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Asnake Final Thesis
Asnake Final Thesis
Asnake Final Thesis
September 2021
Declaration
This research paper, entitled the impact of money supply on inflation in Ethiopia is my original
work submitted for the award of the fulfillment for Bachelor of Art (B.A) Degree in Economics
at the Department of Economics, Addis Ababa University. It has not been presented for the
award of any degree in any other institution of higher learning to the best of my knowledge, and
all resources used have been duly acknowledged.
Signature__________
Date:_______________
Date: ________________
Table content
acknowledgment...............................................................................................................................................................
acronyms...........................................................................................................................................................................
list of figure.......................................................................................................................................................................
list of table .......................................................................................................................................................................
Abstract.............................................................................................................................................................................
CHAPTER ONE.............................................................................................................................................................1
INTRODUCTION..........................................................................................................................................................1
1.1 Background of the study...........................................................................................................................................1
1.2 Statement of the Problem..........................................................................................................................................4
1.3 Objective of the study...............................................................................................................................................7
1.4 Research questions..................................................................................................................................................7
1.5 organization of the study...........................................................................................................................................7
Chapter Two....................................................................................................................................................................8
2 Literature review..........................................................................................................................................................8
2.1 Definition and Functions of Money..........................................................................................................................8
2.2 Theories of money..................................................................................................................................................12
2.2.1 Classical Theories of money demand..................................................................................................................12
2.2.2 Keynes’s Liquidity Preference Theory................................................................................................................13
2.2.3 Friedman’s Modern Quantity Theory of Money..................................................................................................14
2.2 Money supply and Monetary Policy.......................................................................................................................15
2.3.1 Goals of money policy.........................................................................................................................................17
2.4 The definition of inflation.......................................................................................................................................18
2.4.1. Types of Inflation................................................................................................................................................19
2.4.2. Theories of Inflation............................................................................................................................................19
2.5 Inflation and Monetary Policy................................................................................................................................22
2.6 Inflation and Unemployment..................................................................................................................................23
2.7 Inflation and Interest Rate.......................................................................................................................................24
2.8 Empirical literature..................................................................................................................................................25
2.8.1 Empirical finding around the world.....................................................................................................................25
2.8.2 Empirical finding in Ethiopia...............................................................................................................................26
CHAPTER THRE.........................................................................................................................................................33
3 Methodology of the study........................................................................................................................................33
3.1 Analytical framework.............................................................................................................................................33
3.2 Type, source and collection of data.........................................................................................................................34
3.3 Method of data analysis..........................................................................................................................................34
3.3.1 Model specification..............................................................................................................................................34
3.3.2 Variable description.............................................................................................................................................35
3.4Analysis and Data Explanation Techniques.............................................................................................................36
3.4.1 Pre-Estimation......................................................................................................................................................36
CHAPTER FOUR.........................................................................................................................................................39
4 Data presentation, Analysis and Discussion..............................................................................................................39
4.1 Trends Monetary Aggregates..................................................................................................................................39
4.1.1 Trends in inflation rate.......................................................................................................................................40
4.1.2 Trends of CPI general, food CPI and nonfood CPI.............................................................................................43
4.1.3 Trends of CPI and real GDP................................................................................................................................43
4.1.4 Trends of CPI and broad money supply...............................................................................................................44
4.2 Econometrics analysis.............................................................................................................................................46
4.2.1 Unit root test.........................................................................................................................................................46
4.2.2 Co integration.......................................................................................................................................................47
4.3 The Long-Run Relationship....................................................................................................................................48
4.3.1 The long run model..............................................................................................................................................48
4.3.2 The short run error correction model...................................................................................................................50
4.4 Tests for Multi Co-linearity (VIF)..........................................................................................................................52
4.5 Auto-correlation test...............................................................................................................................................52
4.6 Omitted variables test..............................................................................................................................................53
4.7 Normality test..........................................................................................................................................................53
CHAPTER FIVE...........................................................................................................................................................55
5. Conclusions and Implications...................................................................................................................................55
5.1 Conclusions.............................................................................................................................................................55
5.2 Implications.............................................................................................................................................................56
Reference......................................................................................................................................................................58
Appendix...........................................................................................................................................................................
...........................................................................................................................................................................................
...........................................................................................................................................................................................
ACKNOWLEDGEMENT
Being in a very busy schedule, finishing my senior paper in time has not been
possible without the help of others. First of all, I am gratefully thanks my almighty
God, who helping me in all aspect of my life. Secondly, I really appreciate my
advisor Dr. Tadele Ferede for his constructive advice and guidance while I was
writing this thesis. I am grateful to his invaluable comments and suggestions from
which I have benefited a lot.
WB – World Bank
Figure 4.2 trends of CPI general, food CPI and nonfood CPI
List of tables
Table 4.0 Broad money and its components
Inflation is one of the major macroeconomic problems which affect the smooth functioning of
the economy through its adverse effect on the overall social, economic, technological and
political systems of the country. The purpose of this study is to figure out the impact of money
supply on inflation of Ethiopia. The study uses secondary data from the period 1982 to 2020
obtained from National bank of Ethiopia, Central statistical agency and Ministry of Finance and
Economic Cooperation.To identify the true trend, impact and significant determinants of inflation
both in the long run and short run descriptive statistics and econometric analysis are employed.
The finding of this study shows that broad money supply, lagged CPI and real gross domestic
product are significant in determining inflation both in the short run and long run.
Finally, the study recommends that government, other institutions and policy makers should give
more emphasis to those variables which significantly affects inflation by taking appropriate
fiscal, monetary and even income policies and their impact on the economy needs to be
considered at the time of policy formulation.
CHAPTER ONE
INTRODUCTION
Throughout history in every society Barter was used as a means of exchange and always
something has evolved to perform the functions of money where people exchange their product
without any medium of exchange and this system were costly and inefficient each society
innovated something which could be used as a medium of exchange. Barter lacks satisfactory
means of measuring the value of goods. Other failure of Barter trade is difficulty relates to the
storage of goods for the future requirement. Money as a unit of account or standard value
overcomes this problem of barter system. The values of all goods are expressed in terms of
money as a common denominator of values, which fixes the ratio of exchange (Aiyar, 1984).
Today we use money issued by governments. In general money has been different things at
different times: however, it has always been important to people and to the economy. The
existence of an efficient medium of exchange (money) is essential to permit each of us to
specialize in what we are relatively most efficient in producing; that is our comparative
advantage. In its macroeconomic role, money permits the society to achieve a more efficient
allocation of resources. Money facilitates the flow of resources in to their most efficient uses.
The ultimate result is increased efficiency of the economy and increased economics welfare of
the society (Gupta and Abrol, 2001).
Policies are courses of action adopted by the government, business, individual and national
banks. One of the ways that the government manage the economy in such a way as to influence
the behavior as well as the performance of the economy as a whole is through macroeconomic
policy. The main objectives of macroeconomic policies are; to achieve full employment of
resources, price stability, economic growth, balance of payment, equilibrium and appropriate
distribution of income and wealth (Ghatak, 2001).
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But from economic point of view attaining all these issues is very hard or difficult. In this case it
means, policy objective may conflict and hence conducting macroeconomic policies have trade
off between objectives. There are different kinds of variables which the government tries to
control with macroeconomic policies. For example; variables like unemployment, inflation,
interest rates and so on. But the problem is some variables are negatively related, making it
difficult to achieve our objectives. For example, inflation and unemployment are inversely
related; so achievement of full employment may therefore lead to excessive inflation through
aggregate demand excess in the economy. Also, the other possible conflict is between rapid
economic growth and balance of payment. This is, as income increases, it may result into
increasing imports, hence resulting into damaging consequence for balance of payment (Vaish,
2002)
In Ethiopia the monetary policy framework swings between conflicting objectives of restraining
inflation and accelerating economic growth. The Ethiopian government has been undertaking
various measures to stabilize inflation including monetary policies, such measures as raising the
reserve requirement (rr) of banks, increasing interest rates, and reducing domestic credit. Rapid
economic growth in real GDP has closely coincided with the inflation rate in recent years (BKP,
2013). However, some empirical studies indicate that inflationary situation in Ethiopia are due to
fast increase in broad money supply and other fiscal policy instruments (Jema and Fekadu,
2012;ADB, 2011; Desta, 2009). But, the study of Teshome (2011) indicates that the source of
inflation and economic growth in Ethiopia is not a monetary phenomenon, and thus to control
money supply (to reduce inflation) will hinder economic growth of the country. In other words,
money supply has positive impact on economic growth.
During the earlier years of the present regime inflation has been low despite the huge inflow of
money by the IMF and other donors. This happened because the displacement of former
government soldiers and layoffs of workers due to the structural adjustment policy (SAPs)
followed by the country had depressed demand. This depression of demand counteracted the
inflationary impact of increased demand due to the inflow of aid (Mamo, 2008).
2
However in the post 2002/03 inflation began to appear as a major problem of Ethiopia following
the government’s move towards less conservative monetary and fiscal policy and state activism
as a developmental state in the economy. During the same period, the economy is reported to
have recorded a fast growth, export receipts have increased substantially and domestic tax
revenue has increased. Government expenditure have grown considerably, there has also been
fast increase in money supply mainly as a result of growth in fiscal deficits. Studying the linkage
between price developments and various macro-economic variables will, therefore enable us to
understand the causes of the current inflation.
In Ethiopia money supply was increased time to time. components of money supply such as;
narrow money supply, Quasi money and broad money supply. In fiscal year 2019/20 all
components of broad money have witnessed a surge. Narrow money rose by 16.7 percent due to
growth in demand deposits and currency outside banks, reflecting growth in economic activities.
