HAWASSA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DPARTMENTE OF ECONOMICS

THE KEY DETERMINANTS OF INFLATION ON THE ETHIOPIAN ECONOMY

A RESEARCH PROPOSAL SUBMITTED TO THE DEPARTMENT OF ECONOMICS

TOWARDS THE PARTIAL FULFILLMENT OF THE REQUIRMENT FOR THE
BACHELOR OF ART(BA)DEGREE IN ECONOMICS

Prepared By: Hirut Aymro

ID:0893/13
Advisor: Mr. Endalkachew D.

February,16 2024
Hawassa,Ethiopia

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 Acknowledgement
First and foremost glory is to the Almighty God for giving my wisdom and strength in my entire
life journey. Subsequently, i am also very grateful to my lovely family. Furthermore, i would like
to express my gratitude for my advisor Mr. Endalkachew for his in valuable guidance and
constructive comments in undertaking my proposal paper. Foremost i express my gratitude for
my friend Azazh for his helping by gave his lap top to do so this proposal paper. i would like to
express my gratitude to my kindly friend daniel for helping to accomplish my proposal carrier in
finding data from NBE. In the last but not the least, i would like to thank for my intimate and
dorm mate friends for their supportive role in every aspect of my university life.

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 List of
Acronyms AD-
Aggregate demand

ADF- Augmented Dickey Fuller

APPP-Absolute purchasing power parity

BOP- Balance of payment

CPI -Consumer Price Index

CSA- Central Statistical agency

DF- Dickey Fuller

ECM- Error correction model

EEA -Ethiopian Economic Association

FINF_ food inflation rate

GDP-Gross domestic

product GINF_ general

inflation rate

GRBD- Growth rate of budget deficit

GRER- Growth rate of exchange rate

GRRLIR- Growth rate of real lending interest rate

GRRGD-Growth rate of real

GDP IMF- International monetary

fund IMINF-Import inflation rate

LGRRGDP-Lagged growth rate of real GDP

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M2-Broad money supply

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NBE-National Bank of

Ethiopia OLS- Ordinary least

square PPI -Producer Price

Index

PPP-Purchasing power parity

VAR- Vector auto regressive

VECM- Vector of error correction model

VIF - Variable inflation factor

WB -World Bank

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 Abstract
This paper explains the key determinants of inflation in the Ethiopian economy, over the period
from 1981-2025.The objective of the study is to find the main factors determining inflation,
looking at the trends of inflation and finding of which theories of inflation can explain the
inflationary process in Ethiopia. To achieve these objectives, time series data using the
descriptive and regression analysis will be used. Using the long run co-integration test of
ordinary least square (OLS) method and short run error correction model (ECM), the finding
reveals as both monetary and structural factors are the main factors underlying inflation in
Ethiopia. The study, using a single-regression model which includes both long- run and short-run
determinants finds that food prices, growth rate of exchange rate, growth rate of real lending
interest rate, import inflation rate, growth rate of real GDP or economic growth and lagged
growth rate of real GDP or lagged economic growth have long lasting positive effects on
inflation in Ethiopia. Over the short-run growth rate of real GDP or economic growth combined
with domestic food prices seem to have significant effects on inflation in Ethiopia. From all these
significant variables in the short run, growth rate of real GDP has depressing effect on general
inflation while food inflation has positive and direct impact on inflation. However, there are
variables that have insignificant impact on inflation both in the short run and long run which are,
growth rate of budget deficit, growth rate of exchange rate, growth rate of real lending interest
rate and import inflation rate.
The researcher recommends that the government should use effective fiscal and monetary policy
as a means of avoiding the structural bottlenecks and improving the production capacity of the
agricultural sector in the economy, controlling the excess budget deficit and money supply with
balancedexchangeratepolicy.

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 TABLE OF CONTENTS

CONTENTES
PAGE, NO.
ACKNOWLEDGEMENT.............................................................................................................................................I

LIST OF ACRONYMS.................................................................................................................................................II
ABSTRACT..................................................................................................................................................................IV

CHAPTER ONE; INTRODUCTION.........................................................................................................................1

1.1. BACKGROUND.......................................................................................................................................................1
1.2. STATEMENT OF THE PROBLEM.............................................................................................................................3
1.3. OBJECTIVES OF THE STUDY..................................................................................................................................5
1.3.1. General Objectives.......................................................................................................................................5
1.3.2 Specific Objectives........................................................................................................................................5
1.4. RESEARCH QUESTION...........................................................................................................................................5
1.5. HYPOTHESIS OF THE STUDY.................................................................................................................................5
1.6. SOURCES OF DATA AND METHODOLOGY.............................................................................................................5
1.7. SCOPE OF THE STUDY...........................................................................................................................................6
1.8. SIGNIFICANCE OF THE STUDY...............................................................................................................................6
1.9. ORGANIZATION OF THE STUDY.............................................................................................................................6

