MIZAN TEPI UNIVERSITY

COLLEGE OF BUSSINES AND ECONOMICS DEPARTMENT

TITLE: THE EFFECT OF MONEY SUPPLY ON INFLATION IN

ETHIOPIA

A SENIOR ESSAY SUBMITTED TO DEPARTMENT OF ECONOMICS IN PARTIAL

FULFILLMENT OF THE REQUIREMENT FOR THE DEGREE OF BACHELOR OF
ARTS IN ECONOMICS

PREPARED BY: SELOME GETACHEW NURE

ADVISOR: Mr. GIRUM T.

APRIL, 2024

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Acknowledgment

First and foremost, I would like to thanks the Almighty God with his mother St. merry for
endowing me the endurance and courage of going through all ups and down to reach the stage
where I am now.

Next, I am also highly indebted to my family who have been with me through my academic life in
general finally, I would like to forward the deepest of my appreciation and gratitude to my
advisor Mr. Girum T. for his comment, suggestion, and useful advice for me.

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ABSTRACT
This study has aimed at investigating the impact of money supply and related variables on
inflation in Ethiopia and testing the causal link between the two variables. The study uses
secondary data collected from NBE, EEA and CSA for the period 1980-2015. The researcher
had employed both descriptive and econometrics model to analysis the data .the descriptive part
of analysis used graphs, tables and percentage. While, the Econometric model analyzed by
using ordinary least square (ols), as a general method of analysis and error correction model
and co-integration technique were conducted to see the short run and long run relationship
respectively On other hand, Granger causality test was applied to test the causal relationship
between money supply and inflation.

The empirical result of the study reveals that expected inflation and money supply are the major
determinants of inflation in Ethiopia in the short run and realgdp, imported inflation, and
exchange rate would affect inflation in long run again expected inflation and imported inflation
have effect in both time periods. Regarding the causal link between money supply and inflation,
as the result suggested, feedback relationship exist, meaning money causes inflation, likewise,
inflation causes money growth

The police implication of these results includes, among other that the government should further
control the money supply of the country and it should look for other means of revenue generation
than money creation to meet it is transaction, so that the inflation rate of the country will reduce.
And Encouraging and expanding domestic import substituting industries to reduce the effect of
imported inflation through foreign price and exchange rate change are other means of
stabilizing the price.

Key words: Money supply, inflation, Budget deficit, world price, real GDP, Expected inflation,
real effective exchange rate.

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LIST OF ACRONYMS

ADF Augmented Dickey-Fuller

BD Budget Deficit

B2 Broad money supply

CPI Consumer price index

CSI Least developed countries

DF Dickey-Fuller

DW Durbin Watson

ECM Error Correction Model

EEA Ethiopian Economic Association

EG Engle Granger

INF Inflation

LDC least developed countries

MOFED ministry of finance and economic development

NBE National Bank of Ethiopia

OLS ordinary least square

Petrpr petroleum price

REER real effective exchange rate

RGDP Real Gross Domestic Product

Contents
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ABSTRACT ii

CHAPTER ONE 1

1. INTRODUCTION 1

1.1Background of the study.....................................................................................................................1

1.2 Statement of the problem...................................................................................................................3
1.3Objective of the study.........................................................................................................................4
1.3.1 The main objective.....................................................................................................................4
1.3.2 Specific objectives......................................................................................................................4
1.4 Hypothesis of the study..................................................................................................................5
1.5 Significance of the study...................................................................................................................5
1.6 Scope of the study..............................................................................................................................5
1.7 Limitation of the study.......................................................................................................................5
1.8 Organization of the Paper..................................................................................................................6
CHAPTER TWO 7

2. Literature review 7

2.1 Theoretical review.............................................................................................................................7

2.1.1 Measures of the money supply....................................................................................................7
2.1.2Theoretical issues on the importance of money...........................................................................7
2.1.4 Theories of inflation...................................................................................................................9
2.1.5 Types of inflation......................................................................................................................12
2.6 The casual link between money supply and inflation.......................................................................12
2.3Empiricalevidences 13

2.4 Evaluation of the theoretical and empirical literatures in the context of Ethiopia......................16
CHAPTER THREE 18

Methodology 18

3.1 Type and source of data...................................................................................................................18

3.2 Data analysis....................................................................................................................................18
3.3 Model specification.........................................................................................................................18
CHAPTER FOUR 21

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4 Data Analyses and Interpretations 21

4.1 Descriptive analysis.........................................................................................................................21

4.1.1Trend of inflation.......................................................................................................................21
SOURCE: constructed base on national bank of Ethiopian data........................................................22
4.1.2Price development.....................................................................................................................23
4.1.3Current Trends of money supply with inflation.........................................................................24
. 4.2 Econometrics result.......................................................................................................................27
4.2.1 Unit root’ test............................................................................................................................27
4.2.2 Co-integration test....................................................................................................................28
4.2.3 The error correction model.......................................................................................................30
4.3. ESTIMATION STRATEGY, ESTIMATION RESULT AND DISCUSSION...............................30
4.3.1 ESTMATION STRATEGY......................................................................................................30
4.2.3 Estimation result.......................................................................................................................32
4.3.3 Discussion of the result.............................................................................................................34
4.3.4Post- estimation 39

Multicollinearity....................................................................................................................................39
Autocorrelation test...............................................................................................................................40
Hetero skedasticity test..........................................................................................................................40
CHAPTER FIVE 41

5 C0NCLUTION AND RECOMANDATION 41

5.1 Conclusion.......................................................................................................................................41
The major objective of this study was to analyses the impact of money supply on the inflation of
Ethiopia using annual data covering 1980/2015 with the hypothesis that money supply is the first major
cause of Ethiopia inflation.....................................................................................................................41
5.2 Recommendation.............................................................................................................................42
REFERENCE 43

List of tables

Table 4.1. Recent Trend of price development-------------------------------------------------------------

Table 4.2.1 Augmented dickey fuller unit root test-------------------------------------------------------

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Table 4.2.2 Co-integration test result--------------------------------------------------------------------28

Table 4.2.3 estimation result of the long run models dependent variable --------------------------29

Table 4.2.4 short run estimation result dependent variables------------------------------------------33

Table4.2.5 result of the causality test between money supply and price ----------------------------39

List of figures

Figure 1 trends of inflation rate in Ethiopia-----------------------------------------------------------------

Figure2. Recent Trends in the Growth rate of Broad Money and Inflation (1991-2015) ------------

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CHAPTER ONE

1. INTRODUCTION

1.1Background of the study

The central issues in macroeconomics are economic growth unemployment and inflation
(Dornbush, 1978) therefore stabilization of prices is one of the aims of macro economy. This
means low and stable inflation is the aim of any country. According to Lipsey,(2001)inflation is
defined as a persistent and continuous rise in the general level of all prices.

The reduction of money supply is the traditional means through which central banks fight
moderate or prevalent inflation. This is based on the quantity theory of money demand that
inflation is always and everywhere monetary problem.

The quantity theory of money states that the change in price level is directly and proportionally
related with the change in price level in money supply. The quantity theory of money is based on
believe that there is only the channel through which the impact of an increase in money supply
was transmitted to inflation.

While, one agree that inflation is always a monetary phenomena ,it is not true that there is one
channel through which an increase in money supply is transmitted to inflation base on PPP or
money supply and demand frame work or both .PPP- states that the change in nominal exchange
rate is directly proportional to change in price level.

World inflation is recently rising, due to higher energy and food price, rapidly rising demand in
emerging economies, poor harvest in commodity producing countries, and diversion of food
crops to production of bio fuels. For instance in the year 2009 World, Emerging and Developing,
and Sub Saharan Africa -inflations were 2.3%, 5.5% & 9.5%, but in August 2011 it increased to
4.9%, 7.6% and 11% respectively (IMF, 2011)

Historically, the Ethiopian economy was known for its low inflation. Prior to 2003/04, the
country has not suffered from inflation. Prior to 2003/04, the country has not suffered from high
inflation. The hikes in the general price level occurred during the times of war and drought only.

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However after 2003/04 it has experienced high inflation following government’s move towards
less conservative monetary and fiscal policy, and active participation in the economy. For
instance, during 2004-2010 annual inflation average was 15.4% for Ethiopia, which is higher
than the Sub Saharan Africa average of 8.8% for the same period (IMF, 2011). After reaching its
peak, inflation was significantly reduced in2009/10. For instance, the headline inflation, which
went up from 15.5% in May 2006/2007 to 41.6% in May 2008/2009, Went down significantly to
2.4% in May 2009/2010 (EEA database, 2009/2010).

