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CHAPTER ONE

INTRODUCTION

1.1   BACKGROUND OF STUDY

Money demand is certainly one of the most researched fields in economics. Literally thousands of articles have been published over the last decades that contain empirical money demand estimations for numerous countries and time periods. However, despite these considerable efforts the results of this huge literature are quite diverse. The range of the estimated income and interest-rate elasticity is wide and while some papers maintain that Money demand is stable others come to a converse conclusion. This study is however aimed at testing the validity of Milton Friedman’s Quantity Theory of Money, using Nigeria data in the determination of Money demand stability in Nigeria.

Unlike the demand for goods, Money demand is not restricted to one market but also involves other markets (Money Market, Capital Market, Commodity Market and Foreign Exchange Market), hence it has a direct bearing on monetary policy and so relevant to the study of macro-economics. The focus on the demand for money is attributed to the fact that monetary policy will only be effective if the demand for money function is stable. Stability of the demand for money is crucial in understanding the behaviour of critical macro-economic variables (Essien, Onwioduokit and Osho. 1996).

The search for a stable demand for money has been a very contentious issue since the great intellectual debates between Keynesians and Monetarists of the 1960s and 1970s, as no demand for money model set forth by any of these two schools as well as their contemporaries has withstood the test of time. The instability of the demand for money in the 1970s and in the 1980s has been attributed primarily to changes in the performance of financial markets in the area of new financial products arising out of financial innovations.

Financial innovation refers both to technological advances which facilitate access to new information, trading and means of payment and to the emergence of new financial instruments and services, new forms of organization and more developed and complete financial markets, (Odularu, 2010). According to Soludo (2009:23), Nigerian banks account for over 90 percent of financial system assets and dominate the stock market. As a result, a well-funded Banking Sector is essential in order to maintain financial system stability and confidence in the economy.

In Nigeria, the Central Bank of Nigeria (CBN) is responsible for the design and conduct of monetary policy. Over the years, the CBN has adopted a wide range of monetary policy frameworks such as exchange rate and monetary targeting frameworks in order to achieve macroeconomic objectives of price stability, economic growth and balance of payment viability as well as employment creation in its conduct of monetary policy.

According to Yusuf (2010), direct controls, political instability and pervasive government intervention in the financial system resulting in the stifling of competition and resource misallocation, necessitated the introduction of the Structural Adjustment Programme (SAP) in 1986. SAP was a comprehensive economic restructuring programme which emphasized increased reliance on market forces. In line with this orientation, financial sector reforms were initiated to enhance competition, reduce distortion in investment decisions and evolve a sound and more efficient financial system. The reforms which focused on structural changes, monetary policy, interest rate administration and foreign exchange management, encompass both financial market liberalization and institutional building in the financial sector.

According to Owoye et al, (2007), stability of the money demand function has important implications for the conduct and implementation of monetary policy. In other words, these are some of the important issues for empirical analyses because it is possible that the implementation of SAP in 1986 may have altered the stability of real money demand function. They also stressed that, after the implementation of SAP in 1986, the Nigerian economy went through some significant structural and institutional changes. These changes included the liberalization of the external trade and payment systems, substantial degree of financial deepening and innovations in the banking sector, the adoption of a managed float exchange rate system, the elimination of price and interest rate controls, changes in monetary policy, and the emphasis on market determined by indirect instruments of monetary policy.

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