chapter one - Covenant University Repository

CHAPTER ONE
INTRODUCTION 1.1 Background
Not until the events of late 1920s in the United States of America (USA)
and indeed the industrial world, characterized by the Great Depression,
macroeconomics, as a branch of economics was non-existent by that title.
Before then, it was the world of microeconomics and the classical
economists and business cycle was seen as a normal fact of life. Expected
to re-occur periodically (say in every seven or eight years) no attempt was
made to curtail business cycles by way of stabilization policies. The
events of the 1930s provoked a wave of new thinking. By the mid-1940s, Keynes and Keynesian school of thought had fully emerged,
providing alternative explanations to economic phenomena. Consequently,
economists no longer viewed business cycles as a normal fact of life. To
the Classical economists fluctuations are real essence of a market economy.
Thus, if there is disequilibrium between demand and supply, self-
correcting forces will naturally evolve to stabilize the market.
Government, in this case, need not intervene. The Keynesians, on the other hand, were of the view that fluctuations
caused by supply-demand disequilibrium could be and should be controlled.
They pointed out that business cycle characterized by expansions and
contractions "are symptoms of underlying problems of the economy which
should be dealt with". By similar positions, macroeconomics found its feet
in the annals of economists. Today it has become the theoretical and
practical response to the problem of inflation, unemployment, growth and
business cycle. Consequently, business cycle became an issue, both in
theoretical and empirical terms. To date literature on business cycle is abundant. But modern business
cycle research is due to the path breaking paper of Kydland and Prescott
(1982). According to Rebelo (2005: 2), three revolutionary ideas were
associated with that paper. They are that:
"...business cycle can be studied using dynamic general
equilibrium models. These models feature atomistic agents who
operate in competitive markets and form rational expectations
about the future. The second idea is that it is possible to
unify business cycle and growth theory by insisting that
business cycle models must be consistent with the empirical
regularities of long-run growth. The third idea is that we can
go way beyond the qualitative comparison of model properties
with stylized facts that dominated theoretical works in macro
economics before 1982".
Beyond these revolutionary ideas, another major contribution of Kydland and
Prescott (KP) paper is that supply-side shock due to technological advances
are the driving force behind business cycles rather than variations in
demand. It is apposite to point out that KP (1982) model is recognized and
classified as a real business cycle (RBC) model. And in the class of
business cycle research, RBC has received much attention. The RBCs are
models of business cycles that explain cycles as fluctuations in potential
output. The development of such a model is in response to the disillusion
with the Keynesian consumption function or even the IS-LM framework
described as being too simplistic as to take care of the dynamics
underlying macroeconomics particularly intertemporal substitutions and
uncertainties. Consequently, the neo-classical economists suggested that theories of RBC
must be based on microeconomic foundation of choice between the present and
the future consumption in an optimal control manner. Hence, the simple
consumption model is an inadequate explanation of business cycle. In the
case of household, "supply of labour and demand for goods both now and in
the future" will ensure that "lifetime spending was financed out of
lifetime income plus any initial assets. Such plans would then be
aggregated to get total consumption spending and total labour supply" Begg,
Fisher and Dornbusch (2000). We can repeat similar process for other
economic agents (firms, government...)
Given the potential output, and in the RBC explanation, the economy is
disturbed by shocks such as technological breakthrough, changes in
government policy, etc which alter the complicated plans of economic agents
and give rise to equilibrium behavior that symbolizes a business cycle.
RBCs also constitute a point of departure for many theories in which
technology shocks do not play a central role (Rebelo, 2005). They have
also become "laboratories" for policy analysis and for the study of optimal
fiscal and monetary policy (Lucas, 1980). However, the growing volume of literature is skewed in favor of the
industrial economies. Interest in business cycles and RBC research, in
particular, is gaining ground in the Latin Americas and South Asian
countries. The near non-existence of RBC research in Africa tends to
suggest either the absence of the phenomenon or lack of interest in this
area of research. This apparent lack of interest could be explained by the
belief that there is more serious concern than business cycles in the
African economies. As a matter of fact, no economy whether developed or
developing is immune to business cycle fluctuations. In each case,
persistence and magnitude of volatility is important. According to
Mathias (1969), "analyzing the nature of ... economic fluctuation is
important in itself but also gives insights into the process of growth in
the changing structure of the economy and the social hardship brought by
industrialization and economic change". What then is a business cycle? There are several approaches to this
definitional clarification. According to Mitchell (1927) business cycle is
characterized by a "sequence of expansions and contractions particularly
emphasizing turning points and phases of the cycle". Lucas (1977) as
contained in Kydland and Prescott (1990:2) defined business cycle as the
statistical properties of the co-movements of deviations from the trend of
various economic aggregates with those of real output. Kydland and Prescott
(1982) described business cycles as recurrent nature of events .These
definitions underscore the recurrence of upturns and downturns around the
trend of macroeconomic aggregates. This study reviews the literature on business cycle and raises some
research questions with a view to exploring the applicability of RBC
methodology to the Nigerian economy given the unequivocal desire to reduce
sharp fluctuations and ensure steady growth. We thus adopt the more
comprehensive concept of business cycle that incorporates growth with
fluctuations tagged business cycle phenomenon, BCP. The latter is defined
as "...nothing more nor less than a certain set of statistical properties
of certain set of important aggregate time series" (Prescott, 1986; 2).
Another definition is due to Lucas (1977; 9) in which BCP is viewed as "the
recurrent fluctuations of output about trend and the co-movements among
other aggregate time series". In what follows in this chapter, the study looks into the statement of
research problem in section 1.2. In section 1.3, it considers the scope of
the study while section 1.4 discusses the justification for the study.
Sections 1.5, 1.6, and 1.7 deals with the statement of key research
questions, research objectives and research hypotheses respectively. In
sections 1.8 and 1.9 a brief outline of the methodological approach and the
data sources is given leaving detailed discussion to chapter three of the
study. This chapter ends with plan of the study in section 10. 1.2. Statement of Research Problem
The need to understand and distinguish short-run (fluctuations) and long-
run (growth) determinants of the macro-economy has been emphasized in the
literature (Agenor, Mc Dermort and Prasad, 2000, and Lane, 2002). Short-run
analysis provides the basis for regulating the economy and long-run
analysis is concerned with longer term planning purposes. While the latter
is influenced by real shocks, the former is determined by nominal shocks.
This study is premised on identifying the shocks that drive business cycle
fluctuations in Nigeria and classifying them into real and nominal shocks. The deep crises that have pervaded the Nigerian economy since early 1970s
posed considerable challenges to policy makers and economists. At each turn
of events efforts are made to design and implement appropriate policy
response. Nigeria, no doubt, has witnessed periods of boom and also
recessions. In the 1970s, the economy was expanding due to large inflow of
crude oil income and by the period 1981-1985, at the wake of the falling
oil revenue, the economy declined, precipitating a rapid deterioration of
the living standard of Nigerians. Iwayemi (1995:5) points out that "the
cycle of oil price booms and precipitous decline and the associated
transfer problem, in terms of the net resource outflow associated with debt
repayments, triggered profound changes unparallel in the history of the
economy". The subsequent periods were not too different as the consequences of the
preceding period dragged into the following period. Macroeconomic
indicators point to the grave economic situations. In particular, there
were sharp fluctu