The different fiscal, monetary and administrative policy measures taken by the government and
the decline of commodity price in the international market may be the factors behind it.
However, beginning from the end of 2009/10 inflation has been increasing again (for instance, it
climbed to 34.7% in May 2010/2011). This high price development puts inflation as the major
concern, and it is also fair to say that the discussion surrounding this variable for the last few
years in Ethiopia has always been colorful and debatable about its source.
Over the last few years there has been also sharp increase in money supply. Broad money has
grown from 30.5 billion Birr in 2002/03 to 56.7 billion in 2006/07. The share of broad money as
a percentage of GDP has also shown a marked increase jumping from 42.7 in 2002/03 to 53
percent in 2006/07 and in 2012/13 countries broad money supply is increased at 24.2 percent.
MOFED, NBE, CSA (2002/03, 2006/07, 2012/13).
On fiscal front, there has been huge increase in government expenditure as the government
embarked on huge capital projects. Despite the fast increase in expenditure, the government’s
budget deficit (including grants) as a percentage of GDP has fallen considerably. The means of
financing the budget deficit has shifted from external to domestic bank and nonbank sources.
This has led to the monetization of the deficits. The use of domestic means of deficit financing as
percentage of budget deficit has grown from 34.4 percent in 2002/03 to 63.8 percent in 2006/07
(MOFED, 2007/08). There has also been increase in domestic revenue following the introduction
of value added tax (VAT). Export receipts have also improved due to diversification of exports
and recovery of international prices of commodities. During the same period of 2002/03, the
government expenditure has also 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 money supply will, therefore, enable understand the short run and long run
relationship of them in Ethiopia.

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While, the Ethiopian economy registered impressive double-digit economic growth during
2006/2007, 2010/11, it experienced inflationary challenges, with inflation reaching record level.
The inflationary result, which affect the citizen of the country negatively by creating uncertainty
and widening income disparity among citizens (sethi, 1981)
In order to combat its negative effect, knowing question is money supply is the main cause of
Ethiopian inflation? And what is the nature of causal relation b/n the two variables.

1.2 Statement of the problem

Modeling the relationships between money supply and price level has been one of the main
controversial issues of interest for economists, researchers, and policy makers. This is simply
because a clear understanding of the relationship between these macroeconomic variables is of
crucial importance, particularly to the policymakers in ensuring that effective macro-economic
stabilization policies can be designed and implemented effectively.

Camara(1996) argue that, sub Saharan Africa countries finance their budget deficit by
continuously applying monetary expansion than other ways of deficit financing this monetary
expansion may aggravate inflation in these countries

In the Ethiopian case some study has made regarding inflation. For instance, Adugna (2006) with
the aim of examining the dynamics of inflation in Ethiopia in the short run and long run,
Concluded that the world price and money supply had strong pushes in the long run and short
run inflation respectively. Habtamu (2000), investigated determinant of inflation in Ethiopia
using econometric model which include both structural and monetarist variables of inflation it
showed that price expectation to be the most important determinant of inflation. Though, money
supply found to be significant in affecting inflation. Another study was made by Jamal (2007) in
his study of “government budget deficit, money supply and inflation “he investigated the
determinant of inflation and he showed that in the long run the growth of price is proportional to
the growth of money.

Another related work is done by yohannes (2000), he used in his study the monetary, structural
and 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

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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.
However sufficient study was not made specifically on area of the causal link between money
supply and inflation. In addition they are conducted about the determinant of inflation, but
different results are arrived among them due to different method they followed and the number
of observation they took, indicating that the issue is open to further research. In this study special
emphasis was given to weather money supply is the major cause for Ethiopian inflation. or there
is a pushing factor other than money supply in creating inflation in Ethiopia economy and is their
short run and long run relationship between money supply and price in Ethiopian economy ?.

Accordingly, this study finds inflationary response to increase in money supply. To this end the
study use both descriptive and econometrics models by using the time serious data range from
1980/81-2014/15

1.3Objective of the study

1.3.1 The main objective

The main objective of this study is investigate the impact of money supply on Ethiopian inflation

1.3.2 Specific objectives

The specific objective includes

a) To asses trends and structure of recent inflation in Ethiopia

b) To examine whether money supply is the major cause of inflation in Ethiopia
c) To identify the direction of causality between money supply and price in Ethiopia

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1.4 Hypothesis of the study
Based on the above specific objectives we hypothesis that:

 Money supply is the major cause of inflation in Ethiopia

 The causation between the money supply and prices

1.5 Significance of the study

The paper has relevance in understanding the effect of money supply on inflation in Ethiopian
economy. By investigating the effect of money supply on inflation, the paper aims to stabilize
the economy by reducing uncertainty in production and income disparity among citizens. In
addition to this the paper aims to find the way to reduce the inflation rate of the country in order
to make it stable for existing economic growth of the economy.

Moreover, the paper gives policy direction that claims necessary for solving and minimizing
problem related to inflation so as to achieve targeted economic growth of the country.

1.6 Scope of the study

Money supply and inflation are very vast topics, which should be discussed very deeply and
widely. But as far as this paper is concerned the impact of money supply on inflation. The study
focused on macro economic variables that determine inflation and ignores micro economic
variables. The study will cover the time period starting from 1980/81-2013/14. We would try to
see only the basic points which should be discussed under this topic, because there are some
constraints faced by the paper.

1.7 Limitation of the study

Since every activity is depend on the access of resources and equipments which are used to
perform and facilitate the activity. But to undertake this paper there are so many problem that
hinder to undertake. Among these, data inconsistency is the major problem. Internally lack of
access to internet (computer) in the University, limitation of time, lack of econometrics
knowledge to analyze varies variables, lack of finance and limited experience are the main ones.

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1.8 Organization of the Paper
This study is composed of five parts. In the first part, we see introduction or background of the
study, statement of the problem, and objective of the study, significance of the study, scope of
the study, limitation of the study and organization of the paper are discussed. On the second part,
we see on what others have said on the same or related topics, that is literature review. And the
third part deal all about methodology of study. And at the fourth part we will see data analysis
and discussion and. The last part of this paper which is the fifth part will be conclusion and
recommendation

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 CHAPTER TWO

2. Literature review

2.1 Theoretical review

2.1.1 Measures of the money supply

The money supply can be measured in terms of monetary aggregates which are categorized on
the basis of the type of assets that they include in their definition.

According to Mishkin (1986), mo, which is referred to as base money and reserve money
includes domestic currency and banks deposit at the central bank. It’s traditionally the most
liquid measures of the money supply. The other measures of money supply is m1, also called
narrow money supply, constitutes currency in circulation, demand deposit, traveler check and
other checkable deposit. M2 also called broad money supply is composed of m1, time deposit
and possible foreign currency deposits held by resident at bank. M3 is also other measure of
money supply.M3composed of m2, large time deposit, money market mutual fund balances and
term repurchase agreements.

2.1.2Theoretical issues on the importance of money

The importance of money in affecting economic variables has been a debate among classical,
Keynesian and monetary schools. The debate is mainly concerned on whether the money supply
affects real or nominal variables in the economy and on the transmission mechanism.

According to Ghatack (1995) the classical economists argued that money is not important in
affecting real variables that is output and employment for classical economist’s money is
important only in determining the price level in an economy. Harris (1988) noted that, the
classical theory being built around says law which states supply creates its own demand assumes
price and wage to be flexible and they respond to the forces of demand and supply. A given dies
equilibrium in labor or goods. Market will be immediately adjusted by the force of demand and
supply as long as wages and price are flexible. Therefore money has no role in determining real
variables in classical thinking. However this view was challenged by them as Malthus.
According to Gat

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ack Malthus argues that supply May not crate it’s on demand if for instance people save part of
their income. Unemployment and production may fall become of accumulation of inventories
which result from demand deficiencies.

The transmission mechanism from money to price in classical economist id directs (maser et.al,
1984). As manger et.al explains for classicists an increase in money supply will raise agent’s
excess holding of money in order to get rid of excess holding of money agent increase their
expenditure which raises the price level.

The Keynesian theorists unlike the classicists, believed that change in money supply could affect
real variables (Harris, 1988) .Gatack (1995) noted that, Keynesian economists argue that the
economy may not a full employment because ways and price may not be flexible as the
classicists thought. Therefore for Keynesians money supply could mange output through interest
rate

According to maser at.al (1984) for Keynesian the transition mechanism in which the money
supply affects the price and output in indirect through interest rate. As maser at al explains
according to Keynesians, change in money supply affects interest rate in opposite direction. This
affect cost of borrowing negatively and change the level of investment directly depending on
interest rate multipliers and marginal efficiency of investment. The change in investment intern
will change output positively. Price also changes directly though changes demand as a result of
change in money supply.

The other theory of the quantity theory of money argues that money is neutral in the long run in
affecting real variables. It is because output as its potential level in the long run. In the long run
in the long run change in money growth affects the price level only however, in the short run
since output maybe below full employment money growth will ire output because of the increase
in expenditure by economic agents (Harris, 1998)

According to maser at.al (1984) the transmission process in monetarist can be described in terms
of portfolio balance. As money supply increases people hold more money than before and the
equilibrium for their portfolio will be disturbed. To get their portfolio back to equilibrium
peoples obese their money for assets and goods. As a result price rises.

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 In developing countries money market is distinguished from that of developed countries. In
developing countries the economy is characterized by dualism the monetized or organized which
could be fairly competitive, modern and sophscated and non-monetized or unorganized which is
characterized by barter trade. Hence it is not the total national income, but part of national
income, that is important concept as income in monetary economics. The other money market in
developing countries is the existence of different interest rates in organized and un organized
money market. In the organized money market the speculative demand for money is expected to
vary with interest rate whereas in unorganized money market, usually dominated by like money
lenders and landlords, the interest rate are expected to changes with risks, returns and interest
rates. Therefore Keynesian theory tend to fall since under such condition the rate of interest may
not be influenced significantly due to the supply of money in developing countries(Ghatack,
1995).

