ARSI UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS

MACROECONOMIC DETERMINANTS OF INFLATION IN ETHIOPIA

(1981 - 2020)

A RESEARCH PAPER SUBMITTED TO THE DEPARTMENT OF ECONOMICS IN PARTIAL

FULFILLMENT OF THE REQUIREMENT OF “BA” DEGREE IN ECONOMICS
BY ID No
AFEWORK ALEMU………………………………………………UGR/8658/12
ADVISOR: MR. ASSEFA D.

DATE: JUN, 2023

ASELLA, ETHIOPIA
 ARSI UNVERSITY
COLLEGE OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
Title: Macroeconomic determinants of inflation in Ethiopia (1981 - 2020)

Approval page

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Advisor signature date

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Examiner signature date

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 Acknowledgment

First and for most I would like to thank the almighty God who made me to reach here and up
hold me my unit. Next my greatest thanks and heartfelt appreciation goes to my Advisor Mr.
Assefa D. who helps me by advising, giving necessary data, and guide lines. And I also want to
appreciate and thanks to my brother that who stands near to me by moralizing control from
starting to now. Also I need thank all my family those help me financially and morally from
starting to the moment. Eventually, I thank my institution Arsi University especially the
Economics department who gave me sufficient knowledge for four years

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 Abstract
In the last decades, Ethiopia has been one of the fastest growing non-oil producing countries in
the world. Along with the economic growth, inflation has been rising. Therefore, the main
objective of this study was to identify the major macroeconomic factors affecting inflation in
Ethiopia for the year 1981 - 2020. Secondary data were collected from World Bank (WB). Both
econometrics and descriptive statistics were used for data analysis. The findings of the descriptive
result indicated that for forty years the mean official exchange rate was 10.13birr/dollar with
standard deviation of 8.6Birr/dollar. The mean inflation rate for Ethiopia was 9.44% with a
minimum of -9.81% and a maximum value of 44.39%. Growth of GDP was 5.91% with standard
deviation of 6.45%. In order to show long run and short run relationship between variables,
vector error correction regression model was applied. Before estimation, stationery test was
conducted using dickey fuller test. Inflation rate and growth of GDP were stationary at level
while exchange rate and unemployment rate were non- stationary. Therefore, vector error
correction model was justifiable. The result of vector error correction model confirmed that there
is a significant relationship between devaluation of exchange rate and inflation. List the
independent variables and discuss the variable/s which are significant and insignificant.
Therefore, in order to control inflationary pressure appropriate polices must be designed which
compromise sun employment, economic growth and exchange rate regimes.

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 Table of Contents
Acknowledgment...............................................................................................................................................i
Abstract.............................................................................................................................................................ii
List of Tables..................................................................................................................................................... v
List of Figures................................................................................................................................................... vi
Acronyms........................................................................................................................................................VII
Chapter One.............................................................................................................................................1
1 Introduction...........................................................................................................................................1
1.1 Back Ground of the Study...........................................................................................................................1
1.3. Objectives of the study..............................................................................................................................4
1.3.1. General Objective...................................................................................................................................4
1.3.2. Specific Objectives..................................................................................................................................4
1.4. Significance of the Study............................................................................................................................4
1.5. Scope of the Study.....................................................................................................................................4
1.6. Limitations of the study.............................................................................................................................4
1.7. Organization of the Paper..........................................................................................................................5
Chapter Two.............................................................................................................................................6
2. Literature Review..................................................................................................................................6
2.1 The theoretical framework.........................................................................................................................6
2.1.1. Structuralist Theory of Inflation..............................................................................................................6
2.1.2. Keynesian Theory of Inflation.................................................................................................................6
2.1.3. Quantity theory of money......................................................................................................................6
2.1.4. New Political Macroeconomics of Inflation............................................................................................7
2.2. Review of Empirical Literature...................................................................................................................7
Chapter 3..................................................................................................................................................9
3. Methodology of the Study....................................................................................................................9
3.1. Research Design and Approach.................................................................................................................9
3.2. Types of Source of Data.............................................................................................................................9
3.3. Method of data analysis............................................................................................................................ 9
3.4. Model Specification.................................................................................................................................10
3.4.1. Dependent Variable..............................................................................................................................10
3.4.2 .Explanatory variables............................................................................................................................10
3.5. Estimation techniques.............................................................................................................................11
3.5.1. Co-integration test................................................................................................................................12
3.5.2. Vector Error correction model (VECM).................................................................................................13
3.5.3. Autocorrelation Test.............................................................................................................................14
3.5.4. Unit root test of stationary...................................................................................................................14
3.5.5 Lag determination of VECM...................................................................................................................15
3.5.6. Normality..............................................................................................................................................15
Chapter Four...........................................................................................................................................16
4. Results and Discussion........................................................................................................................16
4.1. Descriptive analysis..................................................................................................................................16
4.2.1. Unit root test........................................................................................................................................ 17
4.2.2. Vector autoregressive regression.........................................................................................................18
4.2.3. Lag determination of VECM..................................................................................................................19
4.2.4. Co-integration test................................................................................................................................19
4.2.5. Vector error-correction model..............................................................................................................20
Chapter Five............................................................................................................................................22
5. Conclusion and Recommendation.......................................................................................................22

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5.1. Conclusion................................................................................................................................................22
5.2. Recommendation.....................................................................................................................................23
References......................................................................................................................................................25

iv
 List of Tables
Page
Table 1. Descriptive and summary statistics of variables........................…....................……..16
Table 2. Unit root test (augmenteddickeyfuller test).......................................…...............……17
Table 3. Vector autoregressive regression result of macroeconomic
determinates of inflation........................................................................…............….18
Table 4. Lag determination of before estimation vector error correction
model (VECM).......................................................................................…................19
Table 5. tests for co-integration..............................................................................…..........…..19
Table 6. Vector error-correction model....................................................................…........…..20
Table 7. normalization restriction imposed............................................................….........…..21

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 List of Figures
Page

Figure 1.Conceptual framework of the study.........................…………8

Figure 2. Relation between exchange rate and inflation rate....................…...............16

Figure 3. Relation between growth of GDP and inflation rate......................…...........17

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 Acronyms

AFDB: African Development Bank.

