ADDIS ABABA UNIVERSITY SCHOOL OF GRADUATE STUDIES

1 ADDIS ABABA UNIVERSITY SCHOOL OF GRADUATE STUDIES THE SOURCES OF THE RECENT INFLATIONARY EXPERIENCE IN ETHIOPIA BY KIBROM TAFERE June, 2008 ADDIS ABABA ADDIS ABABA UNIVERSITY SCHOOL OF GRADUATE STUDIES THE SOURCES OF THE RECENT INFLATIONARY EXPERIENCE IN ETHIOPIA A Thesis submitted to the SCHOOL of GRADUATE STUDIES of ADDIS ABABA UNIVERSITY in partial fulfillment of the requirements for the Degree of Master of Science in Economics (International Economics) BY KIBROM TAFERE June, 2008 ADDIS ABABA ADDIS ABABA UNIVERSITY SCHOOL OF GRADUATE STUDIES The Sources of the Recent Inflationary Experience in Ethiopia By Kibrom Tafere Approved by the Board of Examiners: _____ _____ Advisor Signature _____ _____ Examiner Signature _____ _____ Examiner Signature Acknowledgement I would like to forward the deepest of my appreciation and gratitude to my advisor Alemayehu Geda (PhD) for his patience and constructive advice throughout the course of the thesis.

2 Not only did he help me with invaluable advice, I have also learned a lot from him. The brotherly treatment he accorded me has served as an inspiration for the completion of this study. I am in a position where I cannot take the sole credit for the completion of this study. I credit every piece of strength of this study to my advisor and any weakness to myself. I also owe a great deal of gratitude to my family, my friends Henok Asmare, ADDIS Yimer, and Sintayehu Almaw for their moral support. I would also like to thank Muche Netsere for his constructive advice; Abdulaziz Abrar, Getachew Emre and Emerta Getachew for their assistance with the data and providing useful information. Table of Contents Abstract 1. Introduction ---------------------------------------- ---------------------------------------- ---1 Background ---------------------------------------- ---------------------------------------- ---1 Statement of the Problem ---------------------------------------- -------------------------3 Objective of the Study ---------------------------------------- -------------------------5 Significance of the Study ---------------------------------------- -------------------------5 Organization of the Study ---------------------------------------- -------------------------5 2.

3 Macroeconomic Developments ---------------------------------------- ----------------6 General Indicators ---------------------------------------- ----------------------------------6 Growth ---------------------------------------- ----------------------------------6 Inflation ---------------------------------------- ----------------------------------9 Saving and Investment ---------------------------------------- --------------12 Fiscal Developments ---------------------------------------- -----------------------14 Government Revenue ---------------------------------------- --------------14 Government Expenditure ---------------------------------------- --------------15 Monetary Developments ---------------------------------------- -----------------------19 Money Supply ---------------------------------------- -----------------------19 Exchange Rate ---------------------------------------- -----------------------21 Interest Rate ---------------------------------------- -----------------------23 Balance of Payments Developments ---------------------------------------- -----25 Output Supply ---------------------------------------- --------------------------------27 3.

4 Review of Literature ---------------------------------------- --------------------------------29 Introduction ---------------------------------------- ---------------------------------------- -29 Theoretical Literature ---------------------------------------- -----------------------30 Demand-pull Theories of Inflation ---------------------------------------- ---31 Classical/Neoclassical and Monetarist Theories ---------31 Keynesian Theories of Inflation ------------------------------------35 Keynesian-Neoclassical synthesis ------------------------------------36 Cost-push Theories of Inflation ---------------------------------------- -----37 Structural/Post-Keynesian Theories ------------------------------------40 The Scandinavian Approach ------------------------------------41 Kalecki s Approach ---------------------------------------- --------------44 Empirical Literature ---------------------------------------- --------------47 STUDIES of Inflation in Developing Countries ------------------47 STUDIES of Inflation in Ethiopia ------------------------------------49 Modeling Inflation in Developing Countries ------------------50 4.