2.1.4 Theories of inflation

Regarding inflation many theories have been developed. Here the competing hypothesis of
inflation in developing countries, the monetarist and the structuralist hypothesis are discussed.

2.1.4.1 The monetarist hypothesis

In explaining the impact of money supply on inflation, the monetarist base themselves on the
traditional quantity theories of money that states the price level varies directly and proportionally
with variation in the quantity of money(Sethi, 19981). The argument of traditional quantity
theory of money, according to Harris (1998), can be understood using the famous equation:

Mv=py

Where:

M= the stock of money

V= velocity of money

P= the price level and

Y= the level of income

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M is exogenously determined by monetary authority. V on the other hand is affected by the
institutional factors that determined a payment habit of the people. The price level is affected by
the money supply (Mishkin, 19986).

The basic to hold the equality are :output should be at it is potential level, money supply is
exogenous, money must be neutral and velocity is stable since the institutional factor that change
payment habit of individual change slowly(Sethi, 1981). Since v and y are assumed to be stable,
the above equilibrium can be return in logarithmic terms and differentiating it with respect to
times as:

dln M/dt= dln p/dt

It can be return more conveniently as:

m= p

This implies that the rate of change of the money supply is exactly proportional to the rate of
change of price level.

The monetarist argues that as long as money demand is stable a given change in money supply
will be shown proportionately in the level of price changes (Hussein and Chow Dnury, 1999).
For Friedman this is always true since the stability of demand for money is behavioral fact
proven by empirical evidence (Ghatack, 1995). To control the inflation money measures were
taken. But, only those countries that reduced the stock of money succeeded in controlling
inflation (Ball and Doyle, 1972).

2.1.4.2 The structuralist hypothesis

This theory regards the causes of inflation in developing countries as structural bottle necks. Lioi
(1974) argues, the structuralist believe that the structure of the economy to be responsible for the
inflation and low growth in developing countries. For the structuralist, as Lioi further argues, the
system in this countries is such that it generate certain disequilibrium mainly inflation.

According to Canavas (1982), structural bottle necks in developing countries which are shown in
foreign trade, agricultural sector and government sector are the main causes of inflation in those
countries. For instance, the low productivity in agricultural sector does not respond quickly to the

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increased demand due to growing industrialization and urbanization. As a result price of
agricultural products raises hence the general price level too raises. Foreign exchanges
constraints arising from balance of payment disequilibrium because of high expenditures. For
import of value materials to industrialization and low revenue from export is another structural
limitation in developing countries which is responsible for inflation (Canvas, 1982).

Structural reject money supply to be the main cause for inflation in developing countries. They
believe that it may indicate inflation and even if it indicated then it is because of bad structure of
the economy (Patrice and Nixon, 197) cited in (Adugna, 2008). According to Gathack (1995) for
structuralist to eliminate inflation in those countries, policy should be direct toward in removing
varies structural rigidity which are believed to sustain inflation, rather than reducing the money
supply.

The monetarist and the structuralist, discussed above are major competing theory of inflation in
developing countries. However, in literature many other theories exist. Here the Keynesian
hypothesis discussed briefly.

According to ball (1964), for Keynesian the immediate determinates of inflation are the level of
money wages and level of money wages and level of employment. Ball and dole (1972) and ball
(1964) noted that these two determinants of inflation were stated by J.M. Keynes in his article of
how to pay for the war and on his General theory of money interest and prices

According to Keynes, assuming the economy is below full employment and stock of nominal
money is fixed. An increase in wage level say due to labor unions bargain will increase the level
of income for worker to join the labor market and increase cost of production hence price of
goods will be pulled up, Second, the increase the income of the existing labor. As a result the
level of money income will increase creating excess demand and hence the price level increases
(Ball, 1964) and (Harris, 1988). Ball and doyle (1972) noted that, Keynesians gave minor role
for money supply in affected the price level in time of unemployment. But a significant role in
time of full employment Harris (1988) argues that, Keynesians accepted that money can affect
prices only to the extent it can affect interest rates which intern affects level of investment and
hence expenditure.

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According to Dornbush and fisher (1989) the Philips curve which originally relates the rate of
increase of wage to unemployment, gradually become used to describe the rate of inflation to
unemployment rate. According to the Philips curve, there is indirect relationship between
unemployment rate and rate of inflation. The lower the unemployment rate, the higher the wage
rate will be. This means inflation rate will also be higher.

2.1.5 Types of inflation

There are two types of inflation, on the subject of their causes

A. Demand-pull inflation

It is caused by increase in aggregate demand due to increased private or government spending,

etc. Demand inflation encourage economic growth since the excess demand and favorable
market conditions will stimulate investment and expansion.

B. Cost-push inflation

Also called” supply shock inflation “is caused by a drop in the aggregate supply (potential
output).This may be due to natural disasters, or increase in the price of inputs. For example, due
to a sudden decrease in the supply of oil, if price of some key inputs like oil rise, producers will
adjust output supply or translate the higher costs in to a higher output prices. When output
declines because of cost pressure on producers there will be a shortage in output markets and
prices rise as a result, all else constant. This is called cost push inflation.

2.6 The casual link between money supply and inflation

The traditional quantity theorists and many other economists usually assumed the money supply
to be exogenous in examining its impact on inflation. Hence for them unidirectional relationship
exists between money supply and inflation, the causation running from money supply to
inflation. However, other economists believe that the increase in price itself may induce money
supply to grow so that two way causations may also be shown. For example, Harris (1988)
argues that there exists a two way relationship between the two variables, the private sector
needs more cash for transactions, say to pay for the increased wage. For this the private sectors
borrow from banks which increase the money supply.

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Aghevli and khan (1977) argued that, a number of empirical studies have proven that money
supply to a result of the ongoing inflation. According to these authors inflation initiates
governments to finance their expenditure by creation of money which further raises their
expenditure by creation of money which further raises the level of inflation. That kind of
government may even further issue money as the rate of inflation rose since government
expediter rise faster than revenue. For Aghveli and Khan, such policy is particularly followed by
those governments that cannot execute adequate tax programs or manager them effectively to
collect the required revenue.

2.3Empiricalevidences
This section is devoted to review related empirical evidences on developing countries in general
and on Ethiopia in particular. The objective, the data the method, the findings and conclusions of
the empirical evidences are emphasized by this review.

In their inflationary finance and dynamics of inflation Aghevli and Kahan (1977) using the
method of a continuous time frame work and system of stochastic differential equation
simultaneously tested the direction of causation between money growth and inflation of
Indonesia for the period 1951-1972. The result shows that there exist two way causations
between money growth and inflation. Hence Aghevli and Kahan concluded that rising price
makes revenue from will fall short of government expenditure and increase deficit, intern, affects
the government to increase money supply.

Odedukun (1995) conducted a research on the cause of inflation in sub-Saharan African

countries. For this, odedukn used econometric method based on panel data from 1971-1990 for
35 sub Saharan African countries money growth fiscal deficits to GDP ratio, rate of depreciation
of exchange rate, growth of import price, growth of per capita food production, real GDP growth
and expected inflation are taken as independent and consumer price index as dependent variables
on the model. Based on this model the following results were obtained. The entire coefficients,
except fiscal deficit GDP ratio, are significant. According to the study money growth and rate of
currency depreciation together explains 40 percent of inflation. Odeduken concludes that money
growth, rate of depreciation and price index have strong effect on inflation under the period
studied.

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Camar (1996), investigated the inflationary process of Sieraleon using log linear model
developed by sowa and kwakya and tested the causal link between money supply and inflation of
the country applying direct ganger causality method based on annual data from 1966 to 1994 in
his inflation model to examine the process of inflation in Sirraleon he took money supply,
expected inflation ,real GDP, lagged money supply, lagged exchange rate, world price, slop
dummy of exchange rate , parallel exchange rate and its slop dummy, and a war dummy as
explanatory variable whereas the dependent variable. The result shows that the coefficients of
output, money supply, lagged money supply and exchange rate are significant both in the short
run and long run. But slope dummy of parallel exchange rate, expected inflation and the war
dummy are not significant. Based on the result, camara concludes that output growth exerts a
decreasing effect on inflation, while monetary expansion and exchange rate devaluation led to
inflation to the economy. World price also affects the country’s inflation. But the reble war
showed no effect on inflation. Regarding the causal link between the money supply and inflation
Camra has found that a positive feedback (two way causation) between the two variables.

