Understanding Money, Banking, and Inflation in Nigeria (Part 2)

Please read the first part of this article where we answer the following questions: what is money and why is it necessary?

The Central bank and the supply of money

The Central Bank of Nigeria (CBN) was founded in 1958 under the CBN Act, with its objectives later redefined in the 2007 Act. The bank’s primary goals include maintaining monetary and price stability, issuing legal tender currency, preserving external reserves to safeguard the currency’s international value, promoting a robust financial system, and serving as the Federal Government’s banker and economic advisor. To achieve these objectives, the CBN utilizes various tools known as Monetary Policy.

One primary objective is that the CBN is the only organization allowed to issue money in Nigeria. It ensures that the only money used in Nigeria is the currency called the Naira through legal tender laws. Hence by law the Naira is the only type of money approved as medium of exchange in Nigeria.

In essence, maintaining monetary stability means preserving the value of money or its purchasing power. It’s crucial to understand that money itself is not a price, but rather a unit of account used to express prices. In other words, prices are denominated in money, and therefore, money has a price of its own – its purchasing power.

Let’s consider an example to clarify this concept. Suppose Adebisi goes to the market to buy various items – an egg, a donut, a fish, a TV, and a car – priced at NGN 1, 2, 4, 20, and 3000, respectively. Alternatively, we can express the value of the Naira in terms of these commodities: 1 Naira equals 1 egg, half a donut, a quarter of a fish, 1/20 of a TV set, or 1/3000 of a car. This illustrates that the price of the Naira is represented by the array of goods that can be purchased with a single unit.

If, after two weeks, the price of an egg increases to 2 Naira, the purchasing power of the Naira has effectively halved, as it can now buy only half an egg. Similarly, if the prices of all commodities rise, the value of the Naira in terms of these goods decreases: 1 Naira would equal 1 donut, 1/8 of a fish, 1/40 of a TV set, and 1/6000 of a car. This demonstrates that the purchasing power of money is inversely related to the price level of all commodities.

What happens when you increase the supply of money?

Just like any other commodity, the price of money (its purchasing power) is determined by the forces of supply and demand. According to the fundamental principle of economics, when the supply of a commodity increases, its price typically decreases. Similarly, when the supply of money increases, its purchasing power or value decreases. However, it’s important to note that we generally desire the purchasing power of money to increase or remain stable, rather than decline. Economist Hunter Lewis uses a simple example to illustrate this concept further:

“Consider a simple economy with only two knives and a total of $2. In this scenario, it makes sense that each knife would be valued at $1. However, if the money supply suddenly doubles to $4, without any additional knives being produced, the price of each of the two existing knives would likely increase to $2. This illustrates how an increase in the money supply, without a corresponding increase in goods and services, can lead to higher prices and inflation.”

While the increase in supply of money reduces its purchasing power, the demand for money will increase its purchasing power. Hence anytime the Central Bank adds more money to the economy it further reduces the purchasing power of money.

So how does the Central Bank really increase the supply of money in the economy?

Instead of the expense and stress of printing more money, the Central Bank adds more money to the economy by the deposit/reserve ratio (CRR), providing credit to commercial banks at a discount rate and open market operations. Let’s break this down.

• Deposit/Reserve ratio: The CBN calls this the cash reserves ratio (CRR). This is the fraction of depositor’s money a commercial bank is required to have in its reserve. Based on the latest annual report (2024) we found on the CBN website, the reserve ratio stands at 45%, which is approximately a reserve ratio of 1/2. This means that for every Naira a bank has in its vaults (reserves), it can create 2 naira of deposits. For example, let’s say there was only one bank in the economy called Tim Bank. Let’s also say the total amount of cash in the economy was NGN 100. Then everyone in the economy deposited the NGN 100 in Tim bank. Hence, Tim Bank has deposits of NGN 100 and a full reserve of NGN 100. See table 1 showing the assets and liability on a simple balance sheet.

With a reserve ratio of 45% (1/2), Tim Bank does not have to keep all the NGN 100 in its vault. It can loan up to NGN 50 to the public with interest. Remember that to the bank’s original depositors they still believe that have NGN 100 in First bank which they can get at anytime they request for it. But Tim bank only has NGN 50 in its vault. Now remember that there is NGN 50 out there in the economy being used by those who borrowed it from Tim bank to buy things. Hence the total money in the economy is now NGN100 plus NGN 50.  See table 2 for Tim bank’s new balance sheet.

Now let’s say, all these people Tim Bank borrowed the money to now buy cars and houses. Then those people who were paid for selling cars and houses now deposit the money into Tim Bank. Tim Bank’s new balance sheet becomes NGN 150 in total assets (reserves + loans) and NGN150 in total deposits. See table 3.

