Determinants of income velocity in Ethiopia

Abstract

One of the most closely watched variables in order to design effective monetary policy is income velocity. Income velocity relates monetary aggregates to economic activity. In line with this, the present study has examined the determinants of income velocity of both narrow and broad money definition in Ethiopia between the period 1970/71 up to 2010/11 using multivariate co-integration analysis. To achieve the objective of the study: unit root test, co-integration test and stability test are carried out. The result of unit root test shows that the series are stationary at first difference. The study suggest the existence of a unique and statistically significant relationship between the variables under consideration and income velocity of both money definitions. The stability test shows that the relationship is stable for both definitions of income velocity. The result of Johansen co-integration test indicates economic growth and inflation has significant positive effect on income velocity of both money definition. The result implies that money issuing authorities cannot obtain additional power by issuing more money without generating high pressure on inflation. The result also shown that proxy offinancial development has negative effect on both models which supports the hypothesis that the country economy might be operating at earlier stage offinancial development. Finally, real effective exchange rate found to have positive effect on velocity of broad money definition. So, it is better to take in to account the stage of financial development and level of exchange rate in forecasting income velocity in Ethiopia.