The Impact of Monetary Policy on Balance of Payment in Nigeria

The Impact of Monetary Policy on Balance of Payment in Nigeria

In economic literature, divergent views exist on what constitute monetary policy and what the concept of balance of payment is all about, and at the same time what monetary policy seeks to achieve.

According to Udegbunam (2003), “Monetary policy is widely understood to be an important instrument of macro economic demand management, despite the lack of consensus among economics on how it actually works and on the magnitude of its effects on the economy.”  Emeko (2008) also cited this in his study of monetary policy and macroeconomic stability in Nigeria.

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Funness (1992) described monetary policy “as a policy designed to influence economic activity by variation in money supply, in availability of credit and interest rates”.

In the works of Iyoha (2002) “Monetary policy refers to the attempt to achieve the national economic goals of full employment without inflation, rapid economic growth and balance of payments equilibrium through the control of the economy’s supply of money and credit”.  Since the rate of interest is the cost of credit, monetary policy includes the control of money supply (through the control of high-powered reserves) and the rate of interest.  In a wider sense, monetary policy may also be taken to include attempts to influence the external value of a nation’s currency, i.e. exchange rate management.

Chandler (1968) on his part views monetary policy in line with Funness (1992) except that he emphasised variation in money supply and bank credit.  One of the most comprehensive definitions is that given by Hutichism (1980), in his own contribution, monetary policy involves the control of money supply and credit thereby regulating the cost and credit in a manner that will affect aggregate demand in a direction that will contribute to the achievement of macro economic objectives.

On the other hand, Anderson (1980) views monetary policy as “the action taken by the authorities in a country to control the money supply and the rate of interest”.

According to CBN (1992) Monetary policy refers to the “combination of measures designed to regulate the value and supply and cost of money in an economy, in consonance with the level of economic activities”.  It can be described as the art of controlling the direction and movement of monetary and credit facilities in pursuance of stable price and economic growth in an economy.

According to Anyanwu (1993) monetary policy is a major economic stabilisation weapon which involves measures designed to regulate and control the volume, cost, availability and direction of money and credit in an economy to achieve some specified macroeconomic objectives.

Typically, monetary management deals with control of money stock, which is the intermediate target of policy.  This broad objective may be translated into specific objective such as price stability, suitable economic growth, and high level of employment and balance of payments equilibrium.  These objectives are achieved through the use of appropriate instruments whose composition may vary from country to country, depending on the level of development.

A well articulated monetary policy formulation help to achieve the following broad goals as stated by Obadan (1991) includes, full employment, price stability and balance of payment equilibrium.


Choice of Monetary Policy Target

This aspect deals with the tools or instrument through which monetary policy objectives can be achieved.  It is the instruments that are manipulated with a view to hitting the targets with the intensity and timeliness in order to achieve the desired results.  If there are two objectives, a minimum of two policy instruments is usually necessary to achieve both completely.  Each policy tools or instruments needs to be paired with the target on which it is most effective, this means that one instrument may be aimed at one target (or goal).  Sometimes, many instruments may be aimed at one target.  In manipulating instruments there are however time lags as well as leads.  Also there are chain reactions side effects, unintended consequences and even accidental success.  Accordingly, when the instruments are applied one instrument may be found to overshoot the target and this would be late for another to ameliorate its effects (Oesterreichische National Bank, 2000).

In this case a number of other targets may have to be hit first before reaching the elusive target.  What emerges from this scenario is that in the real world it is very difficult to separate causes from consequences and attribute success to failure to any set of policy objectives without running into risk of empirical contradiction (CBN, 2001).

Monetary policy (targets) variables are variables for which the government seeks to desirable values and are the (intermediate) goals of macroeconomic policy.  Macroeconomic policies are the actions of the policy makers directed at influencing viz:

Controlling inflation, maintenance of healthy balance of payments (BOP) position so as to, safeguard the external values of the national currency, maintaining a low level unemployment, provision of an adequate and sustainable level of economic growth, and development, promotion of price stability, reduction of pressures on the external sectors, and stabilisation of the Naira exchange rate (Emeko, 2000).