CPI: Consumer Price Index
EEA: Ethiopian Economic Association
GDP: Gross Domestic Products
IMF: International Monetary Fund.
INVT: Investment
LDCs: Least Developing Countries.
MOFED: Ministry of Finance and Economic Development
MS/M2: Money Supply
NBE: National Bank of Ethiopia
ND: National Debt
PPI: Producer Price Index
RGDP: Real Gross Domestic Product
REER: Real Effective Exchange RateVECM: Vector Error Correction Model.WB: World Bank.
WI: World Inflation
USD: United States Dollar

VII
 Chapter One
1 Introduction
1.1 Back Ground of the Study

This day fluctuation of general price level has been serious problem to the economy of
Ethiopia. While the economy is growing rapidly, presenting many opportunities, there
are also hurdles of inflation in Ethiopia [Mebtu Melaku (2020)]. In 2020/21, annual
average headline inflation was 20.2 percent and real GDP growth was 6.3 percent
[NBE, 2021].

The current high inflation rate is not only harming consumers, but also firms as they are
forced to increase salaries affecting their competitiveness. Inflation also affects the
competitiveness of exporting firms by raising the real exchange rate [EEA (2021)].
According nation bank of Ethiopia report, Ethiopian birr was depreciated against all
major international currencies, such as pound sterling (40.2 percent), Canadian dollar
(37.8 percent), Swedish kroner (36.1 percent), euro (31.7 percent), SDR (29.5 percent),
Swiss franc (28.1 percent), USD (24.9 percent), Djibouti franc (24.9 percent), Saudi
riyal (24.9 percent), UAE dirham (24.9 percent), and Japanese yen (21.1 percent)
[Teamrat Kassay (2017)].

In Ethiopia, inflationary process has been high due to rising money supply, huge debt
servicing, persistence current account and budget deficits, and currency devaluation
Tteamrat Kahssay (2017)]. In the past inflation, Ethiopia had typically been associated with
agricultural supply shocks due to drought. Historical evidence indicated that Ethiopia has
suffered from high inflationary experience owing to weather shocks (drought) and
conflict (war) [Semeneh Bessie Desta (2016)]. For instance, high inflations were
recorded during severe drought (1984/85) and 2002/03 or political instability (1990/91)
when inflation reached double digits [EEA (2001)]. Ethiopia’s inflation rate remains
persistently high, reaching 33.6 percent in February 2022. The headline inflation in
February 2022 is lower than the 34.5 percent recorded in January 2022. Food inflation
stood at 41.9 percent in February, up from 39.9 percent. Non-food inflation declined to

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22.9 percent from 27.3 percent registered in January 2022 [Abdurrahman Mohammed
(2022)].the major factors driving food inflation are spikes in price of cooking oils and
fats, non-alcoholic beverages, bread and cereals, fish and sea food, dairy, and meat
products.

Given this macroeconomic environment, analyzing factors that determines inflationary

process is important. Therefore, this study focused on identifying the effects of growth
of GDP, unemployment and exchange rate on inflation.

The determinants of inflation are different from one country to another. From the economic
perspective, these determinants have been classified as supply side and demand side factors.
Supply side factors are those economic factors which cause inflation by increasing cost of
production. Some important supply side factors are output growth, capital formation, import
prices, exchange rate, tax and wage. On the other hand, demand side factors lead to inflation by
decreasing the purchasing power of money. Some relevant demand side factors are increment of
money supply, private consumption and government expenditure [Eftekhari Mahabadi & Kiaee,
2015]. Several studies have attempted to identify the determinants of inflation in Ethiopia. Based
on their result, authors give recommendation to policy makers to control high rate of inflation.
Similarly, the purpose of this study is to identify the determinants of inflation in Ethiopia from
1981 to 2020 by using annual time series data.
1.2. Statement of the problem
Inflation is bad because people hate it but because it affects people adversely. Inflation reduces
the real income of people, especially those with fixed incomes, reduce their living standard and
reduces saving. The reduction in saving is due to the desire of more money to buy goods and
services. This results in lower investment and capital formation. Inflation also hinders foreign
direct investment because rising cost of materials and inputs makes foreign investment less
profitable. Uncertainty about prices and increase in production costs also reduce production.
Inflation also causes misallocation of resources. Inflation also results in reduction of exports.
This is because rise in domestic input prices makes the price of domestically produced products
expensive in the international market. In addition inflation also results in increased imports. This
is because the inflation results in higher price of domestically produced products which in turn

2
results in increased demand for imports. The increase in imports and the decline in exports
caused by inflation in turn results in adverse balance of payments in the country. Most
importantly inflation redistributes income from wage earners and fixed income groups to profit
recipients and from creditors to debtors. This in turn increases the number of poor and on the
other hand increases the number of the rich and hence resulting in more in equality [Jhingan,
1997)].
It is clear that the currently high rate of inflation in Ethiopia will retard the growth of the country
achieved in recently years. The current inflation has a dampening effect on the current
development of the export sector. This is because inflation makes Ethiopian products dearer in
the international market which in turn makes them less competitive. In addition inflation also
adversely affects domestic industries. This is because the increase in production cost of domestic
industries results in higher product price. This increase in the price of domestically produced
products results in increased imports, which also adversely affects the balance of payments, and
in turn makes domestic industries to be uncompetitive. By reducing savings and increasing
uncertainty inflation reduces investment and capital formation in Ethiopia in the long run.
Inflation in Ethiopia is also hampering Ethiopia from reducing poverty and hunger. The living
standard of urban dweller has been adversely affected by inflation in Ethiopia. Inflation also
redistributes wealth there by increasing the number of poor people in the county. Even if it is,
said by the government that farmers benefit from rising food prices, something that needs
empirical investigation, rise in food prices are causing many to be unable to feed themselves.
Most importantly inflation in Ethiopia may misallocate resources from productive to
unproductive sectors.
Alemayehu G (2011) Examines the sources of recent inflationary experience in Ethiopia
between 1994/5 and 2007/8 using vector auto regressive (VAR) and single equation error
correction models. He finds that the determinants of inflation differ between sectors (food and
non-food) and therefore the time horizons into account. The foremost important forces behind
food inflation within the future are real income, inflation in Ethiopia.

