The Dynamic Effects Of Fiscal Policy And Its Shocks On Economic Performance in Ethiopia

Abstract

Fiscal Policy is defined as the deliberate manipulation of government income and expenditure to achieve economic and social objectives and sustain growth . Fiscal policy significantly influences economic growth in both developed and developing economies. In developed economies, it aims to increase capital formation by reducing consumption and increasing saving propensity. In developing economies, it focuses on creating an equitable income distribution and transferring resources from unproductive to productive use. This study aims to investigate the dynamic effects of fiscal policy and its shocks on economic performance in Ethiopia using data over the period 1974–1975–2021/22 using the Johonson co integration and vector error correction models. The Johanson co-integration test result shows that there is a long-term relationship among the variables. The study found that current expenditure is positive and statistically significant in both the long and short run. It indicates that a 1% increase in current expenditure results in 1.42% (0.33%) increases in economic growth in the long run (short run) on average. The result indicates that capital expenditure has a negative and statistically significant effect on economic growth in the long run. The result indicates that a one percent increase in capital expenditure decreases economic growth by 0.69%, keeping another factor constant. The study explains that both in the long run and short run, tax revenue has a positive sign but is not statistically significant in effecting economic growth. This is due to the fact that tax revenue is restricted by factors like informal economy size, tax evasion, tax structure, fiscal policy effectiveness, and external influences. The impulse decomposition result shows that the impact of capital and current expenditure is permanent. The result of the variance decomposition estimates indicates that a greater proportion of the variation in economic growth tax revenue, current expenditure, and capital expenditure is also due to their own innovations. Finally, the study recommends that improved governance, tax reforms, and effective fiscal management and contribute to economic growth. Fiscal policy is crucial for development and macroeconomic stability, and in developing countries like Ethiopia, balancing infrastructure investment with social and human development needs can stimulate economic growth, create employment, reduce poverty, and improve population well-being.