CBN JAS Article: Determinants of Money Supply in Nigeria

04/08/2021 | 09:40am

CBN Journal of Applied Statistics Vol. 11 No. 2 (December 2020)


Determinants of Money Supply in Nigeria

Aderopo R. Adediyan1

Studies on money supply determinants focus on the Classicists or Monetarists, Key- nesians and post-Keynesians variables like income and money multiplier. This research extends the literature on money supply determinants to include the influ- ence of financial liberalization on money supply with a reference to Nigeria between 1980 and 2019, using the Autoregressive Distributed Lag (ARDL) approach. Data used for the study were collected from the 2019 CBN Annual Statistical Bulletin. The study found that financial liberalization is an important factor in determining money supply in Nigeria, in addition to currency ratio, required reserve ratio and high-powered money. As a result, the extent of the liberalization of the financial sector matters in decisions on the regulation of money supply in the economy.

Keywords: Autoregressive distributed lag, financial liberalization, money supply determinants

JEL Classification: E5, E51, E52

DOI: 10.33429/Cjas.11220.7/8

1. Introduction

A lot of factors determine money supply. For instance, in the traditional or classical model of money supply determination, to control the level of money supply, there are array of options, which includes alteration of the cash reserve requirement. Raising or lowering the cash reserve requirements or the deposits that are required of the commercial banks' to keep with the central bank or monetary authority can change the quantity of money supply. It is to be noted that the larger the commercial banks' deposit, the stronger is its capacity to generate more money. Therefore, the apex bank normally targets the deposit money/commercial banks deposit balances by raising the cash reserve requirement to regulate the growth of money stock that may possibly generate inflation in the economy.

Fractional reserve banking is also believed to determine money stock: "if only a small part of deposits is withdrawn from a bank during a period, the bank does not have to maintain reserves equal to deposits, but could increase its revenues by lending out a part or most of its deposits" (Handa, 2009). Additionally, the supply of money can be regulated via changes in liquidity ratio as well as money outside the bank (in the hands of the non-bank public)

  • Department of Economics, University of Benin. Email:, Phone no: +2347057721315


Determinants of Money Supply in Nigeria


through the bank discount rate. Changes in the banks' discount rate affect the money supply by affecting the volume of discount loans and the monetary base. A rise (fall) in discount loans increases (reduces) monetary base and expands (shrinks) money supply in the economy (Gashaw, 2014; Onwumere, Imo & Ugwuanyi, 2012). Similarly, the money multiplier, a multiplicity of high-powered money, is believed to determine the level of money supply. A decrease or increase in the money multiplier results in a change in the money supply (Gashaw 2014; Bakare 2011).

In the Monetarists point of view, it is the "primate factor" that matters in the determination of money supply. The primate factor consists of monetary base (high-powered money), constituting currency and coins outside the banking system (i.e. notes and coins held by the non-banking public) plus the deposits of deposit money banks with the central bank, reserve and currency ratios. Different from the Classicists or Monetarists view, the Keynesians and Post Keynesians identified variables including income, interest rate and economic activities as factors critical to the determination of money supply. Furthermore, on money supply deter- minations, Handa (2009) submitted that irrespective of the way it is characterized, measured or assessed, the stock of money determination involves some participants. The core of them is the public and the commercial banks together with the central bank. The interaction of these three units and the significance of each in the determination of money supply depend on the state of the economy.

Nonetheless, a crucial factor that is also important in the determination of the quantity of money supply in addition to the aforementioned theoretically justified determinants but yet to be given considerable attention to is the influence of structural economic transformation or reform particularly the effect of financial liberalization reform. For example, according to Shaw (1973) and McKinnon (1973), a restriction on the financial sector in the form of a high reserve requirement, interest rate and direct credit ceiling hinders money flows, financial development and economic activities. These may affect the people's desire to hold currency relative to deposit. Financial regulation reduces the efficiency of the financial system which leads to a reduction in economic activities and income, and consequently, a contraction of money supply. This logically means that the supply of money may be high or low depending on whether financial liberalization policy is implemented.

Regrettably, there is a lack of empirical evidence on this relationship except for the study of


CBN Journal of Applied Statistics Vol. 11 No. 2 (December 2020)


Muhammad and Islam (2010) done in Bangladesh using a Least Square method - a static analysis even though the money supply process is dynamic in nature. Previous studies on the determinants of money supply centred largely around high-powered money and money multiplier (Lodha & Lodha, 2012; Lone & Yadav, 2016; Odior, 2013), reserve money, bank rate, and currency ratio (Tiwari, 2016; Shrestha, 2013; Muhammad & Islam, 2010), income or GDP and interest rate (Ifionu & Akinpelumi, 2013; Chigbu & Okorontah, 2013) and other variables of the same or similar characteristics. Studies like Khan and Hye (2013) consider financial liberalization but as a determinant of money demand. The present study extends the existing literature on the money supply determinants particularly in Nigeria to include the role of financial liberalization on the supply of money using an Autoregressive Distributed Lag approach capturing the timing involved in the money supply process. Essentially, the general objective of this study is to assess the determinants of money supply in Nigeria.