Similarly, quasi money, consisting of savings and time deposits, rose by 17.2 percent and
reached Birr 677.1 billion at the end of the fiscal year as commercial banks increased their
deposit mobilization by opening additional new branches, broad money supply (M2), reached
Birr 1.04 trillion reflecting a 17.0 percent annual growth mainly due to the 23.6 percent surge in
domestic credit. The high growth in domestic credit was attributed to a 37.4 percent increase in
central government and 21.8 percent rise in credit to non-central government (NBE 2020)
Ethiopia experienced lower inflation rate in the past but when we view the recent data have a rate
of 2.7 percent in April 2009 and it varies from time to time as 20.8 percent in 2012, 7.4 percent
in 2013, 8.5 percent in 2014, 10.45 percent in 2015, 7.5 percent in 2016 , 10.69 percent in 2017,
13.83 percent in 2018, 15.87 percent in 2019 and In 2020, the average inflation rate in Ethiopia
amounted to about 20.35 percent compared to the previous year (CSA, 2020). The living
standard of urban dweller has been adversely affected by inflation in Ethiopia. Inflation also
redistributes wealth there by increasing the number of poor people in the country. Even if it is,
said by the government that farmers benefit from rising food prices, something that needs
empirical investigation, rise in food prices are causing many to be unable to feed themselves.
Most importantly inflation in Ethiopia may misallocate resources from productive to
unproductive sectors.
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1.2 Statement of the Problem
Money supply is the total amount of money in the economy. Most of the time it is used in two
senses, a narrow sense and a broader sense. The narrow sense includes currency plus demand
deposits. It refers to the medium of exchange function of money. While money supply in its
narrow sense includes only coins, rates and demand deposits, in its broader sense it would
include time deposits (Investopedia).
In fact, inflation is the increase in the supply of money and credit. When the supply of money is
increased, people have more money to offer for goods. If the supply of goods does not increase
or does not increase as much as the supply of money, then the price of goods will go up. A
“price” is an exchange ratio between a dollar and a unit of goods. Friedman (2011) argued that
“Inflation is always and everywhere a monetary phenomenon.”
Zewdu’s (1997) on the dynamics of inflationary process in Ethiopia is one of the studies. In
identifying the real causes of inflation in the country in both monetary and structural point of
view from the period 1967-1994, he uses a series of equations to identify the major
determinants of inflation on both approaches. The paper looks in to the short-run and long-run
determinants of inflation. Monetarist model is explained by money demand and money supply
framework. There are institutional and structural factors, which are equally important especially
in developing countries. Money supply increase cause inflation to increase but structural factors
cause money supply to expand without central bank influence. Zewdu by adding structural
factors on the monetary model takes money supply, expected price level, world inflation rate
government deficit and real exchange rate in determining inflation.
Habtamu (2000) used the data between1962-1997and his study suggested that money supply has
significant role in determining inflation in Ethiopia but he ignored the impact of other variables
like government expenditure and gross domestic saving on the inflationary pressure on Ethiopian
economy.
Semmu (2004) mentioned factors like money supply, real GDP, budget deficit as determinant of
inflation and finally suggest money supply is statistically insignificant in determining inflation.
4
However in current Ethiopian economy, money supply is the basic determining variable of
inflation.
Kejela (2007 included varies variables such as real GDP, money supply, government expenditure
and real effective exchange rate and budget deficit in his model. But finally his findings suggest
that money supply and real GDP play an important role in determining inflation in Ethiopia.
Another related work is done by Yohannes (2008), he used in his study the monetary, structural
also the supply and demand side models on inflation. The monetarist model explained the short-
run inflation in Ethiopia only. Money supply and output are explanatory factors in the model.
Exogenous factors like war &drought were included in affecting short-run dynamics of inflation.
The monetary model showed that in the long-run inflation is not a monetary phenomenon. The
structural model inflation the supply side (structural) variables of Ethiopia inflation unlike the
monetarist model; it explained the short-run and long -run inflationary process in Ethiopia. This
study shows that monetarist factors explained inflation in the short- run while in the long-run,
inflation remains to be structurally determined. Yohannes also come to a conclusion that
exchange rate plays no role in the short as well as in the long-run in explaining Ethiopia’s
inflation process.
Wolde-Rufael(2008) assessed the causal link among inflation, money and budget deficits in
Ethiopia for the period 1964 to 2003 using the bounds test approach to co-integration due to
Pesaran et al. (2001) and using a modified version of the Granger causality test due to Toda and
Yamamoto (1995). To check the robustness of the bounds test, we also used two additional long
run tests: the dynamic ordinary least squares (DOLS) due to Stock and Watson (1993) and the
fully modified ordinary least squares (FMOLS) due to Phillips and Hansen (1990). The empirical
evidence shows that there was a long run co-integrating relationship among the series with a
unidirectional Granger causality running from money supply to inflation and from budget
deficits to inflation. In contrast, fiscal policy does not seem to have any impact on the growth of
money supply. The implication is that fiscal balance and the control of the money supply are
essential policy tools for the long-run macroeconomic stability of Ethiopia.
5
Bethlehem (2012) analysis current inflation in Ethiopian economy using econometric model. She
included CPI as dependent variable and money supply, real GDP as independent variables and
suggests money supply have no any impact in determining inflation in Ethiopia.
During the Derg regime, inflation has been low in Ethiopia for the reason that the price was
controlled by the government and the government itself was providing goods at fixed price to the
public. Further, the lower and fixed exchange rate has also contributed to the lower inflation rate.
Similarly, inflation rate has been low in the earlier years of the present government (Sisay,
2008). However, in recent years inflation has been high in Ethiopia. Inflation Rate in Ethiopia
averaged 16.52 percent from 2006 until 2021, reaching an all-time high of 64.20 percent in July
of 2008 and a record low of -4.10 percent in September of 2009. The current inflation rate is
20.63 (www.trading economics.com).
Though Ethiopia has experienced a low inflation, recently, double digit inflation has become
worrisome for policy makers as well as the society. Emirta (2013) has studied the optimal level
of inflation in Ethiopia around which inflation affect economic growth optimally. The study has
applied threshold approach. By doing so on the data from 1971-2010 inflation level of about 8%-
10% is optimal for Ethiopia. Any inflation level, greater or less than the estimated threshold
level, may not allow long-term and sustainable economic growth.
Since the level of income in Ethiopia is very low but expenditure on consumption items such as
food is very high, inflationary experience results in a low level of welfare. Thus, it is essential
that the government intervene to control the price trend in the country. However, such
intervention requires appropriate policies devised from careful observation of the forces behind
the price fluctuations. Therefore, studying the possibility of controlling inflation and its
dynamics is one of the themes to be addressed in Ethiopia.
Tsegay(2016) examined the causal link among budget deficit financing, money supply (M2), and
inflation, in Ethiopia using time series annual data over the period 1974/75 – 2013/14. In
analyzing the data, co-integration approach under the framework of the vector error correction
model was employed. The model has supported several statistical tests and hence it is robust.
The study concluded that domestic sources of budget deficit financing and money supply (M2)
growth were long term determinants of inflation. In the short run, in contrast, inflation inertia and
local currency depreciation were found the prime sources of inflation.
6
The empirical evidences show that inflation process in developing countries has been influenced
by both structural and monetary variables. Thus, one of the reasons for differences in countries
on their price stability or inflation is that their use or choice of monetary institution and their
policy structure. All researchers try to see the determinants of inflation and they do not identify
which variables are the lion share in determine inflation and they do not focus on specially the
impact of money supply on inflation and there is no clear cut about the impact of money supply
on inflation. So, this paper tries to fill this gap by taking time series data from 1981/82-
2019/2020.
Specific objectives:
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Chapter Two
2 Literature review
2.1 Definition and Functions of Money
In every society Barter was used as a means of exchange and always something has evolved to
perform the functions of money where people exchange goods and services directly without any
medium of exchange. In a Barter economy people exchange their goods and services directly
without any medium of exchange & since this system were costly and inefficient each society
innovated something which could be used as a medium of exchange.
It is obvious that exchange without money would not be very efficient. Barter requires a double
coincidence of wants. Each of us must find someone else who both wants the goods we have and
has the good we want. Thus, the transaction cost mainly in the form of search cost will be high
and hence it makes specialization unattractive and hence people will tend to be self sufficient in
their production, which will make them inefficient.
Barter also lacks satisfactory means of measuring the value of goods. Money as a unit of account
or standard value overcomes this problem of Barter. The values of all goods are expressed in
terms of money as a common denominator of values, which fixes the ratio of exchange. Other
failure of Barter trade is wants of means of subdivision and difficulty relates to the storage of
goods for the future requirement. Money can be stored with relatively less change in its value
and since money is divisible it avoids a loss occurring due to lack of change in Barter system.
Money is a means to an end, it is valued not for its own sake but for its purchasing power. It
benefits both the consumer and the producer. Money is basis of the specialized production and
the pricing mechanisms of the present days. (Aiyar, 1984)
Money could be defined as (Aiyar, 1984) put it; money is what is commonly accepted in
payment of goods and services or in repayments of debts. Also is could be defined as said by
( Gupta and Abrol, 2001); money is defined as anything that is accepted generally that serves as
a medium of exchange that facilitates economic process of production, distribution and
construction. Another definition of money by (Aiyar, 1984) was, money is a universal third
8
commodity chosen by common consent to be a medium of exchange and measure of value and
accepted in payment of full final discharge of obligation.
“Anything that is generally accepted in payment for goods and services or in payment of debts”
(Mishikin, 2004)Therefore currency, consisting of dollars, bills and coins, clearly fits this
definition and is one type of money. However to define money nearly as a currency us too much
narrow for economist. Because checks are also accepted as payment for purchases, checking
account deposit is also accepted as payment for purchases, checking account deposits are
considered as well. Hence, Mishkin(2004) further pointed that an even broader definition of
money is often needed, because other items such as saving deposits can in effect functions as
money if they can be quickly and easily converted in to currency or checking account deposits.
As we can understand here, there is no single, precise definition of money or the money supply,
even for economists.
The chamber 20th century dictionary (1983) cited in Bain and Howells (2003) provide the
definition of ‘Money’. It is “coin, pieces of stamped metal used in commerce, any currency,
wealth.”