The CBN Briefs (2000) classified the techniques, which the monetary authority used to achieve these objectives are divided into two categories, namely:

  1. The direct or portfolio control approach (Before 1986).
  2. The indirect or market intervention control approach (After 1986). These two categories of approach were differentiated by describing their mechanisms.

The Direct Portfolio Control Approach (Before 1986)

Generally, when the financial environment is underdeveloped, the instruments of monetary management are limited to direct measures which set monetary, and credit targets desired levels as well as mandatory guideline for banks through which the target are enforced (CBN, 2002).

It is important to note that there have been two major phases in the pursuit of monetary policy namely before and after 1986.  The first phase placed emphasis on direct monetary controls, while the second relies on market mechanism (i.e. indirect control approach).  (Central Bank of Nigeria: conduct of Monetary Policy, 2008).

However, the direct instruments used by the monetary authority were credit ceilings, selective credit controls, administered interest and exchange rates, as well as the prescription of cash reserve requirements and special deposits (CBN, 2002).

In the before 1986 monetary policy, the most popular instrument of monetary policy was the issuance of credit rationing guidelines, which primarily set the rate of change for the components and aggregate commercial bank loans and advances to the private sector.  Sectoral allocation of bank credit in CBN guideline was to stimulate the productive sectors and stem inflationary pressures.  The fixing of low level interest rate was done mainly to promote investment and growth.  The occasional special deposits were imposed to reduce the amount of free reserves and credit – creating capacity of the banks.  Even the minimum ratios stipulated for bank’s in the mid – 1970 on the basis of their total deposit liabilities, but since such cash ratios were usually lower than those voluntarily maintained by the banks, they proved less effective as a restraint on their credit operations.  From the mid-1970’s, it became increasingly difficult to achieve the aims of monetary policy.  Generally government macroeconomic goals move in undesirable directions.  However, compliance by banks with credit guideline was less than satisfactory (CBN, 2002).

The major problems of management were the nature of monetary control framework, the interest rate regime and non-harmonisation of fiscal and monetary policies.  Monetary policy failed to achieve its target as their implementation became less effective with time.  The low interest rates on government debt instrument did not sufficiently attract private sector savers.  In early 1980’s oil receipts were not adequate to meet increasing levels of demand and since expenditure were not rationalised, government resorted to borrowing from the central bank to finance huge deficits.  This had adverse implication for monetary management (CBN, 2002).

 The Indirect or Market Intervention Approach (After 1980)

Indirect or market instruments on the other hand, are usually employed in economics where the quantity of money could be influenced through the relationship between money supply and bank reserves.  Since the reserves could be used for money creation and banks, the Central Bank monitors their level and trends to ensure that they are consistent with the objectives of monetary policy.  The ways in which the activities of the monetary authorities influences  the creation of reserves and hence credit and money stock include changes in the reserves/deposit ratio for banks’ and variation in the minimum rediscount rate or bank rate, whose effectiveness depends on the existence of a deregulated money market (CBN, 2002).

Other terms were used to identify these approaches of monetary policy.  Afolabi (1990) used quantitative controls to mean direct monetary controls and qualitative controls to mean indirect monetary controls.  Examples of direct tools include quantitative ceilings on bank credit, selective credit controls and administered interest and exchange rates, while those used for indirect monetary control are reserve requirements discount rate and open market operation (OMO).

According to Anyanwu and Oaikhenan (1995), “the indirect monetary policy tools includes; Open market operation, cash reserve rate, liquidity ratio, minimum Discount Rate, parity changes, and selective Credit polices.

In Nigeria, the policies to be pursued are usually detailed out in the monetary policy and credit guidelines, which are operated within a fiscal year.  Some part can be amended during the year. (Onyiwa,1993)

It was concluded by Onyiwa (1993) that the reliance on direct monetary instruments have tendered to impede the development of the financial system and contribute to insufficient allocation of resources and that the use of those tools have also severely weakened competition in the financial market for bank credit and at certain times contribute to disintermediation as shown by the growth of informal financial institutions.  He further said that they have also imposed significant compliance and enforcement cost on the financial system and may have been a factor contributing to currency substitution and capital flight.