Another research conducted on source of inflation is by Loungami and Swagel in (2001). The
study focused particularly on the relationship between the exchange rate regime and source of
inflation using annual data from 1964 to 1998 for developing countries. Vector auto regressive
method was used to achieve the objective. In the study it was found that in countries with
floating exchange rate regime, money growth and exchange rate change are important factors of
inflation where as in countries with fixed exchange rate inertial (expectations) factors are more
important determinants

In the case of Ethiopia, the following studies are reviews. The study conducted by Habtamu
(2000) investigates determinants of inflation in Ethiopia using econometric model which
includes both structural and monetarist variable of inflation for the period 1962-1997. The
variables taken as determinants were broad money supply, real GDP, import unit value index,
world inflation, real effective exchange rate ratio of government deficit to GDP, per capita food
production, broad money supply to GDP ratio and price expectations. The result shows that price
expectation, real GDP, money supply and food production are found to be significant in affecting
inflation. However, exchange rate import index and ratio of money supply to GDP are found to
insignificant. According to Habtamus finding significant variables price expectation explains

14
inflation more structural (supply side) factors like real income and food production are also the
major determinants of inflation. Though the monetarist variable is significant the coefficient does
not add up to unity argued by monetarists.

Eyerusalem (2005) also made a study on the impact of monetary policy on inflation in Ethiopia,
employing OLS economic model based on annual data from 1970 to 2003 in the model she took
expected inflation, money ,supply, lagged money supply, real output, exchange rate and world
inflation as independent variables. The finding shows that price expectation and RGDP are
significant and have higher coefficient. The coefficient is not unity. Exchange rate and world
information are also found to be significant but showed low coefficient.

Jamal (2007) in his study of Government budget deficit, money supply and inflation
investigation determinates of inflation and tested the causal relationship between money supply
and prices in Ethiopia using Aghevli and khan (1978) model for the period 1974-2005. Based on
assuming there is a policy shift Jemal divided the period and 1992-2005 (post durg regime) as
the second period. Previous year real money balance, price expectation, money supply and
RGDP were among determinates of inflation taken in the model. Regarding the findings, in the
first period of short run, money supply and price expectations are found to be significant. In
period two both in the long run in the short run among the determinants only RGDP was found to
be insignificant in general the author concludes that the monetarist claim that sustained inflation
resulted from the budget deficit by money creation has been empirically confirmed in period
two. According to Jemal, this is precise evidence that in the long run the growth of price is
proportional to the prices of money supply. Regarding the causal link between money supply and
inflation Jemal has concluded that two way causations existed for period two.

Another study was made by Adugna (2008) with the aim of examining the dynamics of inflation
in Ethiopia both in the short run and the long run. The Johansson maximum likelihood approach
and engle ganger procedure was used to estimate the long run coefficients based on annual data
covering 1992-2007. The explanatory variables being taken were: money growth, real GDP,
expected inflation, exchange rate and world prices. According to the finding in the long run
world price is found to be the most determining factor followed by real GDP and money growth
while in the short run money growth is found to be the most determining factor of inflation. The
official exchange rate was insignificant in the short run the coefficient of real GDP was negative

15
in the short run. Consistent with the theory exchange rate was significant in the long run while it
was insignificant in the short run. Based on the findings, Adugna concluded that the world price
and money supply had strong pushes in the long run and short run inflation respectively.

2.4 Evaluation of the theoretical and empirical literatures in the context of Ethiopia
We have reviewed relevant literature on theories of inflation and empirical evidences in pervious
section. In this section, these literatures are evaluated as follows.

Monetarist argued that in the long run only money growth affects inflation and there exists equi
proportional change between money supply and the price level. Money supply may be the major
cause for inflation however; equi proportional change (relationship) may not exist between the
two variables. Their assertion may fail if output and velocity are not stable as traditional quantity
theorist’s claim and money demand function may not be stable as monetarists argue.

The structuralisms theory, by taking, structural rigidities, in developing countries to be the main
determinants of inflation seems to explain inflation more being nearer to the reality. However it
gives less emphasis to money supply in affecting inflation in developing countries.

The Keynesian theory, on the other hand, takes money wages and level of employment to be
immediate determinants of inflation. But this is unlikely to hold for developing countries where
wages account small proportion of national income. In addition, relatively, there is no strong
labor union that can influence the level of wage to be pushed up. Hence wage may affect the
price in some cases but may not be the sole cause.

In general, the monetarist, the structuralist and Keynesian theory of inflation viewed the sources
of inflation focusing on specific and ignoring the other variables. However, despite their
shortcoming each theory constitutes important variables that determine inflation. The
structuralist theory seems to appropriate for Ethiopia as a developing country.

Regarding empirical literature, those which are studied in the case of Ethiopia are evaluated as
follows. Based on empirical evidence reviewed above the role of money supply in determining
inflation in Ethiopia is inconclusive since those studies arrived at different conclusion. The study
made by Habtamu (2000) showed that price expectation to be the most important determinants of
inflation. Though money supply found to be significant in affecting inflation, its coefficient does

16
not add up to unity, inconsistent with the monetarist theory. Eyerusalem (2005) has also arrived
at the same conclusion regarding the role of money growth in affecting inflation positively.

Unlike the above studies, a study made by Jemal (2007) showed that money growth to be the
main determinants of inflation and Jemal arrived at the conclusion in the long run the growth of
price is proportional to the growth of money, consistent with the monetarist claim.

Indeed, different results arrived by the above studies regarding the role of money supply may be
because of different method they followed the number of observation they took and the study
period they covered in their study. In addition, all study conducted on one or another way on the
causes of inflation except the study conducted by Eyerusalem (2005), which focused on how
money supply affects inflation. However in this study special emphasis will be given whether
money supply is the first major cause for Ethiopian inflation.

17
 CHAPTER THREE

Methodology

3.1 Type and source of data

This study used secondary data which is time series data type from 1980/81 upto 2014/15. They
had been collected from national bank of Ethiopia (NBE), Ethiopia economic association (EEA),
ministry of finance and development (MOFED) and external sources like world bank (WP) and
statistical publication from different governmental ministers.

3.2 Data analysis.

The study used both descriptive and econometrics method of analysis in descriptive analysis the
study employed statistical tools such as percentages, average and graphs to shows the structure
and trends of inflation in Ethiopia and to achieve the specific objectives of the study ordinary
least square (OLS) estimates technique was employed as general method of analysis. The Engle
granger two step procedures was followed to estimate the long run and short run coefficients of
the variables of the inflation model and granger causality test was applied to test the causal
relationship between money supply and inflation

3.3 Model specification

As stated in the first chapter the major objective of this study is to investigate the effect of money
supply on Ethiopian inflation. To this end the study will use economic frame work.

As it was seen in theoretical and empirical literature inflation is not only affected by money
supply, rather many factors determine inflation in a given country. In this study the major
determine inflation in a given country. In this study the major determinants will be included to
check whether money supply is the major cause for Ethiopian inflation which is one of the
objectives of the study. Hence, the rational for dependent variable used in the model is the
consumer’s price index (inflation) which captures the inflation level.

18
Broad money supply: As discussed previously, classical economists and monetarists argued
money supply to be the major cause of inflation. As a result broad money supply is included in
the model to check whether it is the major cause for Ethiopian inflation.

The real growth domestic product is included in the model because it affects inflation
negatively. According to Odedukun (1995) economic growth affects inflation negatively either
by reducing the gap between the growth of normal money supply and the growth of real money
demand or more likely, by increasing the domestic supply of goods and services in the long run.

Inflation expectation is another variable included in the model since it is theorized that price
expectation increases the level of inflation. Harris (1998) argues that if people expect higher
price in the future they will buy more goods in current period not to be penalized by future
inflation producers also produce for stock rather than for current sale to get more profit in the
future if they anticipate future rise in price. As a result excess demand not matched with supply
will exist in the current period there for price will rise. To capture this effect lagged inflation is
used.

Real effective exchange rate: Exchange rate means the price of one’s country currency in terms
of another country currency. Since domestic currency per unit of foreign currency will be applied
in the study, an increase in real exchange rate leads to a decline in the purchasing power of
money. A Decline in the purchasing power of money leads to increase in the price of goods and
services which leads to inflation.

Average crude oil price In the globalized world where trade among countries becomes higher
and higher the world price can affect domestic price level. According to kibrom, (2008) citing
kibritciglu (2002) inflation may result from international price pass through effect of rise in
important price due to rise in foreign price or exchange rate changes. As a result the model
included the imported inflations as one variable which is captured by Average crude oil price.

Budget deficit affects the inflation level positively. As the level of government budget deficit
increases and if the government finances it though money creation then inflation follows
(Mishkin, 1986). As a result the level of budget deficit is taken to be one of the explanatory
variables putting all explanatory and explained variables in general form becomes:

19
 DP=f (M2, RGDP, DPt-1, petpr, REER, BD) 3.1
Where
CPI=consumer price index
RGDP=real domestic product
M2=broadly defined money supply
DP t-1=expected inflation represented by lagged domestic price
Oil price =average crude oil price (imported inflation)
BD=the level of budget deficit
So the model in its reduced from becomes:
CPI =β0 + β1M2t + β3DPt-1 + β4petrpr + β5REER+β6BDt + Ut 3.2
Where: ut represents the disturbance term
In order to avoid the incidence of hetroskedacity and to express the coefficients as elasticity
it is appropriate to take the logarithm of equation 3.2. hence; the equation takes the form:

CPI=βo+β1LM2t+β2LRGDPt+β3LCPIt-1+β4LWPt+β5LBDt+β6LREERt+Ut 3.3

NB: βs are coefficients of variables that are to be estimated.

