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DEPARTEMENT OF ECONOMICS
BY-BELETE MENGISTU
ADVISOR- ABREHAM G.
JUNE-2009/2017
AKSUM (, ETHIOPIA)
i
Acknowledgement
First and for most I wish to express my sincere thanks to the almighty
god. Who has given my health, strength, tolerance to rich at this stage.
Next my special tanks got my advisor instructor Abraham G. for his great
advise, assistance guidness, and comment in course of these senior essay
preparation.
i
Table of Contents
TABLE OF CONTENTS
CONTENT PAGE
Acknowledgement …………………………………………………………………………………………………i
Acronyms ………………………………………………………………………………………………………………………VI
Abstract ……………………………………………………………………………………………………………………………..vii
CHAPTER-ONE
1. INTRODUCTOIN
1.1. Background of the study ……………………………………………………………………………………………1,2
1.2. Statement of the problem …………………………………………………………………………………………….3
1.3. Researches questions ……………………………………………………………………………………………………4
1.4. Objectives of the study …………………………………………………………………………………………………5
1.4.1 General objective …………………………………………………………………………………………………5
1.4.2 Specific objective …………………………………………………………………………………………………5
CHAPTER-TWO
2. LITERATURE REVIEW
ii
2.1.4.2 Aggregate money demand ………………………………………………………………………………14
2.1.5. Equilibrium in the money market………………………………………………………………………15
CHAPTER-THREE
CHAPTER-FOUR
CHAPTER FIVE
BIBLOGRAPHY ……………………………………………………………………………………………………….48, 49
APPENDIX ………………………………………………………………………………………..........
iii
iv
LIST OF FIGERS AND TABLE FIGERS
4.1 Development in monetary aggregate ………………………………………………………………………………………28
Table 4.1 growth rate of money demand and real GDP …………………………………………………………………29
Table 4.4 Augmented dickey fuller (ADF) test for first difference of data ………………………………..…..35
v
ACRONYMS
ER=exchange rate
INF=inflation rate
MD =money demand
R=interest rate
WB = World Bank
vi
ABSTRACT
The study conducted to identify the determinant of money demand in
Ethiopia using time series data for year 1982-2014 collected from
different governmental organization like NBE, MOFED, WB and other
annual bases. The data were analyzed using both descriptive and
econometric methods. in the descriptive part the study found that the
macro economic performance of in Ethiopia during the military regime
of the degree was unsatisfactory, but with the change of government in
1991 there come radical change in economic orientation .in
econometric analysis the first step was specification or formulation of
the model for money demand function based on economic theory of
money demand and the model tested for ordinary least square method
(OLS) approach. The study found that growth real GDP has significant
positive effect on money demand. the exchange rate ,inflation rate ,and
nominal interest rate are also significant and have negative relationship
with money demand finally the study recommended that should be
appropriate policy towards money demand condition related to real
GDP ,inflation, exchange rate and nominal interest rate.
vii
CHAPTER ONE
1. INTRODUCTION
1.1. Back ground of the study
The demand for money is verily researched area of economics. This is
due to the important role of private economic agents behavior
indetemining the outcome to economic policy reform that target
monetary aggergat.However, mach of the empirical research has
focused on developed economics.
During the last decade of the 20th century most of African countries
south of Sahara stated to important economic liberalization measures
and structural program(SAP).this changed situation has made empirical
investigation of money demand to remain of interest rate to
researcher.(Mishikin,2004).
Ethiopia is one of the sub Saharan African countries which have start
structural adjustment program(SAP).the reform measures implemented
safer have challenged the price of asset and their changes might have
affected the price of asset and this changes might have affected the
demand for cash balance farther more, Ethiopia is developing economy
with heavy dependence on external assistance. This situation makes the
beaver of domestics agent to the strongly influenced by external
economic and monetary development. This make is appropriate to
including a variable that measures changes in exchange rate. The
presence of stable money demands functions greatly facilitate the
conduct of monetary policy. If tells policy maker have different variables
are affected by change in the money supply.(Samual,2005).