Functional definition of money: as the name implies this approach defines money based on its
functions. This can be best explained by the statement of sir John Hicks, “Money is defined by
its functions: anything is money which is used as money, money is what money does.” also
Scitovisky points out, “money is a difficult concept to define partly because it fulfills not one but
three functions, each of ding a criterion of moneyness ... those of a unit of account, a medium of
exchange, and a store of value.
Legal definition of money: some economists define money as anything which the state declares
as money is money. Such money possesses a general acceptability and has the legal power to
discharge debts. (Jhingan. 2002)
But it has been thought that the functional definition of money is arbitrary because what money
does in one community may be different in other community. Also the legal definition of money
is not convincing because peoples may not accept legal money refusing to sell good and services
against the payment of legal tender money.
9
Theoretical and empirical definition of money
The theoretical approach defines money by using economic theory decide which asset should be
included in its measure. The key feature money is that it is used as a medium of exchange.
Therefore the theoretical approach focuses on this aspect and suggests that only assets that
clearly act as a medium of exchange belongs in money supply.
Professor Johnson (cited in Jhingan, 2002) distinguishes the following schools who give
theoretical definition of money.
The traditional definition of money: according to the traditional view, also known as the view of
currency school, money is defined as currency and demand deposit.
Friedman's definition of money (Monetarist view): Friedman gives two types of definition of
money, one on theoretical bases and the other on empirical basis. Theoretically, he defines
money as "the sum of currency plus all adjusted deposits in commercial banks." This is quite
different theoretical definition because it includes less liquid assets such as time deposit in its
definition of money.
The Radcliffe definition: the Radcliffe committee defines money as note plus bank deposits. It
includes as money only those assets which are commonly used as a medium of exchange.
The Pesek and Saving definition: according to Pesek and Saving, money should include demand
deposits of banks as well as money issued by the government. They exclude time and saving
deposit from bank money.
However, the theoretical approach is not a clear-cut as because other assets than those mentioned
above can medium of exchange function even if they do not posses equal liquidity as currency
and demand deposit.
The ambiguities inherent in the theoretical approach in determining which asset should be
included in a measure of money have lead economists to suggest that money should be defined
with more empirical approach; i.e. the decision about what to call money should be based on
10
which measure of money work best in predicting movements of variables that money is supposed
to explain though this has also its own limitation because we cannot be sure that a measure
which has worked well in the past would work well in the future. (Mishkin, 2005)
In relation to this professor Johnson also identify the following empirical definitions of money.
Gurley Shaw definition: Gurley and Shaw based on their and Goldsmith's empirical findings
regards a volume of liquid assets held in financial intermediaries and the liabilities of non-bank
intermediaries as close substitutes for money.
Money is a liquid asset used in the settlement of transactions. It functions based on the general
acceptance of its value within a governmental economy and internationally through foreign
exchange. The current value of monetary currency is not necessarily derived from the materials
used to produce the note or coin. Instead, value is derived from the willingness to agree to a
displayed value and rely on it for use in future transactions. This is money's primary function: a
generally recognized medium of exchange that people and global economies intend to hold, and
are willing to accept as payment for current or future transactions.
Economic money systems began to be developed for the function of exchange. The use of money
as currency provides a centralized medium for buying and selling in a market. This was first
established to replace bartering. Monetary currency helps to provide a system for overcoming the
double coincidence of wants. The double coincidence of wants is a ubiquitous problem in a
barter economy, where in order to trade, each party must have something that the other party
11
wants. When all parties use and willingly accept an agreed-upon monetary currency, they can
avoid this problem(INVESTOPEDIA)
Irving Fisher (1911) in his book of purchasing power of money gave a clear statement of his
version of quantity theory of money demand. In this analysis, the main question that he raised
was what determines the amount of money an economy needs to carry out a given transaction.
Fisher develops an identity what is known as equation of exchange and can be given as:
MV = PT .................... (2.1)
Where M is the quantity of money supply, V is the number of times money turns over transaction
velocity of circulation), P is price level and T is the volume of transactions.
Fisher treated all the variables in the equation of exchange to be determined independently of
each other and this consideration of him transforms the equation of exchange in to quantity
theory of money.
Where Md/P is money demand measured in real terms (given money market is in equilibrium; M
(money demand) = Md (money demand)), k = 1/v and T is volume of transactions.
Generally, Fisher quantity theory of money suggests that the demand for real money balance is
purely depends on the current value of transactions to be conducted in the economy and equal to
the constant fraction of those transactions.
12
The Cambridge Approach to Money Demand: developed by Marshall and A.C Pigou and
received a clearest exposition in Pigou (1917) is another important contribution of the classical
economists to the theory of money demand. Instead of studying the demand for money by
looking solely at the level of transactions as a key determinant, the Cambridge economists asked
what determines the amount of money an individual agent would wish to hold.
The Cambridge economists substitute volume of transactions (T) by level of income (Y) in the
money demand function by assuming for an individual the levels of wealth, the volume of
transaction and level of income to be in stable proportion to one another. Gupta (1982) gives the
reason for this, as both empirical and theoretical. Empirically data are! available on Y not on T'.
Theoretically, with the publication of Keynes' General theory (1936), the problem of income
determination came to occupy the center of the stage of monetary theory.
Although the Cambridge economist's hypothesized a money demand function which looks
similar to Fisher, there are significant differences between the two. One is the Cambridge
economists substitute velocity of circulation of money by income velocity and the other is even
if they did not explicitly include interest rate in there money demand function they did not ruled
out its effect. Generally, the classical economists put money demand only as a function of
income.
The transaction and precautionary motives give rise to the transaction and precautionary demand
for money respectively and Keynes, like the classical economists; took both to be proportional to
income. The speculative motive giving rise to speculative demand for money most important
contribution Keynes made to the theory of money demand. He identify that the speculative
demand for money is a function of interest rate.
By putting the three motives together, Keynes formulates the following demand for money
function:
13
Md/P= f(Y,r)…………………...... (2.3)
Where Y is real income, r is interest rate and M/P is real money demand. Keynes's theory of
money demand considered the role of money as a store of value in addition to its role as a
medium of exchange. It postulates the demand for money measured in real terms is a function of
income and interest rate. It relates positively to income and negative to interest rate.
The transactions demand for money: this is further development in Keynesian theory of money
demand adopted by Baumol (1952) and Tobin (1956). The model is different from the previous
ones because it recognizes the transaction demand for money is not only a function of income
but also interest rate.
According to him money can be viewed as an asset and one can analyze the demand for money
in the same way the demand for any other goods analyzed. In addition to this, Friedman believes
that money is demanded because it yields a flow of service to its holders.
Where Y is real income. W is the fraction of wealth in non human form (traction of income
derived from property), ry is rate of return on fixed value securities such as bond, re is expected
rate of return on equities (for both (rb and re) including expected change including expected
change in their prices), πe is expected rate of return on real assets (expected rate of change of
14
prices of goods) and u represents other variables that may affect the utility attached to the service
of money.
The novel and important contribution of Friedman to the theory of money demand is his
extension of the margin of substitution of money to stocks of goods, unlike Keynes who consider
bond only as a substitute asset to money.
Money supply is the total amount of money in the economy. Most of the time it is used in two
senses, a narrow sense and a broader sense. The narrow concept: The deposits that are counted
within this occasional concept are current deposits for the private sector only, and the money
supply in the narrow sense is expressed by the following equation: (money supply = currency in
circulation + current deposits), and current deposits mean what is deposited with the bank of
funds for specific periods and deposits vary according to the depositor's right to withdraw from it
immediately or after a specified period, it is divided into the following (demand deposits, current
deposits, current accounts), and the customer has the right to deposit or withdraw from it at any
time, while the broad concept definition of cash presentation revolves around adding savings
deposits for the sector to the money supply and it is expressed by the following equation (money
supply = currency in circulation + current deposits + accounts and term deposits + savings
accounts), and future deposits include placing money in savings accounts in a financial
institution that pays an interest rate Fixed until the specified due date, and money, in general,
cannot be withdrawn during the time frame covered in future deposits to pay a fine. As for the
savings account, savings accounts are generally opened to preserve the money that you do not
intend to use to cover daily or regular expenses, and savings accounts also differ. For current
accounts that allow you to write checks and use electronic debit to access funds, just as savings
accounts are unlike current accounts because they usually put a limit on the number of
withdrawals or transactions that you can make each month. As for the money offer, Samelson
knows it (M2) (Includes quasi money, which includes deposits of savings accounts in banks and
investment fund accounts in the money(Alhamdany and Obaid, 2020)
15
The conventional approach is functional. That is function determines nature. So money is what
money does. It is generally accepted means of payment or it mediates exchange. In this sense, it
includes currency and demand deposits of commercial bank. It is the narrow sense ( Aiyar, 1984)
The Chicago approach headed by Milton Friedman includes other than currency and demand
deposits, saving deposits and time deposits due to their nearness to demand deposits. They are
not perfect substitutes of demand deposits even though they are not directly spendable because
they do not provide means of payments as demand deposits does. (Aiyar, 1984)
The third approach is the Gurely & shaw approach. They consider various assets in which to
hold one’s wealth. And money is one of form of wealth holding. Currency and demand deposits
are not unique assets; they are just two among many things that are claims against financial
intermediaries. This approach considers a large spectrum of financial assets that are close
substitutes as alternative liquid store of value and assign weights on the basis of the degree of
substitute ability ranging from one to zero. The more imperfect a substitute, the less weight is
(Ibid, 1984)
The other approach is the central banking, which considers credit or funds loaned to borrowers
from whatever source. It equates money with total credit and also considers total credit
availability as the key monetary policy variable for regulating the economy. Money supply can
be determined by central bank and by the requirements of the economy. So money supply is
determined partly exogenously and partly endogenously. It is better to see in to the definition of
monetary policy before discussing the details. Monetary policy is a means by which the central
bank influences the demand, supply and hence, price of money and credit in order to direct a
nation’s economic objectives. (Heakal, 2004)
Monetary policy is also one of the tools that a national government uses to influence its
economy. It uses its monetary authority to control the supply and demand availability of money.
