Monetary Policy and Inflation dynamics in Ethiopia: An Empirical Analysis

    Minyahil Alemu, Wondaferahu Mulugeta (PhD), Yilkal Wassie Summary: One of the main objectives any macroeconomic policy is main...

Global Journal of Human Social Science



Minyahil Alemu, Wondaferahu Mulugeta (PhD), Yilkal Wassie

Summary: One of the main objectives any macroeconomic policy is maintaining maximum output, which could ensure sustainable growth and development targets at national level. It, however, is obvious that this broad objective could only be assisted by stable macroeconomic variables. The average price level is among the mentioning in this regards.The issue of inflation, as it is a complex phenomenon, is not an easy task to model its interactions with other macroeconomic variables. Inflation has always been a concern, particularly, for the monetary and fiscal policy makers as it imposes uncertainty in the business environment which could adversely affect the growth and development process. It as well can lead to uncertainty on the future of investment activities thereby creating conservative investment strategies, ultimately leading to lower level business activities and hence economic growth as well. Hence, the level of inflation above the optimum threshold, is once considered to impose adverse effect on the wellbeing of the general economy, it is a crucial task to investigate its dynamism in a relation to other macroeconomic variables; and, hence to tackle any misbehaviors if we are to save our economic environment from all such undesirable patters. Doing so in the economy of Ethiopia has been the critical job of this particular work.

It could be sound to say; the adverse effects of inflation in developing Economies like Ethiopia, is in triples. Associated mainly with structural rigidities in the economies of LDCs, governments of LDCs, resort to monetization of their deficits which could further fuel up an inflationary effect in such economies. It in most cases is particular to LDCs, even though, the problem of inflation is also an issue to developed nations as well. Therefore, the issue of inflation shouldn’t be let stay for tomorrow, if considered well what it mean to the overall welfare of a nation.

While considering various sayings and empirical discoveries on the causes of inflation, we examined the empirical validity of the Classical Quantity Theory of Money(QTM) in the context of Ethiopian economy, by employing the time-series data set for the period ranging from 1974/751 and 2014/15. Consumer Price Index (CPI) is a proxy to the inflation variable in our model, which is the dependent variable predicted. While broad money supply is the principal variable in the inflation model estimated; variables like, the government’s fiscal imbalance, openness to trade, real exchange rate, real GDP and domestic nominal interest rate are also controlled for inflation. Our principal motivation while undertaking this particular study is that the theoretical as well as empirical debates and, or contradictions on the relationship between money supply and inflation variables. Regarding the issue, the QTMhypothesizes for the existence of equi-proportional correlations between the two variables always and everywhere. Money is inflationary and creates no real effect in an economy in the model setting of QTM. In contrast, for Keynes, money cannot be directly transmitted to price in an economy where idle capacity exists. Besides these theoretical contradictions, huge quantities of empirical investigations have been confirming inconclusive results. Thus, it is our turn to have the same job in order to determine which form the two series could exhibit in the economy of Ethiopia. We also at large have been mainly concerned with determining which of the two theories above explain the case in Ethiopia.

To performing our job, we have gone deeply through econometric procedures in dealing with the issues of stationarity, cointegration, model normality, model stability and other pre and post model estimation qualifications. After confirming the absence of unit roots in all the variables employed via the ADF and PP unit root tests, and the existence of long run relationships via Johnson’s maximum likelihood approach for cointegration, we estimated the Vector Error Correction Model to investigate the short and long run dynamics of inflation in a relation to other macroeconomic predictor variables in the model. Below is only the highlight summary of the model estimation results.

From VECM regressions, we see that money supply accounts for the leading role in explaining the dynamics of inflation in Ethiopia both in short and the long run periods. The finding is in line with the traditional QTM; yet, the short run case is in contrast to the Keynes’s preposition. Keynes also ascertains that, inflationary pressures being aggravated by inflationary expectations could impose even a more than proportional effect in the long run. In line with this, the estimated long run elasticity of money supply is more than one. Besides, the short run estimate is also more than one; even though, the relationship is not explained by Keynes, the short run magnitude of money supply is highly in line with him. Obviously, the case in Ethiopia has been, to the largest extent, explained by the monetarist’s hypothesis.
Besides, all of the variables employed in the model, except for RGDP and nominal deposit rates, were found to be important both in the short and the long run. RGDP and Nominal deposit interest rates are suggested to be important only in the long run. Moreover, the signs of the coefficients in all cases were expected, except for the trade openness variable. The trade openness variable has been found to exhibit a positive and highly significant relationship with the inflation variable, which is in contrast to the claims in New Growth Theory and Romer’s (1993) postulate.

In our effort to determine the relative impact of the two big macroeconomic economic policies in the country (the monetary and fiscal policies), we found that monetary policy has been more important in explaining the process of inflation in Ethiopia both in the short and long run periods. The estimated elasticities of the variables corresponding to both policies have been considered for comparison matters. An essential policy implication that comes out of this study is that, the higher sensitivity of inflation to the shocks in the money supply should be given due consideration while designing the monetary and fiscal policies in the country.
GJHSS: Global Journal of Human-Social Science

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We spent one full year to complete this research work, so that, we had enough time to critically review literatures and carefully analyze our findings. Hence, limitations because of time shortages are not welcomed.

As already described somewhere in this blog paper above, the basic inspiration to particular paper is the existence of contradicting theoretical as well as empirical literatures on the nature of relationships between money supply and inflation variables in supplement to our desire to support the process of creating healthy economic environment in the country in particular and the globe at large. No commercial or any personal benefit oriented target has been considered for convenience.

Any interested researcher has still a lot to investigate in this field as the issue of inflation is dynamic and moreover, not fully explained by a single theory. From our past experience, we found that inflation is complex phenomenon so that modeling it is not really an easy task. Hence, further researchers should consider that inflation is subject to various monetary, fiscal, structural factors. Moreover, because no economy can resort to isolate itself from world interactions, inflation in any economy is not free from external pressures. So that, while modeling inflation, any further researchers need to consider all these factors.

About the Authors:

This research work is conducted by three individuals detailed here under;

1. Minyahil Alemu (MSc)
He is currently lecturer of economics in Jimma University. He is also a researcher, research adviser in both the post and undergraduate studies of the university and examiner of research works in the university.
Research activity on progress: “Does Trade Openness Reduce Inflation? Empirical Evidence from Ethiopia”. Coming soon.

2. Wondaferahu Mulugeta (PhD)
He is the research scholar, assistant professor of Economics and dean of the college of Business and Economics in Jimma University. He is also teaching economics in post graduate school of the college. He has many publications in international journals mainly on time series macroeconomic and econometric researches. Here are only the selected sample journals of Wondaferahu;
  • The Long-Run Impact of Bank Credit on Economic Growth in Ethiopia: Evidence from the Johansen’s Multivariate Cointegration Approach
    Published at: European Journal of Business and Management ISSN 2222-1905 (Paper) ISSN 2222-2839 (Online) Vol 4, No.14, 2012
3. Yilkal Wassie (MSc)
He is lecturer of economics in Jimma University. He is also a researcher, research adviser in both the post and undergraduate studies of the university and examiner of research works in the university. He is currently pursuing his second masters degree in Economics at Hungary, Budapest. Yilkal has also a lot of international published journals in economics and econometric research works.

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Monetary Policy and Inflation dynamics in Ethiopia: An Empirical Analysis
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