L represents logarithmic values and growth rates of variable with respect to time.
The expected sign for each coefficient are as follows:
β1>0, β2<0, β3>0, β4>0, β5>0, β>0
in order to achieve the second specific objective of this study, i.e, to test the causation
between money supply and inflation, the Granger causality test will be used based the
following equation:
LDPt=ao+a1LDPt-1+U11 3.4
LDPt=bo+b1LDPt-1+b2LM2t-1+U12 3.5
LM2t=co+c1LM2t-1+U13 3.6
LM2t=do+d1LM2t-1+d2LDPt-1+U14 3.7
Where LDPt, LDPt-1, LM2t and LM2t-1 are logarithmic of domestic price and money
supply with their respective lagged values.a, b, c and d are the coefficient of the variables.
U11, U12, U13 and U14 are the usual error terms in classical linear regression model.

20
 CHAPTER FOUR

4 Data Analyses and Interpretations

The data analysis part constitutes both descriptive and econometric method. The descriptive
method is used to assess the trends of inflation with time, and the two-wayline graph of price
level with money supply is used to see their relationship graphically since1980/2015, whereas
the time series econometric technique is used to estimate the long run and short run relationship
between money supply and inflation and their direction of causality will be determined using
OLS model. Secondary data are used for the purpose of study

4.1 Descriptive analysis

4.1.1Trend of inflation
The trend of inflation shows the change in the inflation over the study period. Looking at the
trends of inflation would enable us to understand the change of inflation during the study period
over the years. Further it observes what goes wrong or right at a particular year. Trends of
inflation during the durge regime was shifted upward grew at a two digit in period 1974/75-
1979/80 alone the average inflation rate reached 14.9 percent this was higher when compared to
the period average of 2.5 percent for year 1967/68 to 1973/74. When we see the trends of
inflation starting from year 1980 to 2015 it have different trends (shapes). The trend analysis in
figure 1 below indicates that trends of inflation show moderate ups and downs from
1980/2015.with exceptions of 1985, 1991-92 and1996.

In 1985 there was a devastating drought which claims the life of many Ethiopian and also created
the current image of the country in the world. Since the country depends on rain fed agriculture
as a main source of income, the drought diminished output growth which in turn has a significant
influence on the increment of inflation. In 1991-92 there was a political transition in country and
later in 1998 there was a war with Eritrea which also affected progress of the economy. The
country has been experiencing the higher price rise since 2003/2004. In 2001/02, the inflation
rate was negative -10.1 percent. In 2003/04, the inflation rate increased to 18 percent. But the
recovery of the agricultural production and the general economic growth has reduced the
inflation rate to 3.2 percent in 2004/05. After 2004/05, the inflation rate could not show any sign

21
of declining till 2008. In 2008, the inflation reached its highest 50.6 percent. According to
MOFED (2009) imported inflation (such as the increase the price of oil, steel, fertilizer)
accelerated economic growth, inefficient market structure and inflationary expectation by the
market participants are believed to be the main driver to the general price rise.

During the fiscal year of 2009/10, the general inflation rate came down to 2.8percent due to a
combination of both monetary and fiscal policy measure taken by the Ethiopian government.
During the period under consideration, food inflation rate was sequenced down to -5.4% while
non-food inflation still remains very high (18.2). (AynalemShita: the inflation-economic growth
nexus in Ethiopia). After declining in 2009/10 (2.8%) then it tends to increase to the next two
years 2011/2012 by (39%)then it tends to decline for the remaining years that was 8.2% and it
tend to increase slowly in 1914 and 1915 which is 8.8and 10% respectively

Figure 1 trends of inflation rate in Ethiopia

Inflation

60

50

40

30 Inf

20

10

0
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16
-1019 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20

-20

22
SOURCE: constructed base on national bank of Ethiopian data

4.1.2Price development
The inflation rate of Ethiopia in the early 1990s was characterized by low inflation country. High
level of inflation was recorded during 1991/92 which was estimated around 21%. This high rate
of inflation was observed asthe result of severe drought and instability. For remaining some year
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 good whether
condition. (NBE, 2004/05)

The decline in price in 2002 peaked up to 15% in 2002/03.The inflation rate further increase 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 and fuel etc.In 2006/07 all there indicates of inflation (general, food and non-food
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 ceilling 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 government also
imposed price cap on basic commodities which have been distortionary as slight decline inflation
rate.

23
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. Generally we
conclude that a trend of prices was at increasing situation, while in the recent year in 2013/14
prices were at decreasing rate

Table 4.1.1 Recent Trend of price development

1998/99

1999/00

2000/01

2001/02

2002/03

2003/04

2004/05

2005/06

2006/07

2007/08

2008/09

2009/10

2010/11
Year

General 4.8 6.2 -5.2 -7.2 15.1 8.6 6.8 12.3 15.8 25.3 33.6 2.8 18.1
inflation
Food 9 8.6 -10.4 -12.9 24.8 11.8 7.7 14.0 17.5 34.9 44.1 -5.4 15.7
inflation
Non- -1.3 2.4 1.9 0.9 0.5 2.8 5.2 8.1 15.2 12.5 23.8 18. 21.8
food 2
inflation

Source: central statistical authority and ministry of finance and economic development.

4.1.3Current Trends of money supply with inflation

The quantitative money theory states that an increase in money supply has a positive and direct
impact on inflation, looking at the trend of broad money (m2) with inflation has more or less
direct effect on Inflation

24
 5
4
3
2
1 the recent relation b/n money supply(m2) and inflation

1990 1995 2000 2005 2010 2015

time

log rm2 log cpi

Source: national bank of ethiopia,2015

Figure2. Recent Trends in the Growth rate of Broad Money and Inflation (1991-2015)

As we see from the above figure broads money and inflation has positive relationships even
though the weak relationship between these two variables for some years. For example the year
1995 up to 2000 inflation showed smooth decreasing and reaching a growth of 1.5 % and 1.4%
in the year 2001 and 2002 respectively, however inflation having a fluctuating trend and being
volatile, its generally increasing, on the other hand money supply also increasing time to time,
with the exception of some years in which the growth rate is decreasing, depending on the
above figure inflation and broad money in some direction starting from 2005 up to 2015, this
mean that when broad money supply increase inflation also rise at the same direction and when
money supply decrease it results a reduction on inflation

In the same way, in 2015 marked as a year in which broad money (m2) and inflation reached a
maximum point and starting from 2010 both variables increasing in the same way. The figure
indicates that money supply and inflation have almost positive relationship even though
fluctuating for some years.

25
generally we conclude that inflationary trend in Ethiopia is fluctuating year to year as depicted in
figure 1 and The major sources which make the inflation rate to increase at an alarming rate
includes increase in money supply, the nature of investment in the country, widening of the
national deficit and ways of financing it, and others (Geda and Tafere, 2008; Goodo, 2008; Seid,
2008).

It indicated that the growth rate of money supply was greater than that of real GDP growth,
citreous paribus, implying that money supply has been growing at a higher rate and leads to
increase in general price level. Besides, as shown in figure 1 above almost in all the study period,
except the period at which inflation reached at its peak the growth rate of money supply was
above the rate of inflation. Moreover, after 2010 growth rate of money supply could not show
any sign of declining and it seems that money supply growth derives inflation up. In addition to
the trend analysis the two-way line plot below in figure 2 more clearly explains the positive
relationship between inflation and money supply. This supports the current situation in
Ethiopia, which the government and stock holders insisted that money supply is one of the
sources of current inflationary pressure

In the same way, in 2015 marked as a year in which broad money (m2) and inflation reached a
maximum point and starting from 2010 both variables increasing in the same way. The figure
indicates that money supply and inflation have almost positive relationship even though
fluctuating for some years.

generally we conclude that inflationary trend in Ethiopia is fluctuating year to year as depicted in
figure 1 and The major sources which make the inflation rate to increase at an alarming rate
includes increase in money supply, the nature of investment in the country, widening of the
national deficit and ways of financing it, and others (Geda and Tafere, 2008; Goodo, 2008; Seid,
2008).

It indicated that the growth rate of money supply was greater than that of real GDP growth,
citreous paribus, implying that money supply has been growing at a higher rate and leads to
increase in general price level. Besides, as shown in figure 1 above almost in all the study period,
except the period at which inflation reached at its peak the growth rate of money supply was
above the rate of inflation. Moreover, after 2010 growth rate of money supply could not show

26
any sign of declining and it seems that money supply growth derives inflation up. In addition to
the trend analysis the two-way line plot below in figure 2 more clearly explains the positive
relationship between inflation and money supply. This supports the current situation in
Ethiopia, which the government and stock holders insisted that money supply is one of the
sources of current inflationary pressure

. 4.2 Econometrics result

Before any time series econometric model is estimated, appropriate tests of the variables must
take place to observe their time series properties. Accordingly, this study has carried out: unit
root test, co-integration test and error correction model.