It also means management of money in furtherance of economic policy of the state. It is also
defined as a regulation of the money supply and interest rate by a central bank affecting cost of
money in turn affects money that is spend by consumers and business. (Web finance. Inc. 1997-
2004)
16
Central bank today is the most important feature of the financial system of most countries of the
world. Central banks are bizarre hybrids. Some of their functions are identical to the functions of
commercial banks. But on certain functions it has an absolute legal monopoly. A nation’s
principal monetary authority, such as the federal bank (USA) and national Bank of Ethiopia,
which regulates the money supply and credit, issues currency and manages the rate of exchange.
(Dr Atnafu, Lecture note)
Activities and responsibilities of central bank Central bank has a wide range of
responsibilities, from overseeing monetary policy to implementing specific goals. Functions of
Central bank includes; monopoly on the issue of bank note, the government’s banker, manages
the county’s foreign exchange and gold reserves and the government’s stock register, regulation
and supervision of the banking industry, and setting the official interest rate; which is used to
manage both inflation and the country’s exchange rate.
Policy instruments of the central bank; are monetary Policy instruments can be divided in two
main types; Direct controls; are typically directives given by the central bank to control the
quantity or price (interest rate) of money deposited with commercial banks and credit provided
by them. And indirect instruments: - in the monetary area, financial liberalization involves a
movement away from direct monetary controls to ward indirect ones. The later operate by the
central bank controlling the price or volume of the supply of its own liabilities, reserve money,
which in turn may affect interest rates more widely and the quantity of money and credit in the
banking system.
There are six basic goals which are mentioned continually by personnel at the Federal Reserve
and other central banks. These are; high employment economic growth, price stability, Interest
rate stability, stability of financial markets and stability in foreign exchange markets. Usually the
objectives of monetary policies in the developing countries are related to money and credit
control, price stabilization and economic growth. Price stabilizing is considered as the most
important or major objectives of monetary policies in the LDs. A tight monetary policy impedes
economic growth (Vaish, 2002)
17
While achieving this objective monetary policy could enable the authority to achieve another
objective, which is full employment. Monetary policies are also regarded as useful for achieving
equilibrium in the balance of payments and stabilize the exchange rate in the LDs. (Ghatak,
1981)
Monetary policy has objectives depending on the changes in the economic environment.
Exchange rate stability was regarded as the principal or major objective of monetary policy for
long. And then the great depression of the thirties with its high unemployment together with
general theory of Keynes (1936) led to the replacement of exchange rate stability as a major
objective 0f monetary policy (Aiyar, 1984).
Inflation is a highly controversial term which has undergone modification since it was first
defined by the Neo-classical economists. Neo classical defined inflation as a galloping rise in
prices caused by excessive increase in the quantity of money. For Keynesian s true inflation
happens when money supply increases beyond full employment level (Jhingan, 1997). Though
various economists define inflation in different ways there is an agreement that inflation is a
sustained increase in the general price level or, alternatively, as a sustained or continuous fall in
the value of money.
Even though inflation is a sustained rise in prices it may be of various magnitudes. When the rise
in prices is very slow Like that of a snail or creeper, it is called creeping inflation. Creeping
inflation happens when prices increase less than 3 percent per annum. Such an increase is
regarded as safe and essential for economic growth. When prices rise at a rate greater than 3 but
less than 10 percent per annum, it is called walking inflation. Walking inflation is a warning
signal for the government to control inflation before it becomes running inflation. An annual
increase in prices at rate of 10 to 20 percent is called running inflation. When inflation rate goes
above 20 percent it is called hyperinflation (Sisay, 2008).
Inflation could be considered as an outcome of demand side (monetary) shocks, supply side
(real) shocks, price-adjustment (inertial) factors and/or political (institutional) factors
(Kibritçioğlu, 2002)
18
2.4.1. Types of Inflation
Even though inflation is a sustained rise in prices, it may have various magnitudes. When the rise
in prices is very slow Like that of a snail or creeper, it is called creeping inflation. Creeping
inflation happens when prices increase less than 3 percent per annul. Such an increase is
regarded as safe and essential for economic growth. When prices rise at a rate greater than 3 but
less than 10 percent per annul, it is called walking inflation. Walking inflation is a warning signal
for the government to control inflation before it becomes running inflation. An annual increase in
prices at rate of 10 to 20 percent is called running inflation. When inflation rate goes above 20
percent it is called hyperinflation. (Jhingan, 1997).
19
Accordingly, there will be a positive relationship between inflation levels and money supply.
They further explain this relationship by using the theory of natural rate of unemployment. The
theory of natural rate of unemployment suggests that there will be a level of equilibrium output,
employment, and corresponding level of unemployment naturally decided based on features such
as resources, employment, technology used and the number of firms in the country etc. The
unemployment level decided in this manner will be identified as natural rate of unemployment.
However, in the short run, expansionary monetary policies will result in the decline in the rate of
unemployment and increase the production but the effectiveness of the expansionary policies
will be limited in the long run and lead to an Inflationary situation ( Labonte, 2016)
C. Structuralism theory of Inflation
According to this view inflation arise in developing countries due to structural rigidities of their
economy. The advocates of structural inflation say that the agricultural sector is irresponsible to
price increases in developing countries due to defective system of land tenure, lack of irrigation,
lack of storage and marketing facilities, bad harvest and the depends of agriculture on rain.
(Jhingan, 1997) to prevent the price rise of food products, through imports is not possible due to
foreign exchange constraints. Moreover the price of imported products is relatively higher than
their domestic prices.
Inflation is caused because of the structural, limitations or bottlenecks inherent in the
socioeconomic system and cumulative inherent in the socioeconomic system and cumulative
inflationary processes. The structural bottlenecks are manifested through the inability of some
sectors of an economy to respond to the changes in the level and composition of aggregate
demand. On the other hand, the cumulative inflationary pressures arise from price distortions and
misallocation of investment funds (Mishkin, 1997)
Agricultural bottleneck is often regarded as consequence of institutional defects. In most less
Developed countries (LDCS) rapidly growing demand for food, which arises from fast growing
rate of population, has been accompanied by a corresponding rise in food price this situation is
more often attached to the backward sector of the economy. Pressure of increased demand is
then manifested not in increase in production but increasing price of food stuff (Taslim, 1982).
In most developing countries, export receipts tend to increase slowly while import demand grows
rapidly this often leads to import or foreign exchange bottleneck and persistent balance of
payment deficit. To tackle this problem, the government is forced to take remedial measures. As
20
short-term cure of the balance of payment problem, import controls and currency devaluation
could be imposed. The introduction of import controls will increase the price of the controlled
items in the domestic market. Whether or not it causes balance of payments crisis, devaluation
will almost certainly impose an upward push to domestic prices of importable goods, if
accompanied by trade liberalization (Taslim, 1982).
21
increasing (i.e., a country experiences inflation), that country's exchange rate must depreciated in
order to return to PPP.
The basis for PPP is the "law of one price". In the absence of transportation and other transaction
costs, competitive markets will equalize the price of an identical good in two countries when the
prices are expressed in the same currency. Economists use two versions of Purchasing Power
Parity: absolute PPP and relative PPP. Absolute PPP refers to the equalization of price levels
across countries, while relative PPP refers to rates of changes of price levels, that is, inflation
rates. This proposition states that the rate of appreciation of a currency is equal to the difference
in inflation rates between the foreign and the home country( OECD, 2015)
What they call inflation is, always and everywhere, primarily caused by an increase in the supply
of money and credit. In fact inflation is the increase in the supply of money &credit. If you turn
to the American College Dictionary, for example, you will find the first definition of inflation
given as follows: “undue expansion or increase of the currency of a country, especially by the
issuing of paper money not redeemable in specie” (emphasis added)In recent years, however, the
term has come to be used in a radically different sense. The second definition given by the
American College Dictionary; ‘a substantial rise of prices caused by undue expansion in paper
money or bank credit’. The word inflation originally applied solely to the quantity of money. It
meant that the volume of money was inflated, blown up, overextended. The word inflation is
now so commonly used to mean ‘a rise in price”.
Let us see what happens under inflation. When the supply of money is increased, people have
more money to offer for goods. If the supply of goods does not increase or as much as the supply
of money, then the price of goods will go up. Each individual’s dollar becomes less voluble
because there are more dollars. There fore more of them will be offered against, say, a pair of
shoes and or a hundred bushes of wheat than before. A “price” is an exchange ratio between a
dollar and a unit of goods. When people have more dollars, they value each dollar less. Goods
22
then rise in price, not because goods are scarcer than before, but because dollars are more
abundant, and thus less valued.(Ibid, 1978) Most classical theorists and modern monetarists
believe that the capitalist system is unstable, money supply ultimately determines aggregate
demand, but not aggregate supply, velocity of money is unstable, money supply should grow
faster than money demand to prevent inflation, money supply should be used to ‘fine tune’ the
economy.
Monetarists would say that the primary cause of inflation is the lack of fiscal responsibility, too
fast a rate of increase in the money supply high interest rates which increase the cost of
borrowing, unstable investment demand.
According to the classical macroeconomic model; grows when the price level rises, real output is
unaffected by the money supply, employment depends on the velocity of money, growth of
permanent income is impossible.
The more sophisticated view was enunciated by Irving Fisher in 1926; when the dollar drops in
value, or in other words, when the price level increases, a businessman finds his receipts rising as
fast, on average, as this general rise in price, but not his expenses, because his expenses are
growing much faster than his receipts. large extent of things which are contractually fixed
employment is then stimulated for a time at least. (Irving Fisher” a Statistical Relation between
Unemployment and price changes, ‘International Labor review, 1926)
This view contains a Kernel of truth. But thirty-two years after it appeared in 1958, the British
economist A.W Phillips published on article which seemed to show that over the preceding
century, when money wage-rates rose, employment rose, and vice versa. (Phillips, 1958)
Keynesian economists struck by the Phillip's thesis, and seeing in it a confirmation of their
previous belief, carried it much further. They began to construct Phillips curve of their own, not
based on a comparison of wage rates and employment, but of general prices and employment.