Differently from the above studies, My study included up-to- date information on statistic
variables up to a year of 2020 and real interest rate which had not been attempted by the previous
works as a serious determinant of inflation in Ethiopian economy. It also included variables such

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GDP growth rate, unemployment rate and real effective rate test their significance to work out
inflation by employing both econometric and descriptive methods of information analyzing.

1.3. Objectives of the study.

1.3.1. General Objective
 To identify and investigate the macroeconomic determinants of inflation in Ethiopia for
the period ranging from 1981-2020.
1.3.2. Specific Objectives
 To investigate the macroeconomic determinant of inflation in the country.
 To measure the structural and monetary determinants of inflationary process in the
country.
 To identify variables which have significant impact on inflation in Ethiopia

1.4. Significance of the Study

Most importantly the study is expected to raise the interest of scholars to work on inflation. The
study identified the determinants of inflation across deferent regions of the country breaking the
traditional methodology of investigating factors contributing to inflationary pressure in the
economy at macro-level. Therefore, this study is expected to provide information to the
government about the determinants of inflation at macro-level and thus will shed light on
alternative policy interventions needed to be adopted by the government and informs researchers
about the need for further research at sub-regional level.
1.5. Scope of the Study
In this study the macroeconomic determinants of recent inflation in Ethiopia is study. The study
covers the time period from 1981 up to 2020. The period was chosen because it can be explain
the inflationary trend experienced in Ethiopia.
1.6. Limitations of the study
The study is expected to have limitation due to lack of time by the researcher. The success of
every study depends on the availability of resources with the conductive environment but this
paper; there are a lot of limiting factors that the researcher may be faced in conducting it.

4
Accesses to internet (Computer), there is no access computer in the university. As result, the
researcher even incurs additional cost for computer outside for econometric regression.
Data the availability of data is one of the main factors that lead the success of the researcher.
However, the researcher may face a lot of problems that is, there is no consistent data in each
concerned organizations.
1.7. Organization of the Paper
The research paper where organized and classified in to five chapters the first chapter is the
introduction part which contains the back ground of the study, the statement of the problem,
objective of the study, significance of the study, Limitation of the study and organization of the
paper. Chapter two will deal with the theoretical and empirical reviews related to the title.
Chapter three contains methodology of the study, data sources, Econometric model specification,
methods of analysis. Chapter four will deal with data analysis and discussion of result and finally
chapter five deals with conclusion and policy recommendation.

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 Chapter Two
2. Literature Review
2.1 The theoretical framework
2.1.1. Structuralist Theory of Inflation
The structuralists hold the view that inflation is necessary with economic growth. According to
this view, as the economy develops, rigidities arises which lead to structural inflation. In the
initial phase, there are increases in non- agricultural incomes accompanied by high growth rate
of population that tend to increase the demand for goods.
Structuralists believe that inflation in LDCs is bound with developmental effort and structural
response to this effort is expressed through gaps of various kinds in these countries. The gaps
that have mentioned in literatures are Resource gap, food bottleneck, foreign exchange
bottleneck and infrastructural bottleneck. They suggest that, to understand the true nature of
inflation in LDCs one must identify the determinants that force to generate bottlenecks of various
kinds in the normal process of development, study how the bottlenecks lead to price increases
and how these increases spread to the whole economy. Since Ethiopia is one of the least
developed countries, the structuralist theory and suggestion hold in Ethiopia too.
2.1.2. Keynesian Theory of Inflation
According to Keynes theory of inflation, an increase in general price levels or inflation due to
increase taken together demand which is over the increase in aggregate supply. If a given
economy is at its full employment output level, an increase
in government expenditure (G), an increase in private consumption (C) and an increase in private
investment (I) will create an increase in aggregate demand; leading towards an increase in
general price levels. Furthermore, Keynesian economists believe that there is a tradeoff between
inflation and unemployment [Jackman, Richard (1981)].
2.1.3. Quantity theory of money
Quantity theory of money (QTM) states that money supply and price level in the economy are
directly proportional to one another. Irving Fisher showed the relationship between them as
follows: M*V= P*T
Where, M is Money supply V is Velocity of money P is price level T is Volume of the
transactions.

6
According to the quantity theory of money, the quantity of money available in an economy
determines the value of money, and growth in the quantity of money is the primary cause of
inflation [Mankiw, N. Gregory (2016)].The faster the growth of money in circulation, the more
increase in inflation. This theory postulated that if the central bank keeps the money supply
stable, the price level would be stable. If the central bank increases the money supply rapidly, the
price level will rise rapidly[Mankiw, N. Gregory (2016)].
2.1.4. New Political Macroeconomics of Inflation
The theories discussed above mainly focus on macroeconomic determinants of inflation.
However, these theories ignored the role of non-economic factors such as political instability and
culture as a cause of inflation. The new political economy theory literature provides a new
perspective on the relations between timing of elections, performance of policy makers, political
instability and inflation (Totonchi, 2011).Government officials use their power to increase
government expenditure, especially at the end of their term. Several studies have been done
regarding the non-monetary variables on inflation. For example, Khani Hoolari et al. studied the
effect Governance and political Instability on inflation in Iran by using annual time series data
from 1959-2010 (Seyed Morteza Khani Hoolari, Abbas Ali Abounoori, 2014).
2.2. Review of Empirical Literature

Several cross-country and country specific studies have been conducted to find out the
determinants of inflation in developing countries. They have found mixed results. Geda and
Tafere in their analysis of inflation found that the most important forces behind food inflation
in the long run are a sharp rise in food demand triggered by an alarming rise in money
supply/credit expansion, inflation expectation and international food price hike [Alemayehu
Geda and Kibrom Tafere (2009)]. The long run determinants of non‐food inflation, on the other
hand, are money supply, interest rate and inflation expectations.

