Inflation and Economic Growth in Ethiopia: An Empirical Analysis

Abstract

Ethiopia’s recent growth performance and considerable development gains are challenged by macroeconomic problem of high inflation. If high economic growth is accompanied by soaring amount of inflation, it is interesting to identify the relationship between inflation and economic growth in Ethiopia Therefore, the objective of this study is to analyze the short run and long run relationship between economic growth and inflation for the period 1991-2021. The data used in this analysis were secondary data collected from national bank of Ethiopia, central statistical agency, ministry of finance and economic development, and additionally from World Bank report. The study used descriptive and econometric methods of analysis. The result of the descriptive analysis showed that the trends of inflation and economic growth revealed that both variables have inverse changes to each other during the study period. The econometric analysis was conducted using Eviews version 9 software. The stationary test showed that all variables were found stationary at first difference and this resulted in one co-integrated long run equation. The lag selection criteria pointed out that the lag two is appropriate lag for the analysis. With the help of co-integration and error correction models, inflation has short run and long run negative impact on economic growth. OLS model was used to analysis the long run relationship between the variables. As OLS model result revealed, inflation rate and money supply growth had negative relations with real GDP growth in the long run while the growth of investment has positive relation with real GDP growth during the study period. The error correction model was conducted to analysis the short-run relationship between the variables, and the result indicated that the coefficient of error correction term is -0.88 and highly significant with correct sign. The term implies, the system adjusts itself to the equilibrium by 88% per annum in the long run when there is a shock in the short run. The estimated coefficient of short run equation reveals that money supply and investment growth are the main determinants of economic growth while all other variables are insignificant including inflation. The causality test showed unidirectional from economic growth to inflation under the study periods. All diagnostic tests were conducted and there was no evidence of any problem. Based on the findings, the study recommends that the government should redirect its attention towards activities that directly and indirectly promote reduction of inflation and encourage both investment and money supply growth as an engine for economic growth.