Monetary policy is set out always to meet or achieve equilibrium in international transactions along side with internal equilibrium.  A balance of payments equilibrium means, total payments are equal to total receipts, but when payments are not equal to receipts, then we have a disequilibrium position and this could be balance of payment surplus or deficit.  A balance of payment deficit implies, say for Nigeria, that more foreign currencies are being demanded by Nigerians than the foreigners are demanding the Naira (Oyiwa, 1993).

Monetary authorities of Nigeria and other countries alike have designed monetary policies because of the problems that are likely to arise from the deficit position of balance of payments to influence the use and promote higher earnings of foreign exchange and Naira exchange rate stability.  Sometimes before 1986, Nigeria adopted the fixed exchange rate policy and was to correct the deficits in balance of payments.  The correction was made by drawing on external reserves.  In other words, when there is balance of payment deficit it is corrected be selling the external reserves and buying the excess Naira supply, such that the Naira exchange rate was made relatively stable during these periods (Onyiwa, 1993).

After 1986, when the Structural Adjustment Programme (SAP) and the floating exchange rate were introduced to correct the country’s balance of payments, the central balance had the discretion to set the exchange rate, which was allowed to float around the US dollars and the British pounds sterling.  The policy encouraged over-valuation of the exchange rate and according to Ojo (1990) the over-valuation of the rate was counter productive which undermined the incentives to produce for export because of resultant uncompetitive prices in local currency.  This also made imports cheaper which has explained the high rate of importation of consumer goods into Nigeria.

He believed that, this is one of the basic reason for the reduction to export in the country.  These over-dependence on import and reduction in export have led to the deficit in balance of payment (Ojo, 1990).


A lot of empirical work has been carried out by money economists to establish which of the instruments, monetary and fiscal policy is more effective in influencing economic activity of the nation.

In 1963, Milton Friedman and Meishman carried out an empirical study on the response of economic activities (GNP) to monetary and fiscal measures.  The authors reduced from using the US data from 1946 – 1957.  They concluded, that “velocity was more table and have a predictable relationship with aggregate demand”.  Friedman and Meischman advocate for the use of monetary policy.

These economists hold that the money supply is a key economic magnitude that exerts a strong influence on other macro economic variables.  They believe that there is a close relation between the money supply on the one hand, and income, employment and the price level on the other hand.

Loeneld Anderson and Jerry Jordan (1968) OF THE Federal Reserve Bank of St. Collins carried out another comparative test.  They concluded this empirical research which aimed at determining which of the two policy instruments is stronger, faster and more predictable using quarterly changes in monetary and fiscal action using US data from 1952 – 1968.  The final result of the study confirmed that monetary policy could be said to stronger, quicker in acting and more predictable than fiscal policy.

Ajayi (1974) carried out an econometric investigation on the relative effectiveness of monetary policy and fiscal policy.  The model was based on the work of Anderson and Jordan using the simple equation approach, he regressed quarterly changes in GNP or changes in government expenditure, revenue and money supply.  In the final analysis, he concluded that monetary policy rather than fiscal policy exert more influence on gross domestic product in Nigeria economy.

Sir John Hicks (1937) “General equilibrium in the economy the two-market model, consisting of the product market and the money market is pedagogically, the most useful case.  This is the basic IS-LM model introduced by Hicks.  In this model, we study simultaneous determination of equilibrium in product and money markets.  Thus, we obtain the equilibrium level of income and the equilibrium rate of interest.  This model also enables us to study the efficacy of fiscal and monetary policy in the closed economy, next, labour market equilibrium analysis of level of employment.  Most importantly, the foreign sector which facilitates analysis of the balance of trade in balance of payments using IS-LM framework will be treated in full including analysis in the case of fixed exchange rate and efficacy of fiscal and monetary policy in the open economy under fixed exchange rates will be fully examined.