In Kenya, the study by Kirimi revealed that Money supply (M2) and exchange rate had a
positive relationship with the inflation rate while GDP growth rate and the corruption
perception had a negative relationship with inflation [Winfred Nkirote Kirimi (2014)].Using
data from the world development indictors, Ahiakpor found that real output growth, population
growth rate, broad money, exchange rate, lending rate and budget deficit were key factors
affecting in Ghana’s inflation [Ferdinand Ahiakpor (2014)].

7
According to Macharia and Otieno, inflation rate and unemployment rate were inversely
related both in the long run as well as in short run [Moses K Macharia and Aggrey Otieno
(2015)]. Empirical findings of Teshale et al indicated that broad money supply, real gross
domestic product and overall budget deficit are statistically significant determinants of inflation
with positive sign[Teshale D. Bedada & Wondaferahu M]. Lim and Sek applied an Error
Correction Model based on the Autoregressive Distributed Lag (ARDL) modeling has been
used to explain the short run and long run impacts of each variable on inflation. In low inflation
countries, GDP growth has negative impact on inflation and imports of goods and services
have positive impact on inflation [Yen Chee Lim and Siok Kun Sek, (2015)].
In his analysis, Girma examined determinants of inflation in Ethiopia by applying vector error
correction model and found that Broad Money Supply in the economy and the Banks and
Financial institutions average lending rate has a positive long run effect on inflation in Ethiopia
[Girma Mulugeta Emeru (2020)]. While, the Rainfall, the deficit budget and the Nominal
Exchange rate has a negative long run determination of the price level in Ethiopia.

Figure 1.Conceptual framework of the study.

Figure1, above depicts the relationship between inflation and exogenous variables. The
dependent variable for this study was inflation rate measured in consumer’s price index and the
independent variables were Official exchange rate, Unemployment rate, and growth of GDP.

8
 Chapter 3
3. Methodology of the Study
3.1. Research Design and Approach
The study mainly focuses on macroeconomic determinants of inflation. Hence time series
research design is found to be more relevant design for the study.
Descriptive research design would be employed because its efficiency to evaluate and determine
the adequacy of a program under existing condition against the established standard. The
descriptive research design is special importance for this particular study to assess several
challenges and portray how they affect performance of determinants of inflation. In general, the
descriptive research design is be lived to generate adequate and relevant data breadth to the issue
under investigation
3.2. Types of Source of Data
The research used secondary data, which was collected for the year 1981 to 2020 from world
development indicator (WDI) of World Bank. This implies that the research used 40 years to
address the pre-defined objectives. The time series data were yearly type in which one can judge
about the macroeconomic determinants of inflation of one nation through having the annual data.
3.3. Method of data analysis
The methodology for analyzing the data includes both descriptive analysis and descriptive tools
like simple statistical tools and percentage with appropriate econometric
classification. Econometric analysis generally due to the quantitative nature of the study the
investigation was in different direction or approach.
Descriptive analysis: - To show the impacts of money supply on inflation descriptive analysis
was used through showing the theory of money supply in Ethiopia, trends of inflation on
economic growth and economic development in Ethiopia.
Econometric Analysis:- This section deals with estimating and interpreting the main behavioral
and policy variables which determine the overall rate of inflation. The time series data over
variables from the year 1981 to 2020 is tested for stationary, Vector error-correction model, Lag
determination of VECM, Vector autoregressive regression, co integration, the error correction
model, auto correlation and normality of the error term.

9
3.4. Model Specification

The model Vector autoregressive models and Error Correction Model (ECM) are used to
investigate the determinants of inflation. In this study, inflation rate was endogenous variable
and 4 exogenous variables (broad money supply, growth of GDP, exchange rate, and
unemployment). The result is conducted in various steps including the Dickey-Fuller Unit Root
test, Co-integration test, Vector Error Correction Model (VECM), autocorrelation test, and Lag
determination of VECM.

Accordingly, following Gujarati, the model specification for determinants of inflation rate rated
was shown as [Gujarati, D. N (2004)]
INFN = f (UNE, G, EXCH)
Where INFN= Inflation rate UNE= unemployment rate G=Growth of
GDP EXCH= Exchange rate
3.4.1. Dependent Variable
Inflation (INF) – Inflation is the overall general upward price
movement of goods and services in an economy. Inflation is measured
by measuring the percentage change in the prices of a given basket
goods over time as compared to the price in the base year. We can use
the CPI to determine differences in price between two points in time
and calculate inflation for that period.
3.4.2 .Explanatory variables
l. Unemployment rate: Unemployment is the situation where a person in the labor force who is
currently looking for job to work at the existing wage rate failed to find any. The Phillips theory
stated that there is an inverse relationship between wage inflation and unemployment rate.
Macharia and Otieno also found that inflation rate had an inverse relationship with an
unemployment rate in the long run as well as in short run in Kenya. This due the fact with
increase inflation, suppliers are willing to supply more goods and services to the market [Moses
K Macharia and Aggrey Otieno (2015)]. In return, the producers will require more labour and
hence this will result to lowering the unemployment rate.
II. Growth of GDP: It is an indicator for the overall economic status of the country. It is
expected to have a positive impact on the level of inflation. GDP growth rate has negative

10
relationship with inflation. Semeneh in his analysis of inflation clearly stated that instead of
stimulating economic growth, inflationary pressure in Ethiopia seems to be on the verge of
distorting the allocation of resources and is likely to be a deterrent to undertaking productive
investments [Semeneh Bessie Desta (2016)].

III. Official Exchange Rate: It is a rate at which Ethiopian Birr exchange for dollar. The
Ethiopian exchange rate is defined as units of Birr per Dollar. It usually believed that
depreciation of Ethiopian birr increases demand for output produced in Ethiopia abroad
[Wondimu Ereda Melaku. (2020)]. This increases demand and expected to increase inflation. The
trend analysis by [Winfred Nkirote Kirimi (2014)], [Tadesse Wudu Abate. (2020)], and [Teshale
D. Bedada & Wondaferahu M] showed that real effective exchange rate varies with inflation.
This vary trend of real exchange rate mayhave resulted in the high impact of its trend on the
trend of inflation minimum. With devaluation, imports became more expensive and export
becomes cheaper.