4.2.1 Unit root’ test

In the classical regression technique of ordinary least square (OLS) the variables are assumed to
be non- stationary. But such non stationary variables give spurious or nonsense regression
(Alemayehu et al, 2000)

But the variables must be stationary if the results have to be non-spurious. According to Gujirati
(2004) a variable is said to stationary if its mean, variance and covariance are constant overtime
in other words as Alemayehu et al (2000) noted a stationary series or time in variable would have
a finite mean, variance and the covariance between any two consecutive periods is time invariant
if a given series contains unit root then the sires is said to be non-stationary otherwise it is called
stationary.

As Gujarat (2004) has noted, different methods can be used to test for the stationary of a series.
But unit root test is the recently developed and widely used test of stationary. The dickey-fuller
(DF) and augmented dickey-fuller (ADF) tests are the two methods, among, other, that are used
to test for the existence of unit root.

27
Table 4.2.1 Augmented dickey fuller unit root test

Vari. Critical value At first difference

t-stat 1% 5% 10% p-val Dec

cpi -7.458 -3.709 -2.983 -2.623 0.0000 **

Cpi_1 -5.029 -3.702 -2.980 -2.622 0.0000

*
Money -5.237 -3.709 -2.983 -2.623 0.0000 *
supply
RGDP -4.754 -3.709 -2.983 -2.623 0.0001 **

Petrpr -4.359 -3.702 -2.980 -2.622 0.0004 *

REERI -5.005 -3.702 -2.980 -2.622 0.0000 *

BD -8.623 -3.702 -2.980 -2.622 0.0000 *

Where: * stationary at first difference

** Stationary at second difference

In this study the variables of the model are tested for unit roots using ADF test which augments
DF test by lags of the dependent variable. All variables are found to be non-stationary at level.
Therefore the variables are tested having differenced them; it can be observed that after first
difference all the variables are stationary at their respective.

4.2.2 Co-integration test

Most micro variables are non-stationary before they are differenced (at level). This shows most
macro variables become stationary after they are differenced once, I.e., most variable are
integrated of order one I(i)) Alemayehu et al, 2004).the concept integration used to take care of
the non-stationary of the variable and to examine whether there exist long run, equilibrium
relationship among the variable under consideration (Gujarat 2004).

28
The Engle Granger (EG) two stage procedures and Johansson maximum likelihood approach are
the two methods testing for existence of co-integration among variables. According to Gujirati,
(2004) while using EG approach in the first step, long run model in level in form which is
integrated of order one. (I (i)),is estimated in the next step the residual form of the long run
model is tested for its stationary. If the residual found to be stationary the variables are co
integrated. That means there is long run equilibrium relationship among the variables.

The Johnson co-integrated hypothesis formulated as follows;

Ho: there is no long run relationship

Hl: there is long run relationship

Decision: if the ADF test on the residual shows that stationary or if in absolute terms t-statistics
greater than critical value at 1%, 5% and 10% we reject Ho, then it mean that there
is long run relationship (accept Hl)

Table 4.2.2 Co-integration test result

Variable Test stat(at level ) p-value

Residual -3.961 0.0016

Critical value 1%=-3.696

5%=-2.978
10%=-2.620

Note: the critical value is taken from MacKinnon (1996)

The above table shows that the error term is stationary at all MacKinnon critical values 1%,5%
and 10%, since the computed test statistics is greater than critical values we reject the null
hypothesis of existence of unit root in the residual. Hence; there is meaningful long run

29
relationship between the dependant and independent variables, which means that the model is co-
integrated.

4.2.3 The error correction model

To explain the short run relationship between independent and dependent variable that are co-
integrated ECM is used. According to Guajarati (2004). Even if the variable of the model are co-
integrated, there may be disequilibrium in the short run as result of the residual of the long run
method, It can be treated as the equilibrium residual and it can be used to connect the short run
behaviour of the dependent variable to its long run value. The ECM is also important since it
convey information for the speed of adjustment from the short run disturbance to long run
equilibrium. If the variables are stationary say at first difference the short run model ECM, can
be given as;

Yt=βo+β1Xt+Ut-1+et

Where e: is the white noise , is first difference and Ut-1 is the one year lagged of the long run
residual value the short run model relates Yt change in Xt and the lagged equilibrium error term.
X represent the short run disturbance in Yt and Ut-1 represent the speed of adjustment toward the
long run equilibrium

4.3. ESTIMATION STRATEGY, ESTIMATION RESULT AND DISCUSSION

4.3.1 ESTMATION STRATEGY

4.3.1.1 on the model of inflation

As was it mentioned previously time series econometrics used as method of analysis to check
weather money supply is major cause of Ethiopian inflation. Since the ADF test on residual is
found to be stationary the following general model is estimated as long run model.

CPI=βo+β1LM2t+β2LRGDPt+β3LCPIt-1+β4LWPt+β5LBDt+β6LREERt+Ut

Where:

30
 CPI=consumer price index

RGDP=real gross domestic product

M2= broadly defined money supply

CPIt-1= expected inflation represented by lagged domestic price

Petroleum price= (imported inflation)

BD=the level of budget deficit

REER=real effective exchange rate

β=coefficients of variables that are to be estimated.

L=logarithmic values of the variable

t=time

4.3.1.2ON THE GRANGER CAUSALITY TEST

A regression analysis, according to Gujirati (2004), focuses on the dependence of one variable on
another variable. But it does not necessity; imply the causation (direction of influence between
variables).

In time series econometrics, it may be difficult to know which variable causing to the other
variables. For instance variable x may cause variable y or in contrary, the variable y may case of
variable x. also both variables may form a feedback relationship or even, they may not exhibit
any relationship. The granger causality test is a method used to test such direction of causation
between or among variables. The test is based on the rational that if a variable, say x case
variable y, then change in x should precede change in y. therefore in regression of y on other
variable (including on its own past values) if we include lagged values of x and it significantly
improved the predication of y, then we can say that x causes y. a similar definition work if y
causes x (Gujirati, 2004).

31
As mentioned 1.3.2, the second objective of the study is to check the direction of causation
between money supply and inflation. Prior to the test, the following regression are needed to be
estimated.

LDPt=ao+a1LDPt-1+ U11 4.3

LDPt=bo+b1LDPt-1+b2LM2t-1+U12 4.4

LM2t=co+c1LM2t-1+u13 4.5

LM2t=d0+d1LM2t-1+LDPt-1+U13 4.6

Where LDPt, LDPt-1, LM2,and LM2t-1 are logarithm of domestic price and money supply with
their respective lagged values as, bs, cs, and ds are the coefficient of the variables U11, U12,
U13 and U14 are the usual error terms, equation one and three are said to be restricted regression
were equation 2 and 4 are said to be unrestricted regression.

4.2.3 Estimation result

In the previous sub section the estimation strategy was defined. In this section based on the
estimation strategy, the long run and short run estimation result represented below

Table 4.2.3 estimation result of the long run models dependent variable -CPI

Variables coefficient Std. Error t-statistic t-prob

lagcpi 45.26387 9.368492 4.83 0.000
realgdp -17.56392 5.956246 -2.95 0.007
reeri .0596386 .0167557 3.56 0.001
bd -.0934954 .4485347 -0.21 0.836
petrpr .0396361 .0072856 5.44 0.000
money supply .000288 .000197 1.46 0.155
_cons 135.648 58.43078 2.32 0.028

F( 6, 27) = 351.64 R-squared = 0.9874

Prob> F = 0.0000 Adj R-squared = 0.9846

32
 Table 4.2.4 short run estimation result dependent variables: LCPI

variables coefficients’ Standard t-statistic t-prob

errors

D1. Lag cpi 26.53962 15.11917 1.76 0.091

Money supply .0006022 .00022 2.74 0.011

D1.
RGDP -4.550637 8.569903 -0.53 0.600
D1.
.0316937 .0068181 4.65 0.000
Petpri D1.
REER .0474781 .0266852 1.78 0.087
D1.
Bd D1. -.1858855 .3184171 -0.58 0.565

u -.5534169 .1962967 -2.82 0.009

L1.
_cons -.2199474 .938923 -0.23 0.817

Prob> F = 0.0000

R-squared = 0.7632

Adj R-squared = 0.6969

DW =1.08975

Table4.2.5 result of the causality test between money supply and price

Direction of causation F value Sign Decision

Money to prices 4.44 Positive Accepted
Price to money 32.964 Positive Accepted

33
Based on the result of these regressions the F statistic is applied to test the direction of causation
between the money supply and inflation note that the result of the test is affected by number of
lagged term used in the regression. However in this study, for the sake of simplicity, only one
lagged term is included.

4.3.3 Discussion of the result

In this section the results along run model the short run model and the granger causality test are
discussed.

4.3.3.1 Discussion of the long run result

As can be seen from table 4.2.3 the R2 and adjusted R2 of the long run model are very high with
the value of o.9874 and 0.9846 respectively. This means 98% of the variation in the long run
domestic price is explained by the variation in all explanatory variables.

Inflation specified as follow;

Inflation=135.648+45.26387cpi-1+.000288M2+-17.556392rgdp+.0596386REER+.0396361pet
price-.0934954BD

(58.43078) (9.368492) (.0001975) (.956246) (.0167557) (.0072856) (.4485347)

Interpretation of coefficients

The individual significance of the coefficient is tested based on the following hypothesis.