N.B:  John Hicks works on ISLM model is one of the key stabiliser in the balance of payment and trade of an open economy.



Flows were not carefully measured due to difficulty in measurement, and the flow proceeded in many commodities and currencies without restriction, clearing being the matter of judgement by individual private banks and governments that licensed them to operate.  Mercantilism took special notice of the balance of payments and sought simply to monopolise gold, in part to keep out the hands of potential military opponents but most upon the theory that large domestic gold supplies will provide lower interest rates (CBN, 2005).

Classical economics, saw private currencies were taxed out of existence, the market systems were later regulated in the 19th century by the gold standard which linked central banks by a convention to redeem “hard currency” in gold (CBN, 2005).

After World War II this system was replaced by the Bretton Woods institution (the international Monetary Fund and Bank for international settlements).  In 1970’s this redemption ceased, leaving the system with respect to the United States without a formal base, yet the peg to the Mark somewhat remained.  Strangely, since leaving the gold standard and abandoning interference with dollar foreign exchange, the surplus in the income account has decayed exponentially, and has remained negligible as a percentage of total debits or credits for decades, a universally desirable commodity due to the dependence of so much infrastructural capital on oil supply; however, no central bank stocks reserves of crude oil.  Since OPEC oil transacts in US dollars, and major currencies are subject to sudden large change in price due to unstable central banks, the US dollar remains a reserve currency, but increasingly challenged by the Euro, and to a small degree the Japanese Yen (CBN, 2005).

The United States has been running a Current Account deficit since the early 1980’s.  The US current account deficit grew in recent years, reaching record high levels in 2006 in absolute terms ($758 billion).  Milton Friedman (Balance of trade) has tried to explain that cheaper, riskier, foreign capital is exchanged for “riskless” expensive, US capital and that the difference is made up with extra goods and services.  Nevertheless, Friedman’s interpretation is incomplete with respect to countries that interfere with market prices of their currencies through the changes in their reserves so only applies to Canada and a lesser extent, the United States (IMF, 2008).


According to IMF (2008), “in economics, the balance of payments (BOP) measure the payments that flow between any individual country and all other countries”.  It is used to summarise all international economic transactions for that country during a specific time periods, usually a year.  It is determined by country’s exports and imports of goods, services and financial capital, as well as financial transfers.  It reflects all payment, liabilities to foreigners (debits) and all payments and obligations received from foreigners (credits).  BOP is one of the country’s indicators of status in international trade, with net capital outflow.  The balance of payments comprises the current account, the capital account, and financial account.  “Together, these accounts balance in the sense the sum of the entries is conceptually zero”.

  • The current account consists of the goods and services account, the primary income account and the secondary income account.
  • The financial account records transactions that involve financial assets and liabilities and that take place between residents and nn-residents.
  • The capital accounts in the international accounts shows (1) capital transfers receivable and payable; and (2) the acquisition and disposal on non-produced non-financial assets.

In economic literature “capital account” is often used to refer to what is now called the financial account and remaining capital account in the IMF manual and in the system of National Accounts.  The use of the term capital account in IMF manual is designed to be consistent with the system of National Accounts, while distinguishes between capital transactions and financial transaction (IMF, 2008).


The balance of payment for a country is the sum of the current, capital and financial accounts.

Current Account

The current account is the net change in current assets from trade in goods and services (balance of trade), net factor income (such as dividends and interest payments from abroad), and net unilateral transfers from abroad such as foreign and, grants, gifts, etc (IMF, 2008).

Current account     =          Balance of trade  + Net factor income from abroad + Net unilateral transfers from abroad.

Income Account

The income accounts mostly for investment income from dividends and interest on credit and payments on foreign taxes strangely, the net of the income account of the United States has been negligible as a percentage of total debits or credits for decades, an extremely outlying instance.

Unilateral transfers:  Are usually conducted between private parties.  For example, Mexico has a large surplus of remittances from the United States sent by emigrant workers to loved ones back home (IMF. 2008).