23
And they announced that they have found there a trade-off between unemployment and prices.
Price stability and reasonably full employment, they asserted, just can’t exist at the same time.
The more we get of the one, the less we can have of the other. We must make a choice. If we
choose a low level of inflation, or none at all, we have to reconcile ourselves to a high level of
unemployment. If we choose a low level of unemployment, we must reconcile ourselves to a
high rate of inflation (Henry Hazlitt, 1978)
The first of these powers help to set short-term interest rates directly. When member banks can
freely barrow money from their Federal Reserve Bank at, say 6 (six) percent, this fixes a ceiling
on the rate they have to pay. They can afford to re lend at any rate above that in classical central
bank theory, the discount rate was treated as penalty rate. (Ibid, 1978)The second power of the
Federal Reserve authorities is the power to lower the reserve requirements of the member banks,
could be used to allow the member banks to expand their loans, but in practice the reserve
requirements is seldom changed. There are quicker and more flexible ways to obtain a desired
expansion of the money supply. The chief way is by the power of the Federal Reserve authorities
to purchase government securities in the open market, which is the third method. This power is
employed almost daily. It is easy to see how it expands the supply of money and
credit(Ibid,1978)
Inflation and interest rates are often linked and frequently referenced in macroeconomics.
Inflation refers to the rate at which prices for goods and services rise. In the U.S., the interest rate
(which is the amount charged by a lender to a borrower) is based on the federal funds rate that is
determined by the Federal Reserve. The Federal Reserve System is the central bank of the U.S.;
it is sometimes just referred to as the Fed. The Fed attempts to influence the rate of inflation by
24
setting and adjusting the target for the federal funds rate. This tool enables the Fed to expand or
contract the money supply as needed, which influences target employment rates, stable prices,
and stable economic growth( INVESTPODIA, 2021)
Mwase (2006) used quarterly data from 1990 up to 2005 in his study of inflation in Tanzania.
Mwase (2006) uses a structural vector auto regression (VAR) model to capture the relationship
between short term movements in exchange rate and inflation. The results of the study indicate
that currency appreciation is associated with a decrease in inflation rate, with one quarter lag.
The exchange rate pass through to inflation Tanzania is found to be incomplete and decreasing.
A low, significant and persistent pass through existed thought the period 1990 to 2005, while
zero pass through exited during the period 1995 to 2005. Mwase (2006) argues that the non
conventional response of inflation to exchange rate movement could be attributed to the effect of
macroeconomic and structural reforms. Mwase (2006) concludes that the decrease in the pass
through is attributed to the macroeconomic and structural reforms that took place in Tanzania.
Mwase (2006) finally recommends for authorities to seek to maintain low and stable inflation
and to continue on the ongoing structural reforms to increase efficiency and production.
Olatunji et al. (2010) have examined the recent factors which are affecting inflation in Nigeria.
Time series data has been selected for this particular study. The study reveals that the previous
year total imports, previous year consumer price index for food, previous year government
expenditure, and previous year exchange rate have negative influence on inflation rate. On the
other side, previous year exports, previous year agricultural output, previous year interest rate
and crude oil exports have negative impact on the rate of inflation in Nigeria.
Abdullah M. and Kalim R (2010) investigated determinants of food price inflation in Pakistan
using time series data from 1972 to 2008 using Johnsons co-integration technique they study
25
inflation expectation, money supply, per capital GDP, food import and export. The result of
study support significant and positive relationship between inflation and its determinants in long
run except money supply which they found insignificant with positive sign. In short run using
vector error correction model they found only inflation expectation and food exports affect food
price inflation. I general they found both demand and supply side factor are important while
structural point of view is insignificant.
Shahadudheen (2012) analyzed the major determinants of inflation in India extracting 54 time
series quarterly observations. The study employed Johansen Juselius co-integration methodology
to test for the existence of a long run relationship between the variables. The error correction
from the long run determinants of inflation is used as a dynamic model to estimate the short run
determinants of inflation. The study concluded that the GDP and broad money have a positive
effect on the inflation in long run. On the other hand, interest rate and exchange rate has a
negative effect.
Aungefber and Anwar Alhag (2012) investigate determinants of inflation in Pakistan using times
series econometrics model of multiple regression analysis technique by using the data collected
for the period of 1981-2010. The variables included in the study were interest rate, Gross
domestic product, fiscal deficit, and unemployment. The result of the study indicates that gross
domestic product is having negative relationship with inflation. Whereas interest rate, exchange
rate, fiscal deficit and unemployment have positive relationship with inflation.
Alain Kabundi (2012) assess the dynamics of inflation in Uganda by using single-equation Error
correction model based on the quantity theory of money including both external and domestic
variables on monthly data from 1999 to 2011. The study emphasized on food price, quantity
theory of money, money demand and food supply. The result indicates that both external factors
and domestic factors are main factor for underlying inflation in Uganda. Monetary aggregate and
world food price have long lasting effects on inflation in Uganda.
26
To show the trade-off between inflation and unemployment, Ayalew has measured
unemployment by estimating the potential output and taking the difference from the actual
output. In other words, the output gap derived is used as a proxy for unemployment. To estimate
the trade-off between unemployment and inflation, inflation is explained as a function of
unemployment. The estimation result disclosed that there is no trade-off between the two
variables under study. A 100% rise in the rate of unemployment increases inflation by 47%.
Thus, the traditional Phillips Curve is not applicable to Ethiopia. To see the long-term
determinants of inflation in the country, the explanatory variables that are used are inflation
inertia, money supply, world price index, unemployment, drought and war. The estimation result
has revealed that structural variables such as unemployment of resources explain inflationary
pressures quite well in Ethiopia. Generally, the major finding of this study implies that as the
unemployment level declines then inflation falls. This shows that in the Ethiopian context there
is a positive relationship between economic growth and inflation assuming that the lower rate of
unemployment is accompanied by higher economic growth.
Kibrom T. (2008) examined the source of recent inflationary experience in Ethiopia between
1994/5 and 2007/8 using vector auto regressive and single error correction model, he found that
the determinants of inflation between sectors (food and non-food and time horizon under
consideration the most important forces behind food inflation in long run is real income, money
supply, inflation expectation and international food prices.
Mehari and Wondafrash (2008) investigated the impact of money supply on inflation in Ethiopia.
The researchers used quarterly data from the first quarter of 1996/97 until the second quarter of
2006/07. Mehari and Wondafrash (2008) used independent models for the narrow money supply
and broad money supply. The result from their work reveals that money supply has a direct
impact on inflation. The impact of narrow money supply which includes currency outside banks
and net demand deposits was found to be greater than that of broad money supply which includes
narrow money supply and quasi money.
Sisay M. (2008) study inflation with the title ‘determinants of recent inflation in Ethiopia’ using
econometric technique of co-integration to study inflation in the long run. He studies using
quarterly data from third quarter of 1997/98 up to second quarter of 2007/8. He study real GDP,
broad money supply, exchange rate, interest rate (lending) overall budget deficit, one period
27
lagged consumer price index, one period lagged money supply and price of gas oil. The study
finds that inflation in Ethiopia is structural and monetary phenomena. It founds inflation in the
country in the long run due to structural, monetary expansion, lending rates and expectations. On
the other hand exchange rate, one quarter lagged money supply, gas oil prices and deficits have
been found to have no significant impact on inflation in the long run.
Josef et al. (2008) analyzed the short run dynamics of inflation in Ethiopia, using a parsimonious
ECM fitted with monthly observations using the time series data of money supply, nominal
exchange rate and agricultural out puts (proxied by a cereal– weighted agricultural production
index). The results of their study confirmed that inflation in Ethiopia strongly of past inflation
determined, with money supply being the second derive of inflation in the short term. They
revealed further that inflationary expectations explain more than half of it, even after three years
of a shock while, in the medium-run, the nominal exchange rate and the output factors were
found to have the positive and a greater than money supply impact on inflationary dynamics. The
study argued hence that, with prevailing structural factors causing rigidities in price formation,
tightening monetary policy alone to contain inflation would become in effective, and claimed
rather to make.
Policy reforms bringing flexible price formation, together with the credible and transparent
central bank in curbing inflationary expectations and enhancing the effectiveness of monetary
policy in Ethiopia. Here, we found that, money supply variable had only a limited role in
explaining inflation for the period exceeding the short run; but rather, the exchange rate(the
external influence) and the output shocks together with inflationary expectations were found to
be important both in short and the medium-term periods.
Geda and Tafere (2008) have also analyzed the forces behind the recent inflationary pressure in
Ethiopia in period 1994/5 – 2007/8. In the formulation of the VAR model explanatory variables
for the Ethiopian inflationary process are: exchange rate, world price index, world nonfood
prices, real income, excess money supply, food imports, food aid, marketed surplus, unit wage
costs and the exogenously administered prices. Using the co-integration vectors for the models of
food and non-food inflation, a single error correction model is estimated for both models. Among
the explanatory variables of inflation income growth is the relevant variable in this case. In this
study it is found out that one of the sources of food inflation is the rise of income. The reason
28
given for this is the low level of income among households. Given the low level of income, an
increase in income leads to higher food inflation because households spend their additional
income on food items. These authors recommend that policy makers to cool down economic
growth through fiscal and monetary conservatism. Since the main source of the recent inflation
in the country is food inflation, an increase in income is found to be the major determinant of
food inflation. Hence, it can be concluded that there is a negative relationship between inflation
and economic growth in Ethiopia. Like the global empirical evidences, studies undertaken in
Ethiopia have different findings on the relationship between inflation and economic growth.