1
Ethiopia had been ruled by the centrally planning socialist regimes for
nearly two decades (1974-1991).during this period most of the macro
economic variables such as interest rate, exchange rate and prices of
major commodities were administrate controlled. This has resulted in
macro economics in balance and generally poor performance of the
economy. After the overall throw of the socialist regime in may 1991,
the country is now in transition to market oriented economics system.
This was the time were structural adjustment program (SAP) was pre
cashed to b ea sleeping stone to adjust macroeconomic in balance and
ensure sustainable economic growth. Hence the government has
accepted and implementing the SAP by the IMF and WB since October
1992. According to this comprehensive economic reform program,
series of policy reform measures and regulations have been made in
view of correcting the distortions in the macro economy and fostering
economic growth.
2
1.2. Statement of the problem
Ethiopia is one of the poorest countries in the world are by ranking
132th out of total of 189 countries in pre capital basis (WB,
2014/15).Ethiopia economy like in other developing countries has poor
performance over effectiveness of macroeconomic policy. Therefore,
Ethiopia or other developing countries introduce different
macroeconomic policy reform to increase the performance their
economy.
3
demand for money has link between economic activity and monetary
policy.(AL.Saji,1998).
4
1.4 objective of the study
1.4.1 General objective
The main determinant of the paper is finding and identifying the
determinant of money demand in Ethiopia.
5
The study is using full to bridge the research gaps that
are not studded by previous researches. More over
hopes that to encourage other researcher in under
teaching. The study more deeply and broadly.
6
Ln MD=β0+β1realGDP-β2LnINF-β3lnER-
β4LnR+ei
Were
MD=money demand
RGDP=real GDP
ER=exchange rate
INF=inflation rate
R=interest rate
Ei=error term
7
Chapter two
2. LITERATURE REVIEW
2.1theoretical frame work
2.1.1 Definition of money
Before discussing the theoretical frame work of money demand, we
began with the definition of money.
The demand for money is closely related to the function and the
definition of money .money can be defined in quit different ways: thus,
the demand for money well be different depending on the combination
of asset that are included in specific monetary aggregate. however,
with some modification a theory of the demand for money (broader)
monetary aggregate can also be developed.Bofinger further explained
that the demand for money is an important building blank in more
economic theory that is it constitutes a main link between the monetary
sphere and the real sector of the economy.(peterBofinger,2003)
8
Money in monetary economics is not identified with total wealth as
the final element as the definition here rather; when we talk at money
we are discussing one part at wealth. An economics definition
concentrates on the earlier elements at dictionary definition; money is
defines by its use in commerce or exchange. This gives as the common
notation at money a medium of exchange or means at payment. in
other word money is the most liquid part of wealth which can be most
readily exchange for good and service.(S.B Guta,2001),but throughout
this paper the definition of money in monetary economics are used.
11
number of transaction determines the demand for money and classical
neglect money’s function as a store of value.(Hailekibret,2003)
13
the commodities consumed. Since interest paying assets such as
government bonds have face values fixed in term of money, however,
the same UN expected increase in price would reduce the real value of
those assets by the same percentages. Because in the riskiness of the
money cause an equal change the riskiness of bonds, changes in the
riskiness of holding money need not cause individuals to reduce their
demand for assets(Mithani,2004)
The price level: if the prices level rise, individual holds weekly
baskets of goods and service. To maintain the same level of liquidity as
before the price level increase, they will therefore have to hold more
money.
Ms=Md………………………………………2.1
Ms/p=L(R, Y)…………………………………2.2
Given price level (p) and output (y) the equilibrium interest rate is
the one at which aggregate real money demand equal to real money
supply. The market always moves towards an interest rate at which the
real money supply equals real money demand. if there is initially an
excess demand, it rises.(Mankiw&scarth,2002)
15
2.2 Empirical literature review
Money demand is one of the highly studied areas in macro
economics. In this section the empirical literature on money
demand function in the context of both developed and developing
economics will be reviewed.
(Daowitz & Elbadawi,1987)cited in kemal (2004) presented an
empirical analysis on the demand for money in Sudan using
annual data for the period 1956-1982the main determinant in the
model were income, the foreign exchange as pay to measures the
opportunity costs as holding foreign currency rather than domestic
money. It was found that in addition to income both the rate of
inflation and the rate of foreign exchange were significant
variables.