Ho: βi=0

H1: not Ho

The test for the individual significance of the coefficients shows that ho is accepted for,β2, and
β6 were as ho is not accepted for the coefficient of β1,β3,β4,β5.This means concerning the
individual significance of the independent variable the coefficient of cpi-1,rgdp,reer, and petpri
are found to be significant at 1% critical value. Whereas the coefficient for M2and BD is in
significant, (see table 4.2.3)

Expected inflation (CPI_1): The coefficient of DPt-1 is consistence with their prior
expectation. The significance of the coefficients for lagged domestic price (expected inflation)

34
indicates that, in the long run a 1% rising in past domestic price will increase the current
domestic price by 45.26387 percent

In the Ethiopian case the price expectation that lead to higher inflation may be from the side of
consumer, by increasing present transaction or feature consumption or the side of producer, by
accumulating inventories expecting higher feature prices, or by combined effects of these two
agents.

Broad money supply (m2): the impact of this variable is found to be consistent with the theory
Because it is consistent with expected sign. The results of the study show that money supply is
found to be insignificant impact in the inflationary process in the long run. The insignificant
result of money supply in the long run reveals that the increase in money supply in the short run
increases price by increasing aggregate demand with lag in output response. However, in the
long run output increases and reduce the price level of goods which offset the short run increased
price. This finding is in line with the findings of Abate Eyesight and Dr. Nandeeswara Rao P.,
(2015).

Petroleum price (petpr) the impact of this variable is found to be consistence with the theory,
because it is consisted with expected sign. This mean that increase in the cost of petroleum
which leads to inflationary pressure, this variable have positive sign, when the price of petroleum
increase or decrease the inflation level also increase or decrease in similar manner it is cost push
inflation. This variable is significant at 1%, the coefficient is 0.0396361 this reflect that 1 dollar
increase in world average petroleum price will lead increase the dmesic inflation rate by
0.0396361 persent.

Real gross domestic product (Rgdp):-this variable also found to be significant and consistent
with theory, According to Odedukun (1995) economic growth affects inflation negatively either
by reducing the gap between the growth of normal money supply and the growth of real money
demand or more likely, by increasing the domestic supply of goods and services in the long run.
So, this means that a1% increase in growth national product of nation will decrease inflation by
17.56392 percents. The reason for using percentage in interpretation is the study used the data in
elasticity form which is LNRGDP

35
Real effective exchange rate: the long run coefficient of the real effective exchange rate is
positive as per the theoretical expectation. If exchange rate at time t increases by 1 % the CPI
measure of inflation rate responds to it by increasing .0474781 %.

Budget deficit: The coefficient of the fiscal variable (ratio of budget deficits to GDP) is not only
insignificant, but also it shows wrong sign, in contrary to the theory. This is similar with the
findings of Abate Eyesight and Dr. Nandeeswara Rao P. (2015)
This insignificant impact of the fiscal variable, in spite of the fiscal dominance in Ethiopia, may
be due to the inclusion of money supply and expected inflation in the analysis, both of which
reflect deficit financing.
.
The insignificance of the budget deficit, on the other hand, is perhaps, because the government
uses other means of deficit financing than money creation. Or the insignificance of any or the
two variables is because of the problem of data or the response for their change is show after a
certain lag.

4.3.3.2 Discussion of the short run results

After determining the existence of long run relationship among the variables, the next step is to
set up the short run dynamic or the error correction model. It is obtained by estimating the first
difference of the dependent variable on its own lag, on the first difference of all explanatory
variables and their lags and also including one year lagged error term which is obtained from the
long-run model estimation. The reason for including one year lag of the error term is to indicate
how the time path matter to correct any error or deviation from the long run equilibrium. The
change in the variables entered into the model to represent variation in the short run, while the
coefficients obtained from the error correction term will represent the speed of adjustment
towards variation the long run equilibrium relationship.
The R2 the adjusted R2 for the short run dynamic are about 76% and 69% respectively being
their magnitude much lower than that of the long run model. As the adjusted R2 show the
variation in the explanatory variables in the explain 76% the variation in explained variable in
the short run.

36
Regarding to the individual significance and sign of variables, the coefficient of broad money
supply and petroleum price are significant at 1% critical value, real effective exchange rate and
the lagged inflation (price expectation) are significant at 10% Their sign are also similar to what
was it expected.
The estimated result of the short-run model shows that the main derivers of inflation in short-run
are money supply, real GDP, expected inflation, interest rate and foreign price. As shown in the
above table 4.2.4, the lagged values of LCPI are positive and significantly influenced the
behavior of current inflation.
Specifically, the coefficient of expected inflation is positive and significant at the 1% significant
level which is consistence with its long run result. That is inflation Expectation is the main
derivers of inflation in Ethiopia both in the long run and short run model. This significant effect
of foreign price both in short and long run revealed that imported or pass through inflation is one
of the main derivers of domestic inflation both in the long and short run.
Money supply: The estimation result indicates that money supply in the country is the Major
determinant that influencing the measure of inflation CPI in short runs. With regard to the
magnitude of the effect, the result suggests that an increase in money supply by 1% can be
expected to result in 0.0006022% increase in the measure of inflation CPI.
Real effective exchange rate: It has appositive sign with the measure of inflation and statistically
significant because of the devaluation of birr by the national bank of Ethiopia leads individuals
to assume the value of goods and services they owned became increase and they decline the
supply of goods and services currently and also individuals who have money value went to
purchase goods and services because they assume that the value of birr decrease in the future.
The combined effect of decrease in the supply of goods and services in the market and increment
in demand leads to the price of goods and services to increase which finally leads to inflation

The coefficient of the fiscal variable (ratio of budget deficits to GDP) is not significantly
different from zero, both in the short and long run. This is similar with the findings of Khan &
Gill,(2010). The insignificant impact of the fiscal variable, in spite of money supply and
expected inflation in the analysis, both of which reflect deficit financing. Deficit depends upon
the methods of covering the deficit and it may not be always inflationary.

37
However, in Ethiopia most of the time budget deficit is financed by money creation which is
inflationary. Thus, the insignificant effect of budget deficit in this case may be due to the first
reasons than the second once.
As can be seen from the result above, inflation is negatively related to real GDP and for a one
percent increase in the lag of real income inflation decreases by 4.5 percent. Because, the
Ethiopia economy is agrarian more GDP means more agricultural output and this in turn reduces
inflation, especially price inflation of food items which comprises 26% of CPI

The short run model shows that the lagged error term is negative and significant with the
magnitude of nearly 0.55. The interpretation for this term is that any previous shock in the short
run will be adjusted by 55% each year to the long run equilibrium. In other words, 55% of the
short run disturbance will be adjusted to the long run equilibrium, per year.

4.3.3.4 Discussion of the causality test result

The result of the granger causality test between money supply and inflation is presented in table
4.2.5 above. The following two hypotheses are tested to see the direction of influence.

1. H0: money doesn’t granger case price

H1: not h0
2. H0: price doesn’t granger cause money
H1: not h0

Hypothesis 1 is based on equation 4.3 and 4.4 where has hypothesis 2 is based on equation 4.5
and 4.6 as result of this expresses (see table 4.2.5), in both case, the computed F value exceed
that of the tabulated F value implying that the above two null hypothesis rejected. This means the
alternative hypothesis are accepted, indicating that there are exist unidirectional or a feedback
relationship between money supply and price.

The result of the causality test is in consistent with the second hypothesis of this study which that
there exists a bi- directional causation running from money supply to inflation. According to the
result an increased in money supply has a significant effect on inflation on the growth of the
money supply of Ethiopia. This result supports the finding of Jamal (2007)

38
The feedback relationship observed in this study may be due to the increases in money supply
would push the domestic prices up through, like the increase demand for goods and services by
increasing income of the consumer or availability of credit at lower costs. This increase in price
perhaps expels the government to issue further money so as to make the necessary government
transactions.

4.3.4Post- estimation

Multicollinearity
Multicollinearity is a problem that there is existence of linear relationship among the explanatory
variable or independent variable. Present of multicollinearity problem could cause the overall
measure of goodness of fit to be very high (high R 2) but estimates will still be unbiased it will be
difficult to explain or to do estimation if there is existence of perfect multicollinearity, all
explanatory variables are linear to each other. So by using variance of inflation factor (VIF), if
greater than 10 there is multicollinearity problem otherwise if less than 10 there is no
multicollinearity problem.

Variable VIF 1/VIF

lagcpi 1.61 0.619556

moneysupply 1.70 0.586700

Realgdp 1.60 0.626483

petrpr 1.78 0.563217

Reeri 1.67 0.600052

bd 1.11 0.900958

Mean VIF 1.54

As a rule if VIF is less than 10 there is no multicolinearity, in our case mean VIF=1.54, since
less than 10, therefore this indicate that there is no multicollinearity problem.