In Nigeria, her personal home remittances (PHR) inflows increase from N637.5 billion in first half of 2006 to N901.4 billion.  India has the world’s largest surplus of remittances, (CBN, 2006).


According to IMF’s definition, the capital account “records international flows of transfer payments relating to capital items”.  It therefore records a country’s inflows and outflows of payments and transfer of ownership of fixed assets (capital goods).  Example of such goods could be factories or heavy machinery transferred to or from abroad and so on.  Summing up: the capital accounts for the transfer of capital goods.

In economics, the term capital account usually refers to what the IMF calls the financial account and capital accounts, combined (IME, 2008).



According to the IMF’s (2008), definition, the financial account is the net change in foreign ownership of investment assets.  In economics, the term capital account has historically been used to refer to the IMF’s definition of the capital and financial accounts.

According to the CBN’s report 2006, the capital and financial account was used together and it showed a deficit from N962.9 billion to N1,896.0 billion in the first half of 2006.

Financial account = Increase in foreign ownership of domestic assets.

  • Increase of domestic ownership of foreign assets

=  Foreign direct investment:

+  Portfolio investment

+  Other investment

The accounting entries in the financial account record the purchase and sale of domestic and foreign investment assets.  These assets are divided into categories such as foreign direct investment (FDI) portfolio investment (which includes trade in stock and bonds), and other investment (which includes transactions in currency and bank deposits) (CBN Annual Report, 2006).

If foreign ownership of domestic financial assets has increased more quickly than domestic ownership of foreign assets in a given year, then the domestic country has a financial account surplus.  On the other hand, if domestic ownership of foreign financial assets has increased more quickly than foreign ownership of domestic assets, then the domestic country has a financial account deficit.  The United States persistently has the largest capital (and financial) surplus in the world.

The United States receives roughly twice the rate of return on all foreign investment than domestic investment by foreign (CBN Annual Report, 2008).

Official Reserves

The official reserves account records the change in stock of reserve assets (also known as foreign exchange reserves) at the country’s monetary authority.  Frequently, this is the responsibility of a government established central bank.  Although practically extinct, change in reserve assets at private monetary authorities is included, as well.  Reserves includes official gold reserves, foreign exchange reserves, IMF special Drawing Right (SDRs), or nearly any foreign property held by the monetary differences between the capital account and current account (and errors & omissions) by accounting identity and are mostly composed of foreign exchange interventions and deposits into international organisations such as the IMF; the magnitude of these changes will depend upon monetary policy and government mandate (IMF, 2008).

According to the standards published by the IMF (2008), Balance of payment manual, net decreases of official reserves indicate that a country in buying its domestic assets, usually currency than bonds, to support its value relative to whatever asset usually a foreign currency, that they are selling in exchange.

Countries with large net increase in official reserves are effectively attempting to keep the price of their currency low by selling domestic currency and purchasing foreign currency, increasing official reserves.  For countries with floating exchange rate, the official reserves will tend to change less, and be used as another tool of monetary policy to influence intervention by directly controlling the domestic money supply (by buying or selling foreign currency); however, this usage has been challenged by economists such as Milton Friedman who in an interview on Icelandic television said that a central bank can control an exchange rate or control inflation but cannot do both.

Interest in official reserve positions as a measure of balance of payments greatly diminished after 1973 as the major countries gave up their commitment to convert their currencies at fixed exchange rates.  This reduced the need for reserves and lessened concern about change in the size of reserves (IMF, 2008).

Countries that attempt to control the price of their currency will tend to have large net change in their official reserves.  Some of the most extreme example include China and Japan.  In 2003 and 2004, Japan had an outflow of reserves, year, by more than equivalently one third of one trillion US Dollars if calculated using exchange rates prevailing at the time.  NB: deficit of official reserves representing outflow of year is not in accordance with the IMF standards (IMF, 2008).


This is the last component of the balance of payments and principally exists to correct any possible errors made in accounting for the three other accounts.  These errors are common to occur due to the complexity of the calculations and difficulty in obtaining measurements (IMF, 2008).