Technically only NGN 100 actually exists. The NGN 50 was money literally created out of thin air. The CRR is set by the CBN and based on this ratio commercial banks can loan money up to the limit. By adjusting the CRR the CBN can add or remove money from the economy.

• The discount rate: The CBN calls this the Monetary Policy Rate (MPR). The CBN can provide loans to banks at a below the market rate. These low rates are meant to encourage banks to use this monetary policy instrument, because the banks can borrow money at low prices and then loan the same money at a higher rate to the general populace and make a clean profit. As at today (2024) this rate is 24.75%. Hence if a bank borrowed NGN 100 billion at 24.75% and loaned it at 30%, the bank just made NGN 5.25 billion in profit.
• Open Market Operations (purchases): The Central Bank of Nigeria (CBN) uses this tool to increase the money supply in the economy. To do so, the CBN buys assets from banks or other financial institutions, injecting liquidity into the system. For instance, if the CBN wants to increase the money supply by NGN 60 billion, and the Cash Reserve Ratio (CRR) is 10%, it could purchase equipment worth NGN 6 billion from EDEROK Global Concept. The CBN creates this NGN 6 billion out of thin air and pays EDEROK with a cheque. Since EDEROK doesn’t have a direct account with the CBN, he deposits the check into his account at Ayoola Bank. Ayoola Bank then increases EDEROK’s checking account by NGN 6 billion and deposits the check at the CBN, increasing its reserves by NGN 6 billion. Based on the CRR, Ayoola Bank can now make loans using the formula: “change in reserves * (1 – reserve ratio)”. In this case, that’s NGN 6,000,000,000 * (1 – 0.1) = NGN 5.4 billion. Therefore, Ayoola Bank can make loans up to NGN 5.4 billion.

Let’s say Ayoola Bank makes this NGN 5.4 billion as a loan to Bold Tech Hub. Bold Tech Hub deposits the money in another bank, maybe Bank of Nigeria. Now because all banks in the economy — Ayoola Bank and Bank of Nigeria included — have a reserve ratio at 10%, as per our current example, Bank of Nigeria will then make loans up to NGN 4.86 billion based on the formula — “change in reserves * (1 — rr)”.

This way after many banks gets the different deposits from loans made by other banks, we have the following: NGN 6,000,000,000 + NGN 5,400,000,000 + NGN 4,860,000,000 + NGN 4,374,000,000 + …. = NGN 60,000,000,000.

This way the CBN carefully increases the money supply by NGN 60 billion in the economy gradually, but only has to physically print 6 billion.

In general, the CBN purchases government securities, like state government bonds, to avoid serious political issues that could arise if it is perceived that the CBN is propping up certain companies unfairly in the market. But in April 2020, due to the recession brought about by the government’s response to COVID-19 stated it would purchase corporate bonds.

How Inflation Affects the Poor and Causes Unemployment

Whenever new money is created, it is the creators who are the first spenders that are the highest gainers in the process. Hence the banks and those who work in the financial sector. As Murray Rothbard explicate this process succinctly:

“The new money works its way, step by step, throughout the economic system. As the new money spreads, it bids prices up — as we have seen, new money can only dilute the effectiveness of each dollar. But this dilution takes time and is therefore uneven; in the meantime, some people gain and other people lose.

In short, the counterfeiters and their local retailers have found their incomes increased before any rise in the prices of the things they buy. But, on the other hand, people in remote areas of the economy, who have not yet received the new money, find their buying prices rising before their incomes. Retailers at the other end of the country, for example, will suffer losses. The first receivers of the new money gain most, and at the expense of the latest receivers.”

Those on fixed incomes, usually low-income households, who are usually the last to get the new money, can no longer afford basic needs like food, shelter as rents are increased by landlords and education, as schools increase their fees. This leads to an increase in the cost of production, disincentivizing employment. Hence more people are furloughed or let go from their jobs and businesses institute hiring freezes. This is why it is no surprise that there has been a net reduction of jobs through the  Buhari administration.

We’ve witnessed the consequences of unchecked money printing and spending in other countries. A recent example is Zimbabwe, where the Zimbabwean dollar collapsed in February 2009 due to excessive money supply. Nigeria must learn from this cautionary tale and avoid a similar fate.

The highlighted controversy over the Obaseki/CBN money printing has already eroded public trust in the Naira’s value and fueled inflation fears among Nigerians. We urge the Nigerian government and CBN to curb their inflationary policies, reduce the budget, and halt the rapid increase in money supply. If they fail to do so, the consequences might/will be dire.