Yemane (2008) investigated the causal link among the time series of money supply, budget
deficits and inflation in Ethiopia, applying the Granger causality test to detect the short run
causality, and the bounds test approach to the long run issues, for the period ranging from1964 to
2003.The results of the study confirmed the existence of long run co-integrating relationships
among the series and only uni-directional forward Granger Causality. Furthermore, budget
deficits were found to have no impact on the growth of money supply; and that both money
supply and budget deficits impose positive and statistically significant impact on inflation, with
the largest pressures sourcing from money supply while confirming the dominance of money in
the dynamics of inflation. Here commended finally that, since both the fiscal and monetary
variables were important in determining inflation, the simultaneous exercising of proper fiscal
and monetary policies would be effective to achieve the national objective of maintaining low
inflation in Ethiopia.
Asayehgn D. (2009) study economic for inflation; The Ethiopian dilemma using data from
1992/3 to 2006/7 with multiple regression including real GDP growth rate, percentage share of
import from GDP, Government budget share of GDP, lending interest rate, nominal exchange
rate as independent variables and consumer price index as proxy for inflation. Based on the
analysis he conclude that the main determinants of inflation in Ethiopia are imports, depreciation
of Ethiopian birr, decline in domestic lending interest rate or an increase in broad money supply.
Solomon Alemu (2011) investigates the determinants of inflation in Ethiopia with econometric
frameworks general method of analysis for the period of 1974-2009. The Engle granger two step
procedures were followed to estimate the long run and short-run coefficients of the variable of
the inflation model. The variable he used to regress the dependent variable (CPI) to independent
29
variables are money supply, government expenditure, volume of export, credit to private sector,
Real Gross Domestic product, Real Effective exchange rate, world price and price expectation
the empirical result of the study show that the coefficient of real gross domestic product was
found to be significant and consistent with expected sign (+) both on long-run and short-run. On
the other hand, credit to private sector, price expectation and real effective exchange rate have
significant effect in the short run. In the long-run money supply, volume of export and consumer
price index has significant effects.
According to Teshome (2011) assessed the relationship between inflation and growth in
Ethiopia. In the analysis Teshome has compared the Ethiopian situation with the other Sub-
Saharan African (SSA) countries, and the author points out that on the average Ethiopia’s
economic growth and inflation rate are higher than the SSA countries by 4.5% and 9%
respectively. After analyzing the nature of the economic growth in the country he concluded that
inflation does not affect the economic growth because of the broad based nature of the growth.
He then concluded that from 2004 – 2010 average economic growth in Ethiopia is 11% and
average rate of inflation during the same period is 16%. The period understudy has witnessed a
positive relationship between inflation and economic growth. According to the author, no matter
what happen in inflation, economic growth is not an affair of choice.
Kurabachew (2012) assess the cause of inflation in Ethiopia using time series econometrics
model of Augmented Dickey Fuller and co-integration for the year (1981-2011). The variables
included in the model are: Real effective exchange rate (REER), Broad money supply, Average
import price, Real Gross Domestic product and price expectation. The result of the study shows
that in the long run inflation is determined by money supply (M2) and exchange rate. As well as
the result of the short run error correction model showed that inflation in Ethiopia is determined
by import price and real effective exchange rate (REER). The study shows that there are
variables which have no significance both in the short-run and long-run like Real Gross domestic
product and price expectation. The study concludes that both structuralism and monetarist factors
determined inflation in Ethiopia.
Fekadu, (2012) analyzed the relationship between inflation and economic growth in Ethiopia for
the period 1980-2011.The Vector Auto regression (VAR) model showed that, an increase in
30
economic growth decreases inflation whereas inflation does not have significant effect on
economic growth in the short run. The Granger Causality test showed that, economic growth has
forecasting power about inflation while inflation does not have predicting power about economic
growth. The Co-integration test indicates that, there exist a long run relationship between
economic growth and inflation in Ethiopia. Vector error correction estimates indicated that,
economic growth significantly reduces inflation in short run while inflation does not have any
significant effect on economic growth.
Habtamu (2013) investigated into the causes and dynamics of price inflation in Ethiopia using a
time series data of CPI, agricultural supply shocks, monetary growth, cost of capital, exchange
rate and others, ranging from (1980-2012) by applying the VEC and Multi-factor Single
Equation Models. His findings suggest that money supply was an important factor in determining
the dynamics of price level in Ethiopia, both in short and the long run. Moreover, the agricultural
supply shocks and the external market conditions (particularly, the exchange rate depreciation,
oil price and the intermediate goods import) were found to have considerable significant positive
impact on domestic inflation in the long run and the short run. The cost of capital was found to
have a positive inflationary pressure only in the short run.
Summary
Inflation is one of the major macroeconomic problems in which governments wants to control
through different variety of policies and strategies due to its wide range of influence on social,
economic and political system of the world. To control this problem selecting its significant
causes and better solutions is a duty of governments and economists.
As we have seen above some of the economists give the cause of inflation to the money supply
through the government whereas others say that the cause of inflation is structural bottlenecks of
the supply side especially in the agricultural production. Therefore, the main contribution of my
study is to investigate the impact of money supply on inflation in Ethiopia as a developing and
change experiencing country.
31
CHAPTER THRE
broad money
supply
real effective
lag consumer
exchange
rate price index
inflation
32
(EEA), Ministry of Finance (MOF) and external sources from different published and
unpublished books, journal and recent pricing on inflation.
M2t (IMF)= Money supply (broad money of international monetary fund (IMF) at time t
This long run model of inflation is expected to vary positively with all variables except real
GDP.
33
3.3.2 Variable description
Consumer price index (CPI): measures change in the price level of consumer goods and
services purchased by household. It also measures the average changes over in the price paid by
the consumer for market of consumer goods and services. This refers to an annual increase in the
price of a basket of goods and services that are purchased by consumers in an economy leading
to the decline of the purchasing power of a country’s currency.
Broad money supply (M2): money supply has been considered as responsible factor for
inflation existence by different theories. In monetarist theory of inflation money supply is the
major and the most important cause of inflation according to freedman’s definition of money
symbolized by m2 (Jagd.sh H, 2009), so monetarist strongly believe money supply has a big
impact on the inflation process on the economy. Hence it incorporated in the model to see its
impact on inflationary condition of the country. Money supply is expected to be positive sign.
Since increase in money supply increase aggregate demand leads to demand pool inflation when
amount of money existed in the economy as surplus.
Real gross domestic product (Rgdp): in Ethiopia inflation affected by supply constraints
especially agricultural production contributing more than half of GDP growth, affect inflationary
prices in the country, more goods and service must actually be exchanged rather than having the
same amount of goods and service increased, real GDP is expected to have a positive sign
because. When amount of GDP increased in the economy it mean that individual income
increased then people tend to offer more money on particular product this lead to demand push
inflation in the country.
Real effective exchange rate (REER): Exchange rate is used to determine an individual
countries currency value relative to the other major currency in the index, as adjust to the effect
of inflation. The adjustment in the relative price of tradable and non-tradable implied by
devaluation often involves an increase in the general price level. It has a direct impact on
inflation by affecting the terms of trade and BOP of a country.
34
Government budget deficit(GBD): occurs when expenses exceed revenue and indicate the
financial health of a country. The government generally uses the term budget deficit when
referring to spending rather than businesses or individuals. Accrued deficits form national debt.
Consumer price index (its lag): In the model of LCPI is included as a proxy variable for
inflation expectation. Expectation of higher future price will affect the actual inflation rate.
People may per chase fixed asset and hoard it in expectation of future price. As a result, shortage
will be created in the market forcing the price level to exploit and it is expected to have positive
relation .because inflation is a sustained increase in general price level.
3.4.1 Pre-Estimation
Stationarity tests
For data to be valid, the data sets must be stationary, that is the mean and the variance of the data
set is time independent and they are constant over time, to test for stationary the study made use
of the order of integration. If a series is integrated of order (0) i.e. I (0) then it is stationary but if
otherwise it is non-stationary and to test for stationary, the research made use of the Dickey
Fuller Unit Root Test. (Gujarati, 1995)
This test is derived from the Dickey Fuller test and it is an appropriate method of checking
whether a variable is integrated of orders one which was proposed by Dickey & Fuller (1979).
However, due to the fact that the dickey fuller test may suffer auto-correlation in the residual
process if OLS is applied we made use of the augmented dickey fuller test. This is because the
errors may not be normally and identically distributed and the residual variance may be biased.
The test can be used to test the order of integration for a variable generated with a drift from and
a deterministic trend. The null hypothesis may be taken to mean prices follow a random walk
and future prices cannot be predicted while the alternative may mean economic agents may
predict future prices and the do not follow a random walk(Gujarati, 1995).
35
Multi co-linearity
When Multi co-linearity exists among explanatory variables, it is impossible to get unique
estimate of all parameters. The explanatory variables should not be correlated, this is because if
they are correlated the determinant will be zero and the variance cannot be found.
This therefore makes it difficult to draw statistical inference about them from a given sample.
The Ordinary least squares remain the best linear unbiased estimator as long as there is no multi
co-linearity.
The problem of multi co-linearity may lead to large variances and standard errors of the OLS
estimators, wider confidence intervals, insignificant t ratios, high values of t ratios and high
values of R2 .It also makes the OLS estimators and their standard errors to be sensitive to small
changes in the data.
When multi co-linearity exists there could be wrong signs of the regression coefficients and in
the presence of serious multi co-linearity problem. This could be solved by having prior
information on the parameters, transformation of variables acquisition of new data, dropping one
of the variables in the model or rethinking the model all together. (Gujarati, 1995).
Heteroskedasticity
This problem occurs when the variances of the population are not constant or unequal. The
problem of heteroskedasticity is tested using the Breusch-Pagan test.
If the chi-square value obtained exceeds the critical chi-square value, the null hypothesis of
Auto correlation
For the ordinary least squares to work there must be no auto correlation that is the current error
term must not be correlated with the previous error term. There should not be correlation
between observations ordered in time. When there is no auto correlation, it simply means;
36
The expected value of the two error terms U i and Uj is zero. This means that the disturbance term
relating to any observation is not influenced or related by the disturbance term relating to another
observation.
