGE
model. Section 5 will present the methodology, covering model set-up,
description and calibrations, while section 6 will provide the results and
interpretations. Section 7 will give the summary, conclude and provide policy
implications.
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