Recently (m.Fafoah, 2003) found that there is a strong co-
integration relation between the narrow and broad monetary
aggregates and the level of economic activity inflation and the
parallel market exchange premium for sirloin. According to
Fafoah, an empirical analysis the rate of inflation, the level of
economic activity and the exchange rate are significant movement
in the amount of domestic real money balance and the interest
rate has no any role in the domestic real balance. Fonfah also
conclude that the economic financial and institution from under
taken the country since 1989 do not preclude the estimation of a
reasonably stable money demand.
When we come to Ethiopia like other least developing
countries the empirical researches regarding to money demand
function are few in number compared to developed countries.
16
A different approach was made by stricken (1999) who discussed
the circumstances of the Ethiopia economy. A part from the
standard determinants of money demand, he specially focused on
a specific circumstance that characterized the Ethiopia economy in
the study period. In the paper he discussed the long run monetary
conditions in Ethiopia for the period 1966-1994, which covers
three decades. These decades come be characterize by large
political changes, leading to shock son income and population
growth and two series periods to drought. Both affected inflation
due to drops in rain fall might have long run monetary
consequances.Stricken found that even though there is a region
shift he find the stability of Ethiopia narrow money demand.
17
etc… had been used as a money in Ethiopia. The most important
and widely spread were salt during that time. Even after the
introduction of Maria Theresa in to Ethiopia salt continued to
exists as one the popular medium of exchange .In addition to
commodity money, metallic money like Maria Theresa, the coin of
Menelik ll, Haile selasie l, the lire the east African shilling and the
present type of coins have been serving as a medium of exchange.
(AyeleKuris, 2006)
18
CHAPTER THREE
3 .DATA AND METHODOLOGY OF THE
STUDY
3.1 Type and source of data
The data used for this is collected from secondary sources. Data
obtained from different organizations like national bank of
Ethiopia(NBE),central statistical authority (CSA),ministry of finance and
economic development(MOFED) and World bank(WB).In this study
annual data from 1982-2014 is used.
19
theories to draw up a list of variables that should be involved in any
equations to be tasted. (Keith Bain and peter Howells, 2003)
Were V=velocity
P=price level
Y=real income
M=money supply
Mv=total spending
Py=nominal in come
V=1/m*Py or m=1/v*Py
20
Mdd=1/v*PY=kPy………………………………(2)
Yp=permanent income
Mdd=money demand
21
expected return on money will fall. i.e. (rb-rm and re-rm) increase leads
to Mdd decrease.
RGDP=realGDP
ER=exchange rate
R=interest rate
𝜀i=error term
24
Test for stationary:-one of the classical liner regressions
is that the series should be in order to estimate on the base of ordinary
least square (OLS) procedure. A is said to be stationary if its mean and
variance are constant over time and the value of the variance between
two time period depends only on the distance or lag between the two
time period and on the actual period at which the covariance is
computed.(Gujarati,2004)
YT=pyt-1+ut…………………………………………………….eq.1
Empirical studies usually use the test ADF. For this study it will
employ ADF test and applied the test to each variable that will be used
in the analysis.
25
In order to ensure that the residuals are randomly dispersed
throughout the range of the dependent variable, we are going to use
the Hetroscedasticity test. The variance of the error should therefore be
constant for all values of the dependent variable. In the presence of
Hetroscedasticity, the distribution of the OLS parameters is no longer
normal. Hetroscedasticity is tested in this study using the Breusch-
pagan Godfrey test. The decision rule is to reject the null hypothesis if
the probability of the F-statistic and observed R2 less than 0.05,
meaning Hetroscedasticity is present. On the other hand, if the
probability of the F-statistic and observed R are greater than 0.05, we
do not reject the null hypothesis, implying that there is no
Hetroscedasticity. As such, errors are Homoscedasticity.
D ≈ 2(1−𝜌)…………………………………eq.2
26
the residuals, d≈ 0. There fore,the closer d is to 0,the greater evidence
of the positive serial correlation.(Gujarati,2004).
VIF=1/(1-rij2
TOT=1/VIF
27
CHAPTER FOUR
4. RESULTS AND DISCUSSION
4.1. Descriptive analysis
4.1.1. Development of monetary aggregate in
Ethiopia
Monetary policy is implemented by both developed and developing
countries; with the goal of achieving the objectives of full employment,
price stability, economic growth and other macroeconomic objectives.