3.5. Estimation techniques

To address the relationship econometrically, a simple ordinary least square (OLS) is applied on
the model. According to Gujarati (2007), the coefficient derived by OLS best approximate the
true coefficient since it adopted the criteria of minimizing the summation of the error term.
However, this method heavily relies on the assumptions of; absence of serial correlation between
the error terms, absence of linear association among explanatory variables. Thus to drive a viable
link appropriate care will be undertaken to avoid these statistical shortcoming. Since the study
employ time series data, it is mandatory that stationary of data to be tested. A stochastic process
is said to be stationary if the mean and variance are constant regardless of the time taken.
Stationary test makes sure that there will not exist a spurious result which often found in non-
stationary time series. If the data is non-stationary forecasting the result of the other time period
may not have a practical significant (Gujarati, 2004). For the purpose of this study, the researcher
used annual time series data. Time series data are often strongly correlated over time. The notion
19 of stationary process is an important one when we consider econometric analysis of time
series data. A time series is called stationary, if its statistical properties remain constant over
time. A stochastic process is said to be stationary if its mean and variance are constant over time,

11
i.e. time invariant (along with its auto covariance). Such a time series will tend to return to its
mean (mean reversion) and fluctuations around this mean will have broadly constant amplitude.
More precisely, a time series let’s 𝒚𝒕 is called stationary if the following conditions are satisfied:

(1) [𝒚𝒕]=𝞵(Constant mean for all t)

(2) [(𝒚𝒕−𝝁)]=𝜸𝒐(Constant variance for all t)
(3) [(𝒚𝒕−𝝁)(𝒚𝒕+𝒌−𝝁)]=𝜸𝒌(Constant covariance for all t)
Where; μ, γ0, and γk are finite-valued numbers that do not depend on time t. So the mean has to
be constant over time, and, if the series has a trend, this should be removed. Also the variance
has to be constant, and, if the series contains seasonal fluctuations or changing variance, this
should also be removed. Finally, the co-variances are constant over time. If a time series is not
stationary (fails to satisfy the above requirement), it is called non-stationary time series which
contains time varying mean or time varying variance or both. If the variables are non-stationary,
the consequence leads to inaccurate results or so called spurious (false) regression problem.
Spurious regressions in a sense means that two variables are trending over time, a regression of
one on the other could have a high R2even if the two are totally unrelated or although there is no
meaningful relationship between the variables (Gujarati, 2004). So, the researcher uses different
tests to check whether the data is stationary or non-stationary.
3.5.1. Co-integration test

Co integration means that despite being individually non-stationary, a linear combination of two
or more time series can be stationary. Co integration among the variables reflects the presence of
long run relationship among non-stationary variables in the system. Testing for co integration is
important because differencing the variables to attain stationary generates a model that does not
show long run behavior of the variables. When estimating regression models using time series
data it is necessary to know whether the variables are stationary or not (either around a level or a
20 deterministic linear trend) in order to avoid spurious regression problems. This analysis can
be performed by using the unit root and stationary tests.

If the time series variables are non-stationary in their level, they can be integrated with
integration order 1, when their first differences are stationary. These variables can be co-
integrated as well if there are one or more linear combinations among the variables that are

12
stationary. If these variables are being co-integrated then there is a constant long-run linear
relationship among them or long term equilibrium between them.

It is well known that if two series are integrated to different orders, linear combinations of them
were integrated to the higher of the two orders. Thus, for instance, if two economic variables
(𝑦𝑡,𝑥𝑡) are I (1) the linear combination of them, (𝑧𝑡) will be generally I(1). But it is possible that
certain combinations of those non-stationary series are stationary. Then it is said that the pair
(𝑦𝑡,) is co-integrated. Co-integration is important to the analysis of long-run relationships
between economic time series. It implies that these pairs of variables have similar stochastic
trends. Test for co-integration can be checked by Engle-Granger (EG) test on the residual
estimating from the co-integrating regression. If the variables are individually non-stationary,
there is a possibility that this regression becomes spurious. But when we performed a unit root
test on the residual, if the absolute value of calculated Engle-Granger (EG) value is greater than
the absolute value of critical (tabulated) Engle-Granger (EG) value our conclusion is that the
estimated residual is stationary (i.e. the co-integrating regression is not spurious even
individually they are non-stationary).

3.5.2. Vector Error correction model (VECM)

A vector error correction model is the short run model which reflects the current error in
achieving the long run equilibrium relationship among variables. VECM is used to estimate the
short run economic growth function and allows us to study the short run relationship among
variable under consideration. An important theorem known as the Granger representation
theorem, states that if two variables X and Y are co-integrated, then the relationship between the
two can be expressed as VECM (Gujarati, 2004).

Generally, since VECM is a short run model, the coefficients of the independent variable show
the short run relationship of them with the dependent variable. For example, if we consider a
consumption function with consumption as dependent variable and income as independent
variable, the coefficient of income shows the short run marginal propensity to consume. The 21
VECM developed by Engle and Granger is a means of reconciling the short run behavior of an
economic variable with its long run behavior.

13
3.5.3. Autocorrelation Test

Autocorrelation occurs when covariance of errors are not zero, 𝑐𝑜𝑣𝑎𝑟 (Ԑ𝑡,Ԑ𝑡−1)≠0 covariance of
errors are nonnegative. This is mainly a problem observed in time series data. There are several
causes which gives rise to autocorrelation. These are; 1. Omitted explanatory variables: We
know in economics one variable is affected by so many variables. The error term represents the
influence of omitted variables and because of that an error term in one period many have a
relation with the error terms in successive periods. 2. Misspecification of the mathematical form
of the model: It we have adopted a mathematical form which differs from the true form of the
relationship, then the disturbance term is the must be show serial correlation.