Auto correlation may occur due to various reasons and one such cause is due to inertia or
sluggishness. Time series such as price indices and GNP may experience business cycles where
there are fluctuations in the economic activities causing interdependence.
This phenomenon auto correlation may also occur due to error in the model specification either
by being stated in the wrong functional form or some important variables being omitted in the
model. Data manipulation may also cause auto correlation and here the Durban Watson test is
used to check for auto correlation. (Gujarati, 1995).
Normality Tests
This test seeks to prove that the error term is normally distributed and is based on the assumption
that Ui is normally distributed. The research will make use of the Shapiro-wilk test for testing for
normality (Gujarati, 1995).
37
CHAPTER FOUR
The relationship between growth and money was not concern before 1990, in Ethiopia due to
fact that, first large portion of the economy is non-monetized and second output and growth has
been large dedicated by natural factor such as rainfall. However, following the structural
adjustment policy (SAP) of early 1990, any surge in money supply was viewed to simultaneous
trigger inflation. (EEA)
Net foreign 39,787.69 45,648.53 45,972.30 37,570.95 21,524.19 38,034.79 39,376.20 14,505.2
asset
credit
government
other sector
Broad money 189,398.78 235,313.59 297,746.59 371,328.91 445,266.25 573,408.60 740,572.50 886,752.5
38
Narrow money 94,849.88 114,745.69 134,063.78 154,706.34 178,609.66 216,794.60 281,154.70 308,937.1
deposit
Quasi money 94,548.9 120,567.9 163,682.8 216,622.6 266,656.6 356,614.4 459,418.2 577,815.4
From the above table we can see that the domestic liquidity as measured by broad money (m2)
relatively show high in 2018/19 and relatively low in 2011/12. The growth in net foreign asset
and domestic credit contributed to the highest growth rate recorded. It can also be seen that credit
given to government in declining, the decrease in government borrowing from banks is expected
to reduce inflationary pressure.
During the fiscal year 2018/19 the level of quasi money, that comprises saving and time deposit
reached record level 577,815.4birr. This may be associated with improved financial intermediary
as banks started extending their branches. Also, as we see in fiscal year 2018/19 narrow money
and its components (demands deposit and currency outside banks) increased to 308,937.1 birr
compared to fiscal year 2012/13.On asset side, domestic credit expanded to 963,699.9 birr
significant change compared to other fiscal years.
39
inflation was at deflationary situation for instance the inflation rate was 2.2% in 1996/97 and -
0.1% in 1997/98 in the year 2001/02 a country experience a deflation of -7.2% due to a decline
in food price associated with bumper agricultural production following a gold whether condition.
(NBE, 2004/05)
The decline in price in 2002 peaked up to 15% in 2002/03. The inflation rate further increased
and reached 18.6% in 2003. Though there was a slight decline in 2003/04 it continuous to rise
again in 2004/05. In 2005/06 general inflation reached a record level of 12.3%, food inflation
14.0% and non-food inflation price 8.0% from previous level of 6.8%, 7.7% and 5.2% in
2004/05. This increasing in non-food price was due to an increase in house rent, prices of
construction materials, water and fuel etc. in 2006/07 all there indicates of inflation (general,
food and nonfood inflation) continuous to increase.
However, in 2007/08 through year on year basic annualized inflation and food inflation shows
increase which non-food inflation showed a slight decline from 15.2% (2006/07) to 12.5% (in
2007/08) this was due to drop in house rent, construction materials and fuel. It also as the end of
2009/10 annualized inflation was 2.8% which was 33.6% lower than 2008/09 due to slow down
in prices of food items. During the same year annualized food inflation dropped to -5.4% due to
a significant decline in the price of cereals, bread and prepared food (NBE, 2008/09).
Further the action taken by the national bank of Ethiopia in 2009/10 to exercise tight monetary
policy through instrument particularly direct credit ceiling and reserve requirement also
contribute in reducing inflation rate during this year.
Also the national bank devaluated the birr against us dollar by 17%, the governments increased
the salary of civil servant, the government also imposed price cap on basis commodities which
have been distortionary as slight decline inflation rate.
The fiscal year 2011/12 witnessed another round of high price inflation which was annualized
general inflation stood at 34.3%, food price grew by 43%and non food inflation rate are averaged
22% during the period. Expansion of monetary aggregate in particular domestic credit, relatively
slower growth of agriculture, output is the cause of high inflation rate.
40
In 2019/20, the annual average headline inflation rose to 19.9 percent from 12.6 percent a year
ago. This was largely owing to 10.2 percent rise in food & non-alcoholic beverages inflation
from 13.1 percent to 23.3 percent and 3.9 percent increase in non-food inflation from 11.9 to
15.8 percent, annual average food & non-alcoholic beverages inflation scaled up to 23.3 percent
from 13.1 percent last year depicting a 10.2 percentage point annual increase, on account of
higher price inflation of bread & cereals (14.1 percentage point), fruit (12.1 percentage point),
food products not classified elsewhere, (10.8 percentage point), vegetables (10.7 percentage
point), nonalcoholic beverage (10.6 percentage point), oils & fats (10.4 percentage point) and
meat (5.7 percentage point), likewise, annual average non-food inflation scaled up by 3.9 percent
and reached 15.8 percent in 2019/20 due to higher inflation in alcoholic beverage & tobacco
(11.9 percentage point), transport (11.0 percentage point), housing, water, electricity, gas & other
fuels (9.6 percentage point), restaurant & hotel (4.3 percentage point), recreation & culture (2.8
percentage point), communication (1.5 percentage point), health (1.3 percentage point) and
miscellaneous goods (0.8 percentage point), Similarly, headline inflation surged to 21.5 percent
from 15.3 percent a year ago on the account of a 3.3 percentage point increase in food & non-
alcoholic beverages inflation and 9.2 percentage points in non-food inflation. Therefore, general
it can be concluded that trends of prices increased in Ethiopia (NBE, 2019/20).
60.0
50.0
40.0
30.0
20.0
10.0
0.0
-10.0198
2 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16 18
19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20
-20.0
41
From the above graph, the consumer price index is fluctuating from year to year. It reaches its
peak in the year of1991/1992 and 2008 which records at the rate of 45% 55%respectively and the
lowest rate is recorded in the year of 1986/87, 1996 and 2001that are recorded the rate of around
-10%. Starting from 2001/2002 generally the value of the consumer price index is increasing at
relatively higher level; this is the result of the good performance of economic activity.
100.0
80.0
60.0
0.0
2 4 6 8 0 2 4 6 8 0 2 4 6 8 0 2 4 6 8
-20.0198 198 198 198 199 199 199 199 199 200 200 200 200 200 201 201 201 201 201
-40.0
42
4.1.3 Trends of CPI and real GDP
The figure below reveals that in all years, except 2001 where RGDP growth exceed inflation
with high differences, inflation and RGDP growth rate exceed one another with small amount
interchangeably up to 1998. But starting from 2004/2005 go together. This implies that real gross
domestic product has positive impact on inflation, because the government deliberately reduce
the interest rate to motivate economic growth. The figure also reveals the close association of
inflation and RGDP growth.
120.0
100.0
80.0
60.0
CPI
RGDP
40.0
20.0
0.0
43
above figure money supply was continuously increasing during all years except 1996/97 and
1999/2000.
60
50
40
30
M2
20
CPI
10
0
82 984 986 988 990 992 994 996 998 000 00 2 00 4 00 6 00 8 01 0 01 2 01 4 01 6 01 8
-1019 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2 2
-20
44
4.2 Econometrics analysis
4.2.1 Unit root test
First the regression based on non-stationary time series explains the relation during the study
period only. This means that it is impossible to infer about the long run relationship of the
variables. In addition, regression of non-stationary time series on the time series stationary time
series may lead to spurious regression. In economics a time series that has a unit root has is
known as a random walk which is an example of non-stationary time series can be stationary by
differencing the variables. If the time series is differenced once and the differenced series is
integrated of order of one, denoted by I (1). Similarly, if the original time series can be
differenced twice before it became stationary the original series is integrated of order two or I
(2). In general, if the time series is differenced d times it is integrated of order d or I (d).
Among the various method of testing for stationary, augmented dickey fuller (ADF) test is used
in this study.
45
LnGBD -7.535 -3.668 -2.966 -2.616
As indicated from the above table, all the dependent and explanatory variables are non-stationary
except lnGBD and lnREER at level because the ADF test of statistic in absolute value is less
than the critical values. Therefore, to make all the variables stationary do the difference until it
becomes stationary.
value
As we can see from the above table, the dependent and all explanatory variables are become
stationary at first difference or integrated of order one, I (1). The dependent variable and all the
explanatory variables are significant at 1% 5% and10% level of significant.
4.2.2 Co integration
Regression based on unit root has meaning if the variable is co integrated i.e. have long run
relationship. According to time series econometrics, if the residual from a regression of a unit
root are stationary when the variable is said to be co integrated. This is because even if the
46
variables are individually non stationary their linear combination is stationary which is depicted
by the stationary of the residual i.e. the variables are co integrated the result from the model will
show the long run relationship among the variables (. Guajarati 2004).
In order to check the long run relationship, co integration, in the model; the unit root test on the
residuals from the regression has been conducted using augmented dickey fuller test.
The AEG test revealed that the residuals from the regression of CPI on the other variable are
stationary the variables are co integrated at 1%, 5% and 10% level of significance this shows that
there is long run relationship among variables.
47
_cons -413.2075 118.9804 -3.47 0.001 [-655.5627 -170.8523]
F( 5, 29) = 79.69
Prob> F = 0.0000
R-squared = 0.9257
Estimation of long run inflation model in the Ethiopian economy gives us the following result
LnCPI=-413.2075+34.57967lnRGDP+-0.2152579lnREER+2.305979lnM2+0.4061231lnlCPI
+0.0353447lnGBD+ut
It is clear from the above that the only explanatory REER and government budget deficit are
statistically insignificant. The other explanatory variables i.e., broad money supply, real gross
domestic product and lagged consumer CPI are statistically significant.
