Macroeconomic Determinants of Inflation in Ethiopia: ARDL Approach to Co-integration

Abstract

Maintaining inflation rate at optimal level is among important mechanism of balancing macroeconomic volatility to ensure steady economic growth. The main objective of the research was to examine the macroeconomic determinants of inflation and analyse whether the identified variables have significant impact on inflationary situation in Ethiopia. The study employed ARDL model using annual data for period 1981-2020. To realize the objective, macroeconomic variables’ data were taken from National Bank of Ethiopia, International Monetary Fund and World Bank databases. The study also used augmented Dickey-Fuller and Phillips-Perron unit root tests to check stationarity of the variables. The test result revealed that almost all variables become stationary after the first difference. The ARDL-bound test was applied to examine the presence of con-integration between the variables. Accordingly, the result from bound test indicated the existence of long run relationship between the variables entered into the model. The estimated error correction model (ECM) with -0.53 coefficient also confirmed the existences of co-integration with high speed of adjustment towards the long run equilibrium. In the long run, natural logarithm of both real GDP and real effective exchange rate, and lending interest rate are positive and significant determinants of inflation, while broad money supply, real GDP, population size, gross national saving and previous year imports all in natural logarithmic are found to be the short run drivers of inflation. To contain inflation in Ethiopia, the study recommends that a policy action on reducing real effective exchange rate and utilizing broad money supply in productive way along with supply side measures should be designed, among others