The consequences of autocorrelation are the property (minimum variance property) is not
satisfied. If the disturbance terms are auto correlated then the OLS variance is greater than the
variances of estimate calculated by other method therefore the usual are no longer valid. The
variance of random term u may be seriously underestimated if the u`s are auto correlated. Durbin
Watson d statistic: is the most usable test detecting autocorrelation between the errors in different
time periods (Maddala, 1992). 22

3.5.4. Unit root test of stationary

Augmented Dickey Fuller (ADF) test is useful to know whether or not there exist a unit root of
time series data is stationary at level, it is integrated of order zero or I (0) which means it is not
spurious. In conducting the dickey fuller test t assumed that the error term 𝑒𝑡was uncorrelated.
But in case of 𝑒𝑡are correlated, dickey and fuller have developed a test known as the augmented
Duckey-Fullr (ADF) test. This test is conducted by augmenting the equation by adding the
lagged values of the dependent variables. The number of lagged difference terms to include is
often determined empirically, the idea being to include enough terms so that the error term is
serially uncorrelated. If the data is not stationary at level, we take first difference, second
difference and so on until it became stationary. A time series data is said to be stationary if the
calculated ADF is greater than the critical ADF at a given level (Gujarati, 2004).

The early and pioneering work on testing for a unit root in time series was done by Dickey and
Fuller which we call Augmented Dickey-Fuller (ADF) test. It is also known as tau (τ) test. So, a

14
time series data is said to be stationary if the computed ADF or τ-value is more negative than
critical ADF value or when we take absolute value, a time series data to be a stationary it must
fulfill that calculated ADF or τ-value is greater than the critical ADF value at a given level
(calculated τ > critical τ) (Gujarati, 2004.
3.5.5 Lag determination of VECM
Johansen co-integration test and vector error correction model is usually preceded by a test of
determining optimal lag length due to the estimated results are affected by the number of lags
included. Therefore, it is mandatory to determine the number of lags before estimating the model
(Denbel et al., 2016). In practice determining the number of lags requires balancing between
choosing too few and too high lags. Choosing too few lags omit potentially valuable information
contained in the more distant lagged values. On the other hand, if it is too high the model will
estimate more coefficients than necessary, which in turn introduces additional error in forecast
(Stock H. & Watson W., 2019). 15
3.5.6. Normality

According to the Shapiro-wilk W test for normality the error term is said to be normally
distributed or the null hypothesis which says the error term is normally distributed is rejected
when the value of sw is less that the relevant critical value.

On the other hand, the error term is said to be normally distributed if it has zero mean and
constant variance [Mankiw, N. Gregory (2016)]. In this model the swilk r test shows that the
mean value of the error term (probability) is zero in approximate value. Previously the model
was tested for hetro-scedasticity and its variance is proved to be constant. There for the error
term is normally distributed.

15
 Chapter Four
4. Results and Discussion
4.1. Descriptive analysis
In order to ascertain the distribution of the data being used for this analysis, some descriptive
analyses such as mean, standard deviation, minimum and maximum were performed. From table
1, the average Official exchange rate, Unemployment rate, Inflation rate, Broad money supply,
and growth of GDP was 10.13 birr/dollar, 2.83%, 9.44% and 5.91%, respectively.

1980 1990 2000 2010 2020

time in years
Inflation Official exchangerate

Source: computed from World Bank Data (2022)

Figure 2. Relation between exchange rate and inflation rate.

Variables Observation Mean Standard deviation Minimum Maximum

Official exchange 40 10.13 8.6 2.07 34.9
rate
Unemployment 40 2.83 0.43 2.25 3.71
rate
Inflation rate 40 9.44 10.886 -9.81 44.39
growth of GDP 39 5.905 6.445 -11.14 13.86
Source: computed from World Bank data (2022)

Table 1. Descriptive and summary statistics of variables.

Table 1 summarizes the statistics of all variables. As we can see in Table 1 the average Official
exchange rate, Unemployment rate, Inflation rate, growth of GDP were 8.6 birr/dollar, 0.43 %,
10.886 % and 6.445%, respectively.

16
Trends Analysis

1980 1990 2000 2010 2020

time inyears
Inflation growth ofGDP

Source: computed from World Bank Data (2022)

Figure 3. Relation between growth of GDP and inflation rate.

4.2. Econometric Analysis

To address the relationship econometrically, a simple ordinary least square (OLS) is applied on
the model. According to Gujarati (2007), the coefficient derived by OLS best approximate the
true coefficient since it adopted the criteria of minimizing the summation of the error term.
However, this method heavily relies on the assumptions of; absence of serial correlation between
the error terms, absence of linear association among explanatory variables.

This section deals with estimating and interpreting the main behavioural and policy variables
which determine the overall rate of inflation. The time series data over variables from the year
1981 to 2020 is tested for stationary, co integration, vector error correction model, normality of
the error term, Vector autoregressive regression and Lag determination of VECM.
4.2.1. Unit root test
ADF Test static at level
variables without trend Interpolated Decision with trend Interpolated Decision
Dickey- Fuller 5% Dickey- Fuller
critical value 5% critical value
exchange rate 6.1 -2.96 Non- 3.8 -3.544 Non-
Stationar Stationary
y
Unemployment 0.71 -2.96 Non- -061 -3.544 non-
rate stationary stationary
Inflation -4.8 -2.96 Stationar -5.23 -3.544 Stationary
y
growth of GDP -4.43 -2.964 Stationar -5.33 -3.548 Stationary
y

17
 Source: computed from World Bank data (2022)
Table 2. Unit root test (augmented dickey fuller test).

From Figure 2, we observe that inflation rate and official exchange rate moving together.
Ethiopian exchange rate has been increasing overtime. There is ups and down movements for
inflation rate over time.
From Figure 3, when inflation rate is rising then growth of GDP is falling. It seems that there is an
inverse relationship between economic performance and inflation.
Unit root test
The hypothesis for unit root test is stated as: H0: non-stationary
H1: stationary
If time series data is non-stationary, this resulted in spurious regression. Prior to testing Co-
integration and implementing further econometric methodology, it is necessary to examine
stationarity test for each individual time series variables. Most macroeconomic time series
data are non-stationary, i.e. they tend to exhibit a deterministic and/or stochastic trend. It is
recommended that a stationarity (unit root) test should be carried out for having logical and
meaningful result. In our analysis of inflation, we cannot reject the null hypothesis that
unemployment and exchange rate exhibits a unit root. Therefore, unemployment and
exchange rate are non-stationary time series.
4.2.2. Vector autoregressive regression
Independent variables Coef. Std. Err.
Inflation 0.25 0.144
unemployment rate -13.789 4.386
Growth of GDP -0.794 0.257
Exchange rate 0.201 0.161

Note: ***, indicates that the variable is significant at 1%

Source: Computed from World Bank Data (2022)
Table 3. Vector autoregressive regression result of macroeconomic determinates of inflation.