Omissions are rarely used usually by governments to conceal transactions.  They are often referred to as “balancing items” (IMR, 2008).


The balance of payment identity states that:

Current Account = Capital Account + Financial Account + Net Errors and Omissions.

This is a convention of double entry accounting, where all debt entries must be looked along with the corresponding credit entries such that the net  of the current account will have a corresponding net of the capital and financial accounts:

X + KI  =  M + Ko­


X         =          export

M        =          Imports

KI        =          Capital inflows

ko         =          Capital outflows

Rearranging, we have:      (X-M)  =  Ko – KI

Yielding the BOP identity (IMF, 2008).

The basic principle behind the identity is that a country can only consume more than it can produce (a current account deficit) if it is supplied capital from abroad (a capital surplus) from Alfred Marshal’s Money, Credit, and Commerce, “In short, when a country lends abroad £1,000,000 in any form, she gives foreigners the power of taking from her £1,000,000 of goods (IMF, 2008).

Mercantile thought prefers a so called balance of payments surplus where the net current account is in surplus or, more specifically, a positive balance of trade (IMF, 2008).

A balance of payments equilibrium is defined as a condition where the sum of debit and credits from the current account and the capital and financial accounts equal to zero; in other words.

Current account + (Capital and financial accounts ) = 0

This is the condition where there are no changes in official reserves.  When there is no change in official reserves, the balance of payments may also be stated as follows:

Current account  =  (Capital and financial accounts)

Current account deficit (or surplus) = capital and financial account surplus (IMF, 2008)

Canada’s Balance of Payments currently satisfies this criterion.  It is the only large monetary authority with no changes in reserves (IMF, 2008).

Nigeria currently in 2006 CBN Report indicate that her external reserve rose from US $28.3 billion to US 41.9 billion, representing an increase (CBN Report, 2006).


Monetary policy generally refers to a combination of measures designed to regulate the value, supply and cost of money in an economy in line with expected level of economic activity may be translated into specific objectives such as price stability, sustainable economic growth high level of economic activity.  Typically, monetary management deals with the control of money stock, which in the intermediate target of policy.  The broad objective may be translated into specific objectives such as price stability, sustainable economic growth, high level of employment and balance of payment equilibrium.  These objectives are achieved through the use of appropriate instruments whose composition may vary from country to country, depending on the level of development (Emeko, 2008).

The management of monetary policy in Nigeria is carried out in practice by the CBN in collaboration with the Federal Government (Emeko, 2008).

Thus, the responsibility of seeing that monetary conditions are consistent with the achievement of the objectives of the country is that of the CBN.  These objectives are the macroeconomic goals, the CBN has, therefore, some monetary control functions to perform.  Such functions could be, employing monetary restraint to prevent excessive monetary growth from causing inflation and expanding money stock so as to support aggregate demand during economic recession (Emeko, 2008).

So many economists have propounded theories in order to explain the impacts.  One of such economist is Lord Keynes who propounded the Keynesian theory, that a change in monetary policy could affect aggregate demand, what means that any change in stock of money through the use of monetary policy tools will affect investment demand through interest rates (CBN, 2005).

Johnson (1976), attributed Britain’s persistence trade deficit to the monetary consequences of the rapid post-war growth in government sector, which proclaimed persistent pressure on domestic goods in the market and raised prices above purchasing power parity.

Akhtar (1978), used monetary approach to the balance of payment to examine the impact of fiscal constraints of monetary policy in United Kingdom and gave explanation to the variation in the foreign reserve position as percentage changes in economic variables (Net exports, inflation, exchange rate and money supply) and domestic credits with respect to its share in high powered money.

However, we now analyse the efficacy of monetary policy in an open economy under fixed exchange rate using Sir John Hick’s model of product and money market (IS-LM Framework) to show equilibrium position in balance of payment (Iyoha, 2002).

In other works done, it has been shown that an expansionary monetary policy will unambiguously worsen the balance of payments.  Conversely, a tight monetary policy will necessarily improve the balance of payments.

Diagrammatically, we can show the effect of monetary policy in an open economy

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