28
Table 4.1 Growth rate of MD and R GDP
29
2006 19.99 10.83 8.699
2007 22.21 11.45 8.966
2008 23.39 10.78 9.6
2009 24.29 8.802 11.78
2010 39.19 12.55 14.41
2011 33.49 11.17 16.9
2012 22.09 8.65 17.7
2013 22.99 10.49 18.24
2014 23.99 21.29 19.53
Source: own Computation.
Based on the above table during Dergue regime i.e. 1982-1990, the
average annual growth rate of money demand was 12.79 percent per
annum. The average growth of MD during transitional government and
the beginning of EPDRF i.e. 1990-1999 was 12.62 percent per annum. By
the time of 2000-2008, the average growth rate of MD was 17.17.this
result shows that during the dergue regime average growth rate was
higher than transitional government and beginning of EPDRF. But it
starts to rises highly after the EPDRF stood its ground in the year of
2000 onwards.
30
decrease to 22.09 percent as compared to the past fiscal year growth
rate of money demand. And after 2012 again after 2012 again it starts
to rise reached 23.99 in 2014 year.
31
The macro economic performance of the military regime of the derge
was unsatisfactory. Over this period, real GDP grew on an average rate
of 1.44 percent per annum against population growth rate of 2.6
percent indicating declining of per capital income. This weak result is
attributed among other things, to the poor performance the agriculture
sector and huge military spending. During the same period the growth
of money demand or broad money were about 13.1 percent.
32
The performance of the economy as can be represented by the
country gross output is positively related to the money demand. This is
because in the more of Keynes, the Cambridge school invents the
theoretic model of money demand, shows that when income rise,
individual demand for money increases.
33
(birr) has been administratively fixed at 2.07 per us dollar for over three
decades.(Befikadu,1991)
The above table analysis shows that money demand has negatively
relationship with exchange rate.
35
As the Stata result of a Augmented Dickey Fuller (ADF) test at level
shows broad money demand (LMD) and real GDP are variable are
stationary at all (1%, 5%, 10%) critical values. but inflation rate (LINFL)
is stationary at (5%, 10%) and interest rate (LR) and exchange rate (LER)
are not stationary at 1%, 5%, 10%, and at all critical values.
37
Breusch-Pagan/cook-Weisberg test for
Hetroscedasticity
Ho: Constant variance
Variables: fitted values of md
Chi2 (1) =5.53
Pro > chi2 =0.187
From this we can conclude that there is no Hetroscedasticity
problem because the probability of F-statistics and observed R2 are
greater than 0.05.
3. Autocorrelation test
The most celebrated test for detecting serial correlation is that
developed by statisticians Durbin and Watson. It is popularly known as
the Durbin-Watson d statistic. A great advantage of the d statistic is
that it is based on the estimated residuals, which are routinely
computed in regression analysis.
38
This result shows that there is no serial correlation because it is found to
be closer to 2 in an application.
39
FROM the above table the value of VIF for the independent variables
are less than 10 and the value of the tolerance are less than 90% .from
this, we can conclude that there is no problem of Multicollinearity.
40
DLMD COEF STD.ERR. T P|T| 95%
CONF.
INTERVAL
DLRGDP 1.241416 .6210326 8.57 0.00 -1.108584
4.235592
DLINF -1.59356 .0168307 2.52 0.018 -.0493002
.0955329
DLER -0.626463 .5153178 8.94 0.000 -3.342879
1.091588
DLR -0.15707 .0107206 1.54 0.001 -.029612
.0626423
CONS -.1895583 .0341107 2.15 0.041 -.0040238
.2975568
Source own survey, 2016
41
So in my case because the residual of the residual of the original
data is non stationary I can take the first difference regression results
for the data analysis.
R 2= 0.9429 F( 4, 2 ) =2.78
42
R2 the higher value of R the higher fitness of the model (Guajarati,
2004). From the Stata the result the value R in which interred as the
explanatory variable explains about 94.29 % of the variation in money
demand. The remaining 5.71% of the money demand is explained the
variable which is not included in the model.