In Table 3 above, Vector autoregressive regression was fitted a Vector Auto-Regressive model of
order 1 VAR (1) with three exogenous variables "Unemployment rate, Growth of GDP and
Exchange rate. Both unemployment rate and growth rate of GDP has negative relationship with
inflation rate.

18
 4.2.3. Lag determination of VECM
Lag LL LR Df p FPE AIC HQIC SBIC
0 -398.284 32650.200 21.745 21.807 21.919
1 -272.081 252.410 16 0.000 85.054 15.788 16.0951* 16.6589*
2 -253.635 36.892* 16 0.002 77.0317* 15.6559* 16.209 17.223
Sample: 1981 - 2020 Number of
obs = 40
Table 4. Lag determination of before estimation vector error correction model (VECM).
Endogenous: inflation, unemployment rate, grow GDP, Exchange rate Exogenous: constant
Source: Computed from World Bank Data (2022)

Lag determination of VECM verso reports the final prediction error (FPE), Akaike’s information
criterion (AIC), Schwarz’s Bayesian information criterion (SBIC), and the Hannan and Quinn
information criterion (HQIC) lag order selection statistics helps to get maximum lag to be
included in vector error-correction model (VECM). To use this sequence of LR tests to select a
lag order, we start by looking at the results of the test for the model with the most lags, which is
at the bottom of the table. An ‘*’ appears next to the LR statistic indicating the optimal lag. The
results above show that the HQIC and SBIC chose one lags. This means determinants of inflation
were explained by one lags. Once we have determined the number of lags, our next task is to test
for co-integration amongst the variables.
4.2.4. Co-integration test

Co-integration test, also known as the eigenvalue test or trace test, is a likelihood ratio test. The
hypothesis for co-integration test is stated as: H0: no co-integrating equation
H1: H0 is not true
Maximum parms LL Eigen value trace statistic 5% critical value
rank
0 20 -285.512 . 63.7554 47.21
1 27 -265.813 0.65521 24.3570* 29.68
2 32 -258.65 0.32104 10.0306 15.41
3 35 -253.656 0.23658 0.0424 3.76
4 36 -253.635 0.00115
Table 5. tests for co-integration.

In the above table (table 5), the trace statistics at Maximum rank r=0 of 63.7554 exceeds its critical
value of 47.21, we reject the null hypothesis of no co-integrating equations. The trace statistics
at r=1 of 24.3570 is less than the critical value of 29.68; we cannot reject the null hypothesis

19
 that there is one co-integration relationship between inflation, unemployment, economic
growth rates and exchange rates. Therefore, this confirms the possibility of applying VECM. If
series are co-integrated; i.e. they t exhibit a long-run relationship, there is a need to estimate
long run models.

4.2.5. Vector error-correction model

Variables Lags/difference Coef. St. Err. t-value Sig
Inflation_ L -.875 .18 -4.86 0.063 ***
Inflation _ LD .063 .162 0.39 -0.00074
D _ inflation unemployment _LD -7.654 18.672 -0.41 -0.364
Growth of GDP_LD -.519 .3 -1.73 -0.028 *
Exchange rate _LD 4.662 2.175 2.14 0.063 **
Constant .044 2.291 0.02
unemployment L .001 .003 0.46 -7.65
Inflation _ LD -.001 .003 -0.28 0.799
D. unemployment unemployment _LD .799 .304 2.63 -6.91 ***
rate
Growth of GDP_LD .002 .005 0.35 0.74
Exchange rate _LD .02 .035 0.57 -7.65
Constant .002 .037 0.04
Growth of GDP_L .479 .1 4.81 -0.519 ***
Inflation _ LD -.364 .09 -4.05 0.0017 ***
D. Growth of unemployment _LD -6.913 10.326 -0.67 -0.039
GDP
Growth of GDP_LD -.039 .166 -0.24 0.0024
Exchange rate _LD -2.458 1.203 -2.04 -0.52 **
Constant .054 1.267 0.04
Exchange rate _L .039 .016 2.40 4.662 **
Inflation _ LD -.028 .015 -1.93 0.020 *
D. exchange rate unemployment _LD .737 1.674 0.44 -2.458
Growth of GDP_LD .002 .027 0.09 0.619
Exchange rate _ LD .619 .195 3.17 4.662 ***
Mean dependent var 5.977 SD dependent var 6.558
Note: *** p<.01, ** indicates that the variable is significant at p<.05, * p<.1
Source: computed from World Bank Data (2022)
Table 6. Vector error-correction model.

20
 4.2.6 Normalization
Variable Coef. Std. Err. Z
Inflation 1 . .
Unemployment 9.02** 4.31 2.09
Growth of GDP -1.03** 0.3 -3.41
Exchange rate 1.05*** 0.29 3.65
Note: *** p<.01, ** indicates that the variable is significant at P<0.01, p<.05, *p<.1
Table 7. normalization restriction imposed.