39
Autocorrelation test
Auto correlation is a common when using time series data in regression. It occurs when the
resident does not form random around a regression line. The existence of auto correlation
problem cause less efficiency in the model (over estimate R 2) and the variance are biased.
Therefore use of t-test and f- test for significance are not reliable.(Gujurati, 2009)

The hypothesis made for auto correlation problem is

Ho: no auto correlation

Hl= auto correlation

If the calculated value is much smaller (closer to zero) or much longer than two (closer to four)
will reject our null hypothesis which indicate that there is auto correlation. From the regression
result we get DW value 2.2%. So, we accept the null hypothesis or there is no auto correlation.

Durbin-Watson d-statistic ( 7, 33) = 2.208808

Hetero skedasticity test

Hetero skedasticity test is a problem that the disturbance term has un equal variance it can arise
as a result of the presence of outliers .(Gujarti, 2009. The existence of hetero skedasticity may
cause the model over estimated. the t-statistics smaller thus cause in correct conclusion. To
detect hetroskedasticity, Breusch-Pagan / Cook-Weisberg test for heteroskedasticity.

From fitted variable of inflation we got

Ho: Constant variance

Variables: fitted values of cpi

chi2 (1) = 0.01

Prob>chi2 = 0.9281

By comparing the calculated Chi 2with the criticalChi2 to decide whether the above model has a
problem of hetroscedasticity or not. Consequently, since the calculated value of Chi 2is 0.01 is
smaller than the critical Chi2 of 0.9281 the null hypothesis which says constant variance will fail
to reject (accepted).

40
 CHAPTER FIVE

5 C0NCLUTION AND RECOMANDATION

5.1 Conclusion
The major objective of this study was to analyses the impact of money supply on the inflation of
Ethiopia using annual data covering 1980/2015 with the hypothesis that money supply is the first
major cause of Ethiopia inflation.

To achieve the stated objective and to test the hypotheses of the study both descriptive and
econometric framework was employed. Before making an econometric estimation, the variable
were tested for their order of interaction and it was found that they are integrated of order one I
(1). The stationary of the residual also indicated that the variables co integrated. OLS was used to
estimate the long run and the short run coefficients of the model.

OLS results show that expected inflation, rgdp, petroleum price and real effective exchange rate
are significant in affecting inflation at 5%, Long run co-integration result indicates that the
variable in the model have been long run relationship with dependent variable. Whereas short
run error correction model show that broad money supply and petroleum price affect inflation in
short run. While, real gross domestic product and budget deficit not significant in short run and
the insignificance of the coefficient of these variables show that the variable have no statistical
impact on the inflation of Ethiopia

Regarding, the casual relationship between money supply and inflation, granger causality test the
direction of causation between the two variables. The result reveals that a feedback relationship
exists between money supply and inflation. As a result a growth in money raises domestic prices
similarly a rise in rise leads the money supply to grow. This finding confirms the same result
obtained by Jamal (2000).

This study set out to find answer for the questions what factors are determining inflation in the
country and among them which variable is taking the lion share in explaining the recent inflation
in Ethiopia. The finding of the study warrants the following conclusion.

41
The recent inflation in Ethiopia appears to both demands pulled and cost push. This is true
because RGDP on the demand side and petroleum price on the cost side are found to have a
significant effect on inflation and Individual’s price expectation on both side. Individual’s price
expectations have the lion share on inflation in the country followed by RGDP and petroleum
price. Generally conclude that inflation in Ethiopia is structural and monetary phenomenon.

5.2 Recommendation
Based on the analysis made and conclusions arrived the following policy implications are
drown.
 As it was observed from the result, price expectation is one of the major causes and
consequence of inflation since past inflation makes current induces future higher
inflation to occur will at the same time create higher expected price. There for, the
government should take anti-inflationary measures like controlling the money supply,
so as to reduce future inflation (current price expectation). Other measures could also
be taken that would convince economic agents not expect higher price

 The money supply is the other major determinant of Ethiopian inflation. This implies
that the control of money supply via more stringent monetary policy by the concerned
body is appropriate. However, this may limit the growth of output to some extent.
Therefore, money supply should be balanced so that it would help stabilize prices and
at the same time it would enhance output growth.

 Encouraging and expanding domestic import substituting industries to reduce the

effect of imported inflation through foreign price and exchange rate change

42
 REFERENCE
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Adugna Berhnu (2008),”Modeling inflation dynamics in Ethiopia and error correction

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Abdullah M and Kalim R.(2010), determinants of food price inflation in Pakistan working
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Aghevli, B.B. and M.S. Khan.(1977a, June). Inflationary Finance and the Dynamics of Inflation:
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Central statistical authority (2002/2003, 2006/07, 2012/13)

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Economic Commission for Africa (2009),” Economic report on Africa,” AA

Engle, R. F., and Granger C.W.J. (1987). Co-integration and Error Correction: Representation,
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Ethiopian economic association database (2009/2010)

Eyerusalem Regasa (2005),” The impact of monetary policy on inflation in Ethiopia,” BA,

Thesis. AAU

Frisch h.(1989) theories of inflation Cambridge university press.

Friedman M. (1980). The counter revolution in monetary theory institute of economic affairs
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presses. Ltd. London

Gujarati O.N (2004) “Basic Econometrics” fourth edition, Harvard University, worth
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International monetary fund report 2011

Jamal AbdiAli (2007),”Government Budget Deficit, money supply and inflation and Policy
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Maser at.al (1984) the transition mechanism of money supply to inflation in Nigeria

Mishkin Fredric (1986),”The Economic of money, Banking and Financial market,” Little Brow,
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Ministry of finance and economic development (2014/15)

National bank of Ethiopia (202/03, 2006/07, 2012/13,2014/15), Adisabeba.

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Ethiopia,” MSc, Thesis, AA.

44
Yohannes Ayleow, (2002). The dynamics of inflation in Ethiopia, M.sc thesis, AAU

www.indexmundi.ne t(2013).Ethiopian economic profile

APPENDEX

COINTEGRATION TEST

Dickey-Fuller test for unit root Number of obs = 33

Interpolated Dickey-Fuller
Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value

Z(t) -3.961 -3.696 -2.978 -2.620

MacKinnon approximate p-value for Z(t) = 0.0016

D.u Coef. Std. Err. t P>|t| [95% Conf. Interval]

u
L1. -.6683823 .1687457 -3.96 0.000 -1.012541 -.3242233

_cons -.0527939 .6182064 -0.09 0.932 -1.313634 1.208046

OLS ESTIMATION (long run)

45
 Source SS df MS Number of obs = 34
F( 6, 27) = 351.64
Model 34610.2545 6 5768.37576 Prob > F = 0.0000
Residual 442.919653 27 16.4044316 R-squared = 0.9874
Adj R-squared = 0.9846
Total 35053.1742 33 1062.2174 Root MSE = 4.0502

cpi Coef. Std. Err. t P>|t| [95% Conf. Interval]

cpi_1 45.26387 9.368492 4.83 0.000 26.04131 64.48643

moneysupply .000288 .000197 1.46 0.155 -.0001163 .0006923
rgdp -17.56392 5.956246 -2.95 0.007 -29.78512 -5.342709
reeri .0596386 .0167557 3.56 0.001 .0252587 .0940186
peroliumprice .0396361 .0072856 5.44 0.000 .0246872 .054585
bd -.0934954 .4485347 -0.21 0.836 -1.013813 .8268217
_cons 135.648 58.43078 2.32 0.028 15.75789 255.538

Error correction model(short run)

Source SS df MS Number of obs = 33
F( 7, 25) = 11.51
Model 1053.89724 7 150.556748 Prob > F = 0.0000
Residual 327.013473 25 13.0805389 R-squared = 0.7632
Adj R-squared = 0.6969
Total 1380.91071 32 43.1534598 Root MSE = 3.6167

D.cpi Coef. Std. Err. t P>|t| [95% Conf. Interval]

CPI_1
D1. 26.53962 15.11917 1.76 0.091 -4.598885 57.67813

realgdp
D1. -4.550637 8.569903 -0.53 0.600 -22.20068 13.09941

moneysupply
D1. .0006022 .00022 2.74 0.011 .000149 .0010554

reeri
D1. .0474781 .0266852 1.78 0.087 -.0074812 .1024374

bd
D1. -.1858855 .3184171 -0.58 0.565 -.8416777 .4699068

oilprice
D1. .0316937 .0068181 4.65 0.000 .0176516 .0457359

u
L1. -.5534169 .1962967 -2.82 0.009 -.9576976 -.1491363

_cons -.2199474 .938923 -0.23 0.817 -2.153696 1.713801

Hetroscendacity

46
Breusch-Pagan / Cook-Weisberg test for heteroskedasticity
Ho: Constant variance
Variables: fitted values of cpi

chi2(1) = 0.01
Prob > chi2 = 0.9281

Multi colinarity
Variable VIF 1/VIF

avgcrudoil~r
D1. 1.77 0.563473
moneysupply
D1. 1.70 0.589824
reeri
D1. 1.62 0.615597
realgdp
D1. 1.53 0.654109
lagcpi
D1. 1.48 0.674241
bd
D1. 1.08 0.923995

Mean VIF 1.53

Auto-correlation

Durbin-Watson d-statistic( 7, 33) = 2.208808

47