CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND TO THE STUDY

Interest rates play important role in controlling major macroeconomic variables.

The primary role of interest rate is to help in the mobilization of financial

resources and to ensure efficient utilization of resources for the promotion of

economic growth and development (CBN 1970).

However they are various states of interest rates in the financial system. They

are generally classified into two categories: Deposit and lending rates. Deposits

rate are paid to savings and time deposits of different maturities while lending

rates are interest rates charged on loans to customers and they vary according to

cost of loanable funds and lending margins.

A number of factors influence the behaviour of interest rates in an

economy. Prominent among these are the volume of savings inflation

investment government spending monetary policy and taxation constitute the

major source (supply) of credit while investment represents the major demand

for credit. Therefore the level of savings partly determines the level of interest

rates. For instance a decrease in the accumulation of loanable funds (savings) is

bound to exert an upward pressure on interest rates just as the reverse situation

would tend to have a moderating effect. Usually when the structures of interest

rate are changed the resulting relative rates of return will induce shift in the

assets portfolio of both banks and the non-banks public institutions. Hence the

direction and magnitude of changes in the market interest rates are of primary

importance to economic agents and the policy makers.

Consequently the Nigerian Economy has been highly prone to interest rate

volatility and fragility (CBN 2000). Interest rates of all instruments have

experienced very volatile movements. Inconsistencies have been the order of

the day (Adewunmi 1997).

Prior to the structural adjustments programme (SAP) the level and structure of

the interest rates were administratively determined by the Central Bank of

Nigeria (CBN). Both deposits and lending rates were fixed by the bank based

on policy decision (CBN 1962). At that time the major reasons for

administering interest rates were the desire to obtain social optimum resource

allocation promote orderly growth of the financial market and combat inflation

in implementing the credit policy. During this time the minimum rediscount

rate which was very low averaging about 7.25 percent between 1975 and 1985.

Also preferred sectors could not access funds because financial institutions

were unable to raise sufficient funds form the money market at the favoured

concessionary rates (Staley and Morse 1966). Within the general framework of

deregulating the economy in 1986 in order to enhance competition and efficient

allocation of resources the CBN introduced a market based interest rate policy

in August 1987 (CBN 1987).The policy decision was not without controversy

and laterit was generally agreed that low interest rates did not encourage

savings. It was feared that high interest rate which was likely to accommodate

the deregulation of interest rates allowed banks to determine their lending and

deposit rates according to market conditions through negotiations with their

customers (CBN 1987).

However the minimum rediscount rate (MRR) which influenced interest rates

continued to be determined by the CBN in line with changes in overall

economic conditions. The MRR which was 15 percent in August 1987 was

reduced to 12.5 percent in December 1987 with the objective of stimulating

investment and growth in the economy (CBN august 9 2006). During the same

period the prime lending rates of commercial banks and merchant banks were

on the average 18.0and 20.5 percents respectively. But following the need for

moderate monetary expansion in 1989 the MRR was raised to 13.5 percent. It

was also observed that there were wide disparities in the interest rates structure

of the various banks.

As it were the ceiling on interest rates were removed in January 1992 and

retained in 1993. Interest rate in 1993 was volatile and rose to unprecedented

level. On the basis of the foregoing developments some measures of

regulations were introduced in 1994. The developments in interest rates within

this period were generally within the prescribed limits but the rates on the other

hand were negative in real terms since inflation was estimated to be over 50

percent.

All the same the banks still maintained the interest rate regime in 1995 with

some modifications just to make it flexible. Nevertheless it should be noted that

the change in interest rates were significantly different from what prevailed

during the era of regulation. Over the past three decades high macro-economic

instability has become a key determinant and the consequence of poor economic

management. Nigeria a country blessed with abundant natural resources is seen

as one the countries that have the most volatile macroeconomic aggregates. This

is in order with National Economic Empowerment and Development strategy

(NEEDS 2004) which says that “between 1975 and 2000 Nigeria’s broad

macroeconomic aggregates growth the terms of trade the real exchange rate

government revenue and spending were among the most unstable in the

developing world”.

It is these developments which have fuelled the need to embark upon this study.

It could be possible that the macroeconomic instability is deep rooted in erratic

movements of interest rates.

1.2 STATEMENT OF THE PROBLEM

It is a well known fact that the Nigerian Economy is characterized by volatile

interest rates macro economic instability. Several measures embarked upon by

the CBN failed to correct these defects in the economy. The most important of

these measures were contained in the amendment of the CBN monetary circular

No 21 which diverted the control of rates from CBN on August1 1987. The

bank had been in control of the cost of credit in the economy regulating the

interest rates charged by the commercial and merchant banks in their lending

activities.

As it is banks determination and control of interest rates on loans did not help

for the stability of major macroeconomic variables due to the volatile nature of

rates during the planning period. Currently interest rates are market determined

and the study intend to investigate the impact of interest rate on some selected

macroeconomic variables. In view of this the research questions are stated as

below;

1. What is the nature of the relationship between interest rates and the gross

domestic product of Nigeria?

2. What is the nature of the relationship between the interest rates and the

level of domestic investment in Nigeria?

1.3 OBJECTIVES OF THE STUDY

The broad objective of the study is to determine the relationship between

interest rate and other selected macroeconomic variable such as Investments and

Gross Domestic Product (GDP) in Nigeria.

The specific objectives are;

1. To determine the impact of interest rate on GDP.

2. To determine the impact of interest rate on investment

1.3 STATEMENT OF HYPOTHESES

The research hypotheses will be formulated in the null and alternative

hypothesis form.

1. Ho: Interest rate has no significant impact on GDP in Nigeria.

Hi: Interest rate has significant impact on GDP in Nigeria.

2. Ho: Interest rate has no significant impact on investment in Nigeria.

Hi: Interest rate has significant impact on investment in Nigeria.

1.5 SIGNIFICANCE OF THE STUDY

The findings of this study will be considered significant in the following ways;

1. The major findings would be very useful to the CBN when formulating

monetary policy for the country.

2. The findings will be useful to the policy makers for providing guidelines

for controlling operations in money and capital market.

3. Lastly the findings will serve as guidelines to the investing public in their

decision making.

1.6 SCOPE OF THE STUDY

Interest rates include mainly the lending rates. However this study will be

limited to lending rates during the floating interest rates regime. The study will

cover the years from 1970 to 2010