The rest of the paper is as follows: Section 2 is the literature review, data and methodology are in Section 3, results and discussion are presented in Section 4 while Section 5 is for the conclusion and policy recommendations.

2. Literature Review

2.1 Theoretical Literature

In the classical or traditional model of money supply determination, a cluster of economic variables like minimum cash reserve ratio, currency ratio, bank reserve and liquidity ratio are the fundamental determinants of money supply (Handa, 2009). In the Monetarists view, the primate factors are the important variables to be considered in the money supply de- termination. In contrast, the Post-Keynesians hold that the rate of interest and real output or economic activities which affect the desire of the people to hold currency rather than deposits are what determine the level of money supply at a point in time (Fontana, 2003). According to Jhingan (2008), an alteration in the level of economic activities that affect the desire of the economic agents in terms of currency holding in relation to the deposits determines the supply of money. In this spirit, Handa (2009) concluded that the more people desire to hold currency, the lower the money supply will be.

Andersen and Jerry (1968) while analyzing the determinants of money supply identified "monetary base" as the core determinant of money supply. The study maintained that the monetary base or "high-powered money" is a useful concept for characterizing the behaviour


Determinants of Money Supply in Nigeria


of money supply. More so, a multiple of the monetary base has also been argued to be a determinant of money supply. Handa (2009) referred to the multiple of monetary base as the "money supply multiplier approach or model". Based on the multiplier approach, the supply of money is basically a multiplicity of the high-powered money. Odior (2013) opined that the multiplier model is a function of the currency ratio, the reserve ratio and the high-powered money (monetary base). The mathematical illustration of the money multiplier model provided by Goodhart (2017) is as in equation (1)


1 + cr



rr + cr

where Ms is the money supply, rr is reserve ratio, cr is the currency ratio and H stands for high-powered money. However, as noted by Howells (2010), the multiplier approach is an identity rather than representing behavioural function; hence, inadequate.

The behavioural theory of the money supply determination improves upon the Base-Multiplier approach by taking into consideration the behaviour of the publicly held currency, the commercial or deposit money banks' reserves, the quantity of the money borrowed by the public and Banks coupled with the high-powered money that the apex bank desires to offer mostly in terms of the interest rate. In this regard, the money supply depends on the free reserves of the deposit money bank, in addition to the cash desired to be held by the public relative to deposit with respect to the interest rate. A free reserve, ceteris paribus, is a function of the opportunity cost of holding it. As the opportunity cost lessens, the free reserves demand would shrink; this, in turn, implies an increment in the money stock (Bain & Howells, 2003; Handa, 2009).

Conversely, according to Thornton's model of the money stock determination: a model of non-commodity money, the Apex bank generates money by wedging the difference between the natural interest rate and the market interest rate. In the model, the demand for the real money is not affected by the wedge linking the natural rate and the market such that the price has to adjust to the level of the nominal money. In a different way, the Tinbergen model of money supply incorporated Keynes' theory of liquidity preference in the determination of money stock. The model presupposes that the Apex bank fixes the discount rate together with the value for the non-borrowed reserve. This model links the supply of money to the behaviour of banks' in a quest for the free reserves. The model explains further that demanding


CBN Journal of Applied Statistics Vol. 11 No. 2 (December 2020)


for free reserves by the banks is necessitated by banks' want of the interest. In a similar way, the Shaw (1973) and McKinnon (1973) deregulation framework which focuses on financial system liberalization hammered, among others, on liberalizing interest rate and the stoppage of direct credit ceiling to improve efficiency of banks and cash flows in the economy.

2.2 Empirical Literature

Globally, the empirical literature focuses much on the debate on income, output, interest rate, reserve and currency ratios, money multiplier and high-powered money as the determinants of money supply. Virtually all the studies find statistical support for these determinants, even though the degree of importance and preference for some of these variables may differ. For example, Shirvani and Bayram (2014) study the determinants of money supply in the United States (US). The Johansen co-integration and Dominance methods of analysis were employed. The study establishes that excess reserve and currency ratios are important determinants of money supply in the US. In India, Lodha and Lodha (2012) studied the money multiplier and high-powered money as the determinants of money stock. The study showed that the high-powered money and money multiplier positively contributed to the growth in money supply between 1981 and 2012.

Also, Lone and Yadav (2016) researched the money stock determination in India. The research suggests the high-powered money and the money multiplier determine money supply in India. In Nepal, Shrestha (2013) studied the process of the money supply. The research identified high powered-money as the core determinants of the stock of money. Currency ratio and the Multiplier also affect the supply of money. Similarly, Tiwari (2016) examined the money supply determinants in Nepal. The estimation technique adopted was the OLS method. The study identified reserved money as the most important money supply determinants in Nepal.

In Bangladesh, Muhammad and Islam (2010) empirically study the money stock function using autocorrelation correction Ordinary Least Square (OLS) approach. The research establishes that the Bank rate, financial liberalization and external resources control the level of money stock. In Ghana, Sanusi (2010) examines money supply determination. The study suggests that prior to the 1990s, fiscal deficits determine money supply; but, in the aftermaths of the 1990s, the banks net foreign assets are the major determinant of the supply of money.


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