5 Methodology ---------------------------------------- ---------------------------------------- -54 Theoretical Model ---------------------------------------- --------------------------------54 The Model ---------------------------------------- ---------------------------------------- -55 Data Analysis ---------------------------------------- -----------------------62 Unit Root Tests ---------------------------------------- -----------------------63 Cointegration and Error Correction ------------------------------------64 Engle-Granger Procedure ---------------------------------------- -----65 Single Equation Error Correction Model ---------------------------66 The Johansen Procedure ---------------------------------------- -----67 Data Source and Description ---------------------------------------- -----69 Data Limitations ---------------------------------------- -----------------------71 Definitions of Variables Used in Estimation ---------------------------71 5.

6 Model Estimation and Interpretation of Results ------------------------------------73 Unit Root Test Results ---------------------------------------- -----------------------73 Cointegration Analysis ---------------------------------------- -----------------------75 Food Price Model ---------------------------------------- -----------------------76 Non-food Price Model ---------------------------------------- --------------81 Single Equation Error Correction Model ---------------------------------------- -----86 6. Conclusion and Policy Implications ---------------------------------------- --------------90 Conclusion ---------------------------------------- ---------------------------------------- -90 Policy Implications ---------------------------------------- -----------------------92 References ---------------------------------------- ---------------------------------------- ----------94 Appendices Acronyms 2 SLS Two Stage Least Squares ADF Augmented Dickey-Fuller ADL Autoregressive Distributed Lag AIC Akaike Information Criterion CPI Consumer Price Index CSA Central

7 Statistical Agency DBE Development Bank of Ethiopia DF Dickey-Fuller DPPA Disaster Prevention and Preparedness Agency ECM Error Correction Model EDRI Ethiopian Development Research Institute GDP Gross Domestic Product I(0) Integrated of Order Zero I(1) Integrated of Order One IFS International Financial Statistics IMF International Monetary Fund MoFED Ministry of Finance and Economic Development NBE National Bank of Ethiopia NGO Non-Governmental Organization OLS Ordinary Least Squares PP Phillips-Perron PPP Purchasing Power Parity SC Schwartz Criterion SVAR

8 Structural Vector Autoregressive VAR Vector Autoregressive VAT Value Added Tax VECM Vector Error Correction Model List of Tables Table : Growth contribution of agricultural manufacturing and service sectors --9 Table : Inflation rates during the 1997/98-2006/07 period ---------------------------10 Table : Sources of Data ---------------------------------------- --------------------------------69 Table : ADF unit root test results ---------------------------------------- --------------73 Table : PP unit root test results ---------------------------------------- --------------74 Table : VAR lag order selection criteria for food price model ------------------78 Table : Johansen Cointegration test for food price model ---------------------------78 Table : VEC Granger Causality/Block Exogeneity Wald Test for food price model----------------------------------- ---------------------------------------- -----------80 Table : VAR lag order selection criteria for non-food price model ------------------82 Table : Johansen Cointegration test for non-food price model ------------------83 Table : VEC Granger Causality/Block Exogeneity Wald Test for non-food price model ---------------------------------------- ---------------------------------------- ------84 Table : Parsimonious Error Correction Model ------------------------------------88 List of Figures Figure.

9 Growth rates of GDP, agricultural output, manufacturing output and service sectors ---------------------------------------- -------------------------7 Figure : GDP growth rate, agricultural output growth and mean deviation of rainfall as a percentage of mean rainfall --------------------------------------8 Figure : Inflation by region (2002/03-2006/07) ------------------------------------11 Figure : The evolution of current and capital expenditures ---------------------------18 Figure : Evolution of money supply and inflation ------------------------------------21 Figure : The trend of exchange rate ---------------------------------------- --------------75 Abstract One of the prime objectives of governments is achieving stable macroeconomic condition. This objective requires that prices be kept to a reasonably stable level.

10 High and persistent inflation introduces uncertainties into the economy and may lead to slowdown of economic growth by discouraging domestic as well as foreign investments. It may also cause balance of payments problems by eroding a country s competitive advantage. Moreover, because it hits the poor the most it needs to be tackled. This study aims at understanding the forces behind the current inflationary process in Ethiopia. In order to achieve the stated objective a synthesis model of monetarist and cost-push inflation theories is estimated using vector autoregressive (VAR) and single equation error correction models. The estimated models enable to understand the short run and the long run price dynamics in Ethiopia between 1994/95 and 2007/08. The findings of the study suggest that the determinants of inflation differ between sectors (food and non-food) and the time horizons under consideration.