Table 7 above reflects the normalization restriction test where the purpose of the test is to evaluate
the long-term effect of unemployment, Growth of GDP, and exchange rate on inflation. All the
included variables have significant long term effect on inflation at p <5%

21
 Chapter Five
5. Conclusion and Recommendation
5.1. Conclusion
Ethiopia has encountered with serious macro-economic problem during most of the years under
investigation stagnant growth GDP negative group of per capital income Hugh debt servicing
preexistent balance of payment, budget deficit and continuously rise money supply are among
the various ways the problem revealed However under such circumstance inflation did not go out
of control in Ethiopia as it did in some Africa and other countries. Rather it has been tow as
compared to other countries in the last four decades. The rate shifted upward in the degree
regime and a bit decline in some years of the present year, but the rate registered recently is
higher than that of the previous year. Particularly the inflation rate of information in 2013 up to
2020. Therefore, the rate of information registered in both regimes is higher than that imperial
regime.
Having briefly discussed the overall economic and inflationary situation of the country, a logical
question that was raised in this study is that what are the determinants behind the inflationary
situation in the country and what are the means to manage inflation to a level that is not harmful
to the country. To this and we, have employed econometric techniques to investigate the
relationship between inflation and variable which are theoretically presumed to determine it.

The empirical analysis we have used annual data and consumer price index model is estimated
for inflation. The inflationary model function has been esteemed by using time series data by the
Engle Granger single dynamic equation which uses the econometrics theories error correction
and the dynamic structure of the inflation.
In formulating the inflationary function the paper has tried to include real, GDP budget deficit
deflated By GDP world, inflation real effective exchange rate and money supply Broad to
determine inflationary situation in the country.
The time series characteristics of the above variables have been established using augmented
Dickey fouler (ADF) Dickey fuller that all variable are integrated of order on or I(1)
The estimation of the model revealed that real GDP, real effective exchange rate and budget
deficit are negatively related with the consumer price index in the long run while the long-run,

22
real GDP budget difficult world inflation and real effective exchange rate are also negatively
related with consumer price index inflation.
On the other hand, money supply (M2)(IMF) and world inflation are positively related with
inflation in the long run where as in the short run only broad money supply is positively related
with inflation
We have regressed inflationary function using Ordinary Least Square (OLS) and ECM models.
These regressions results obtained are interpreted and analyzed. The finding shows that in the
long run except world inflation which are insignificant, all the rest are important determinants of
inflation in the country and significant at 1% level of significance.
On the other hand broad money supply (M2 (IMF) world inflation and dependent variable are
significant at 5% level significance in the short ICM However real gross domestic product
budget deficit deflated by GDP and real effective exchange rate are significant at 1% level of
significance. therefore both in the long run and short run monetarist and structuralist variables to
pother play a key role in determining inflation in the country. This conclusion is encounters with
the work of Betelihem (2012) But similar with the work of Habtamu (2000)
5.2. Recommendation
This study has tried to identify the macroeconomics determinates behind Ethiopian inflationary
process. The results indicated that the determinants of inflation differ between sectors and the
time horizon under consideration.
The policy implications that can be from this empirical study are:
 The policy interventions aimed at tackling the current inflationary processes need to take
into account the priorities of the government as the effect of policy instruments highly
depends on whether it is meant to temporary deal with the inflationary problem or
permanently reverse the inflation cycle. This is essential in that choice of policy
instruments may bring forward the need to trade of economic growth for macroeconomic
stability. The fact that the determinants of inflation in the short run somewhat differ from
those in the long run supports the above argument.
 Money supply growth has been one of the prime sources of long run inflation. Therefore,
in order to be able to curb the upward trend in prices, it is essential to adopt conservative
monetary expansion. This may, however, restrict the government on fiscal front and
engender problem of slower growth as observed in 2003 period when the government

23
 followed conservative fiscal and monetary policies. Finding the appropriate balance was
the role of policy makers.
 Inflation in Ethiopia is structural. Hence avoiding the structural bottle necks of the
economy should be given priority. Most importantly necks of the agricultural sector are
removed, but the same time removing the bottle necks of the other sector also important.
 As Friedman states inflation in Ethiopia is also monetary phenomena. To make money to
contribute to the growth of the economy, but not to inflation, it is necessary to balance
money supply growth with without growth.
 Even though the study has not incorporated market structure variable, the recent act of
few traders’ shows that a lot have to be worked to make the more competitive. Increasing
access to information and avoiding oligopoly elements in the economy must be given
priority. In short a lot must be done to make the market as competitive as competitive as
possible.

24
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27
 Appendix

Year Inflation Unemployment GDP Growth EX.R

rate
1881 6.14 2.44 5.30 1.54
1882 5.59 2.19 0.92 1.58
1883 -0.68 2.97 8.24 1.65
1884 8.42 4.21 -2.85 1.76
1885 19.06 3.15 -11.14 1.49
1886 -9.81 2.47 9.66 1.88
1887 -2.43 2.77 13.86 1.87
1888 7.08 3.50 0.50 1.90
1889 7.82 4.01 -0.36 1.99
1990 5.15 3.21 2.73 2.02
1991 35.72 3.08 -7.14 2.07
1992 10.53 3.10 -8.67 2.8
1993 3.54 3.05 13.14 5.7
1994 7.59 3.10 3.14 6.2
1995 10.02 3.21 6.13 6.3
1996 -8.48 3.31 12.43 6.5
1997 2.40 3.47 3.13 6.8
1998 0.89 3.62 -3.46 7.5
1999 7.94 3.71 5.16 8.1
2000 0.66 3.51 6.07 8.3
2001 -8.24 3.30 8.30 8.5
2002 1.65 4.02 1.51 8.5
2003 17.76 2.94 -2.16 8.6
2004 3.26 2.69 13.57 8.6
2005 12.94 2.50 11.82 8.6
2006 12.31 2.47 10.83 8.7
2007 17.24 2.44 11.46 9.2
2008 44.39 2.41 10.79 10.4
2009 8.47 2.38 8.80 12.4
2010 8.14 2.34 12.55 16.1
2011 32.01 2.31 11.18 17.2
2012 23.38 2.29 8.65 18.1
2013 7.46 2.25 10.58 19.7
2014 6.89 2.26 10.26 20.1
2015 9.57 2.27 10.39 21.1
2016 6.63 2.29 9.43 22.4
2017 10.69 2.30 9.56 24.4
2018 13.83 3.06 6.82 29.4
2019 15.81 3.22 8.36 31.9
2020 20.36 4.13 6.06 32.6