From the above result, it can be shown that 92.57% of variation in consumer price index is
explained by the independent variables. Simply the model explains 92.57% of the variation in
dependent variables I.e., CPI
The F-test shows that all the independent variables jointly explain the dependent variable. Thus
the overall significance of the model is good. The value of the constant term413.21 which is also
significant, shows that CPI will have a value of -413.21units if all the explanatory variables
included in the model are zero.
Quantity theorists state that inflation is always and everywhere a monetary phenomenon. An
increase in broad money supply by one percent ceteris paribus will increase CPI by 2.3percent on
average in the long-run. As it is shown from the estimation result broad money supply is
statistically significant factor affecting inflation. Due to higher money supply, more funds will be
available to invest in the economy, investment will be take place, more employment will be
48
generated, aggregate demand will increase, and finally there will be increase in consumer price
index. It affects price level through demand side.
RGDP is found to be directly related with the CPI. It has an inducing effect on consumer price
index implying that consumer price index will increase by 34.6 percent due to 1 percent increase
in gross domestic product on the average in the long run. This positive relationship between GDP
and inflation may be due to the economic situation in the country. That is, to support the
economy to grow fast enough; the national bank of Ethiopia lowers interest rates to make
borrowing more attractive. The reason behind this is that it will enhance spending, which will
lead to a rise in GDP. Government budget deficit is found to have a positive sign but it is
insignificant variable.
REER is an insignificant variable in explaining the actual inflation rate in the long run. As REER
increase by one percent, ceteris paribus, CPI decreases by 0.22%.
The last variable is lagged consumer price index which is also having a significant impact on
inflation0.41% of change in CPI, ceteris paribus; result from one percent change lnLCPI.
49
DlnGBD .0583747 .0454251 1.29 0.209 [-.0343957 .151145]
R-squared = 0.3764
Based on the above table, R2 and adjusted R2 for the short-run model are 38% and 25.2%
respectively showing that 38% and after adjustment 25.2% of the variation in CPI is explained
by the variation in the explanatory variables in the short-run. Further, the result of the short-run
model revealed that only broad money supply are significant variables in explaining the variation
of inflation in the short-run whereas real gross domestic product, real effective exchange rate,
lagged CPI and government budget deficit rate are insignificant variables. The lagged ECM
coefficient indicates that 8% percent of the disequilibrium in CPI in one period is corrected in the
next period. In other words, it indicates the speed of adjustment of about 8%percent from the
actual price level in the short-run to the long-run equilibrium level. Moreover, it shows 8%
percent of the discrepancy between the actual and the long-run or equilibrium value of CPI is
corrected each year.
As M2 increase by one percent CPI increase by 2.4%. It shows us the increasing money supply
faster than the growth in real output will cause inflation. The reason is that there is more money
50
chasing the same number of goods. Therefore, the increase in monetary monetary demand causes
firms to put up prices.
One of the assumptions of classical linear regression model (CLRM) is that there is no perfect co
linearity among some or all explanatory variables. If the explanatory variables are perfectly
linearly related to each other, the problem of multi co linearity will arise. The result of multi co
linearity test indicates that the mean value of variance inflation factor is 4.28 which is less than
10 and indication of absence of multi co linearity.
1 0.150 1 0.6981
The model assumes that successive values of the random variables are temporarily independent
and that values which we assume in any period is independent from the value it assumed in any
previous period. If this assumption is not satisfied, then the value of in a particular period is co-
51
related with its own presiding values this is called serial auto correlation. The result of the model
indicates that the pro>chi2 =0.6981which is greater than 0.05, indicates that there is no auto
correlation problem.
We are looking in view of Durbin-Watson d-statistics for first order serial correlation, Durban-
Watson –statistic will always have a value between 0 and 4. If a value computed is 2 and close to
2 (1.5 to 2.5) are relatively normal. Durban-Watson d-statistic (6, 38) = 1.854667that means
there is no auto correlation problem.
This test seeks to prove that the error term is normally distributed and is based on the
assumption that Ui is normally distributed. The research used of the Shapiro-wilk test for
testing for normality (Gujarati, 1995).
As shown in the table Shapiro wilk test for normality at least the pro>z exceeds 0.001 at 1% level of
significance .so that the residual r is normally distributed and we can see the graph below.
52
Kernel density estimate
.02
.015
Density
.01
.005
0
-100 -50 0 50
Residuals
53
CHAPTER FIVE
The recent inflation in Ethiopia appears to both demand pulled and cost push. This is true
because RGDP on the demand side and lagged consumer price index on the cost side are
found to have as significant effect on inflation.
Money supply has the largest effect on inflation in the country followed by RGDP and
lagged consumer CPI. But fiscal deficit and real effective exchange has been found to have
no meaningful relation with inflation. So, it can be said that the recent inflation in Ethiopia is
a monetary and structural phenomenon.
In Ethiopia in the face of series macro-economic problems, this includes rising money supply
huge debt servicing, persistent balance of payment problem, budget deficit currency devaluation,
inflationary process is high. Recently though there is continuous GDP growth recorded, the
inflationary trend is continuously rising, given this macroeconomic environment, analyzing
factor that determine inflationary process is vital. To this end the study employed econometric
technique to investigate the impact of money supply on inflation and the determinate of inflation
and variables which are theoretical and practical presumed to determine it both in the long run
and in the short run. Descriptive analysis used to identify the trend of inflation and its
determinant variables.
The finding of the study revealed that, in the long run broad money supply, lagged CPI and real
gross domestic product are an important determinant of inflation in Ethiopia. In the short run
only broad money supply is founded to have a significant impact on the inflationary pressure.
But government budget deficit and real effective exchange rate are insignificant variable both in
the long run and short run.
54
The impact of money supply found to be significant both in the long run and short run suggesting
that there is inflationary monetary policy followed by the government. However, the monetarist
presumption of one to one relationship between money supply and price is not applicable in
Ethiopia case due to the existence of other significant variable such as lagged CPI and real gross
domestic product.
As expected theoretically, inflation expectation revealed significant impact. Agents base their
price expectation revealed significant impact in the long run suggesting that behavioral variable
or behavior of economic agent affect inflationary process in Ethiopia.
Another variable which increase inflation in the long run is real GDP. Real gross domestic
product is the cause and consequence of inflation in the study. This result shows that there is a
growth of national income.
5.2 Implications
Based on the finding of the study the following measures may help in reducing inflation in
Ethiopia.
Though expectation is a behavioral variable, the government should take unexpected action
in order to reduce the impact of expectation. If not, agents will adapt the government’s
action and expect similar trend. Thus, the government should interrupt the agent’s
expectation by taking sudden actions which would disturb their normal adapted behavior of
price trend. Moreover, the government should manage speculative and hoarding activities of
agents for proper market functioning.
As Friedman states, inflation in Ethiopia is also a monetary phenomenon. Hence, the use of
effective monetary policy as a control of inflation is necessary to limit the expansion of
money supply. The government has to supply money in order to contribute to the growth of
the economy, but not inflation. Money supply growth should be kept in line with output
growth.
RGDP is found to be directly related with the CPI. This positive relationship between GDP
and inflation may be due to the economic situation in the country. That is, to support the
economy to grow fast enough; the national bank of Ethiopia lowers interest rates to make
borrowing more attractive. The reason behind this is that it will enhance spending, which
55
will lead to a rise in GDP. So that government has to take in account to increase in real
physical output not inflation when it thinks to motivate the economy. the government has to
make critical research before entering to the economy.
The government needs to continue supply of goods and services to urban dwellers at lower
cost to minimize the effect of inflation on the fixed (low) income group of people.
56
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60
Appendix
Notes:
1. (/v# option or -set maxvar-) 5000 maximum variables
2. New update available; type -update all-
. tsset year
time variable: year, 1982 to 2020
delta: 1 unit
. dfuller r
Interpolated Dickey-Fuller
Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value
. vif
. ovtest
. dfuller dlncpi
Interpolated Dickey-Fuller
Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value
Interpolated Dickey-Fuller
Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value
. dfuller dlnreer
Interpolated Dickey-Fuller
Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value
. dfuller dlngbd
Interpolated Dickey-Fuller
Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value
. dfuller dlnm2
Interpolated Dickey-Fuller
Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value
. dfuller dlnlcpi
Interpolated Dickey-Fuller
Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value
1 0.150 1 0.6981
. gen dlncp1i=d.lncpi
(1 missing value generated)
. gen dlngdp1=d.lngdp
(1 missing value generated)
. gen dlnreer1=d.lnreer
(2 missing values generated)
. gen dlngbd1=d.lngbd
(2 missing values generated)
. gen dlm21=d.lm2
(2 missing values generated)
. gen dlnlcpi1=d.lnlcpi
(2 missing values generated)
. swilk r
. kdensity r,norm
(n() set to 39)
. dwstat
-100 -50 0 50
Residuals
lnGB
year lnCPI lnRGDP lnREER D LM2 lnLCPI
25.756932 11.603253
1982 35 16
27.337369 25.756932
1983 26 11.66864 2.21 30.43 15.8 35
13.213346 89.596966
2007 100 03 4.21 83.41 16.03 55
13.324842
2008 112.31 07 11.41 27.83 15.33 100
13.430885
2009 131.67 77 4.94 2.7 22.15 112.31
13.526571
2010 190.12 7 27.86 15.79 20.35 131.67
13.627024
2011 206.22 44 -6.54 -56.35 21.01 190.12
13.818272 162.2
2013 297.09 74 1.38 6 39.21 223
13.913060
2014 170.2 95 13.48 6.55 30.28 297.09
14.011089
2015 183.23 68 0.6 91.09 24.24 170.2
14.110085
2016 196.3 07 0.45 63.69 26.53 183.23
14.186658
2017 216 17 11.92 12.73 24.72 196.3
14.283312
2018 230.5 39 1.05 -5.26 19.91 216
14.357538 105.6
2019 261.21 87 7.93 9 28.78 230.5
14.443953
2020 290.08 34 -5.89 10.74 29.15 261.21