If the rate of real GDP increase by one percent other thing remain
constant, the money demand will increase by 1.241416percent. We
know that as GDP grows the per capital income of individuals will
increase this lead to the rise of money demand. The income and any
other variable that measures the value of the transaction emanates
from roles of money as a medium of exchange. The use as such a
variable is well documented in the works of Keynes, the Cambridge
school and Baumol Tobin inventory theoretical model of money
demand. In all the works it is shown that when real income raises
individual demand for money increases.
On the other hand if the rate of inflation rises by one percent other
thing remain constant, the demand for money will fail by 1.593564
percent. Since holding of money for a long period of time is opportunity
cost, peoples demand for money as inflation rises will fail. The use as
such a variable is documented in the work of kenyes. As expected
inflation increases individual reduce their holding of money. Thus,
43
inflation rate and money demand have negative relationship the other
variable is exchange rate.
From the table we can see that as the rate of exchange rate rises by
one percent other thing remain constant, the demand for money will
decrease by 0.6264634 percent. That is the depreciation of the currency
by one unit will result a decline in the demand for money by 0.6264634.
The use as such a variable is documented in work of Keynes. The
exchange rate increases individual money demand decrease.
44
CHAPTER FIVE
5. CONCLUSION AND RECOMMENDATION
5.1 conclusions
As the researcher tried to indicate in the outset, the main objective
of the study is to identify the determinants of money demand in
Ethiopia, knowing this determinant is very crucial for policy formulation
and its effectiveness.
45
The econometrics part result showed that the effect of real GDP on
money demand is very high relative to other variables and the inflation
rate is low. In general the paper found that in Ethiopia money demand
is affected by different factors but the main determinant are realGDP,
inflation rate, exchange rate and interest rate.
5.2 Recommendations
The main intent of this paper is to identify the main determinant
of money demand in Ethiopia. The result of the analysis showed that
exchange rate, inflation rate, realGDP, and interest rate are statistically
significance.
46
other measures beside deprecation of exchange rate have to be
taken like introducing import substituting industry and developing
the capacity of small scale industries. Otherwise only deprecation
of exchange rate will not be effective because it will affect money
demand in the long run negatively.
Strength supervision and regulation of financial institution;
Creating the opportunities for banks to allocate their resources on
economic principles in view of sterilizing the structure liquidity
problem.
Maintain creditability, transparency and public confidence in the
public confidence in the financial system by creating a sound and
competitive financial market; and
Deepening the financial sector liberalization to enhance
competition in the banking sectors.
47
Bibliography
AL. Saji. (1998). Foreign aid, foreign investment rate and the demand
for money in some developing countries in saving and development. No
Milan
Bain & Hawells. (2003). “the demand for money in iron “journal of
macroeconomics.
Behailu. (2003). the demand for money and monetary policy. Addis
Ababa. UN published MSC study.
48
M.Fafoah. (2003). The Demand for Money and the Implication for
Monetary Police in Sierra Lone” MSC Thesis School at Graduate Study
.Sierra Leion.
49
APPENDIX
Appendix 1
Appendix 2
VARIABLES 1% 5% 10% Test P value
critical critical critical statistic
value value value
51
Variables 1% critical 5% critical 10% Test P value
value value critical statistic
value
DLMD at -3.709 -2.983 -2.623 -6.312 0.027
second
difference
DLRGDP -3.709 -2.983 -2.623 -4.692 0.0060
at first
difference
DLINFL at -3.709 -2.986 -2.623 -6.602 0.000
first
difference
DLER at -3.716 -2.986 -2.624 -5.487 0.015
second
difference
DLR at -3.709 -2.983 -2.623 -5.106 0.000
first
difference
|
52
Total 030486648 6.005081 0.04819
53
Variable VIF 1/VIF
DLER 1.36 0.736410
DLINF 1.32 0.793745
DLRGDP 1.22 0.818364
DLR 1.14 0.876279
Mean VIF 1.25 ---------
Breusch-Pagan/cook-Weisberg test for
Hetroscedasticity
Ho: Constant variance
Variables: fitted values of md
Chi2 (1) =5.53
Pro > chi2 =0.187
54
55