The Relationship Between Inflation, Money Supply and Economic Growth in Ethiopia: Cointegration and Causality Analysis

Abstract

The Ethiopian Economy has the feature of low and stable inflation before the period 2002/03. However, in the post 2002/03 period continues rise in the prices level along with sustained and rapid economic growth has been emerged. On the basis of this situation, this study has examined the existing causal relationship between inflation and money supply and between inflation and economic growth in Ethiopia for the period 1970/71-2010/11. The study used tri-variate Granger causality with VECM methodology along with impulse response function analysis. Statinarity tests, selection of optimal lag length and cointegration tests are under taken before estimation of the model. The test of stationarity revealed that CPI, money supply and RGDP are non-stationary in level and they become stationary at first difference. The Johansen cointegration test indicates the presence of one cointegrating vector and the VECM demonstrates the existence of long run bi-directional causality between inflation and money supply and uni-directional causality from economic growth to inflation. In the short run one way causality were found from money supply and economic growth to inflation. Furthermore, the impulse response function shows the response of inflation in money supply and economic growth shocks. Therefore, the key findings of the study are inflation is a monetary phenomenon in Ethiopia and inflation is negatively and significantly affected by economic growth. Thus, based on the results of the study, monetary policy should be planned to maintain price stability by controlling the growth of money supply and combined effort should be made by policy maker to increase the level of output by improving productivity and supply so as to reduce the prices of goods and services (inflation) and boost the growth of the economy.