CHAPTER TWO; REVIEW OF RELATED LITERATURE................................................................................7

2.1 THEORETICAL LITERATURE...................................................................................................................................7
2.1.1 Definition of Inflation....................................................................................................................................7
2.1.2 Measures of Inflation;...................................................................................................................................7
2.1.3 Types of Inflation...........................................................................................................................................8
2.1.4. Theories of Inflation...................................................................................................................................10
2.1.4.1. The monetarist versus structuralist theories of inflation with respect to developing countries.............................10
2.1.4.2 The Keynesian theory of Inflation...........................................................................................................................11
2.1.4.3 Imported Inflation Theory.......................................................................................................................................12
2.1.4.4 Purchasing Power Parity Theory.............................................................................................................................12
2.1.4.5 Inflation as an Economic Growth Phenomenon......................................................................................................12
2.2. REVIEW OF EMPIRICAL LITERATURE..................................................................................................................12
2.2.1 Empirical Finding in the World...................................................................................................................13
2.2.2. Empirical Finding in Africa.......................................................................................................................13
2.2.3 Empirical Finding in Ethiopia.....................................................................................................................14

CHAPTER THREE; METHODOLOGY.................................................................................................................17

3.1. DATA TYPE AND SOURCE...................................................................................................................................17
3.2. METHOD OF DATA ANALYSIS............................................................................................................................17
3.3. THEORETICAL FRAMEWORK................................................................................................................................17
3.3.1. Model Specification....................................................................................................................................18
3.4. DESCRIPTION OF VARIABLES..............................................................................................................................19
3.5. ESTIMATION TECHNIQUES...................................................................................................................................20
3.5.1. Stationary test: Unit root test.....................................................................................................................20
3.5.2 Estimation of Long Run Model....................................................................................................................20

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 3.5.3. Co integration test......................................................................................................................................20
3.5.4. Error Correction model..............................................................................................................................21
3.5.4.1. Estimation of short run model................................................................................................................................21

CHAPTER FOUR; BUDGET AND TIME PLAN...................................................................................................23

4.1 BUDGET PLAN.....................................................................................................................................................23
4.2 TIME PLAN...........................................................................................................................................................24
REFERENCES............................................................................................................................................................25

VII
 Chapter One; Introduction

1.1. Background
Inflation is defined as a continuous rise in price levels of goods and services leading to a fall in
currency’s purchasing power (Romer, 2012) as cited by Girma(2012). Inflation is a sustained
rise in general price level of goods and services. Inflation concern neither increase in price of
particular commodity nor for particular period of time. Inflation reflects a situation where the
demand for goods and services exceeds their supply in the economy (Hall, 1982). Stable price
level is one of the manifestations of healthy economy. Inflation reduces the real income, living
standard, saving, investment, export and increase import leading to adverse effect on the
economy of any country (Sisay, 2008).According to Milton Friedman (1970), inflation is found
in all kinds of society, at every stage of economic development, under every variety of
government and within all kinds of political, economic and social atmospheres.

History of inflation began from the time of evolution of money. However prior to the Second
World War inflation tended to occur during and immediately after wars, when government
financed the war, or during periods when gold discovers of the significant kind had been made.
Such as German hyperinflation of 1923, weak government has attempted to by their way out
economic crises by printing vast sum of money (Richard, 1996), this inflation had two important
characteristics. Such as; it occurred in response to some particular events, such as wars, gold
discover or unmanageable economic crises and it lasted only as long as the events with which
they were associated, and that was normally not very long.

The Second World War accompanied by rapid world inflation as had been happened often before,
the war time inflation continued into post war period. Between 1953 and 1959 the retail price in
the main industrial countries rises at an average rate of about 2-4 percent per annum. After 1974
the inflation rate quicken in most industrialized countries (ibid). Although the country has faced
different serious macroeconomic shocks, including drought, devastating wars and distorted
investment environment the inflation in the country was not miserable and it was very low in the

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past regime, except the 1972/1973 and 1978/1979 oil crises and fluctuations of non-oil import
prices. Because price control has kept prices stable. The government was also distributing goods
at fixed prices to the public. In addition the lower and pegged exchanged rate has also helped to
lower the impact of international price like in Ethiopia and makes imports cheaper. During the
earlier years of the present regime also inflation had been low (Sisay, 2011). However in the post
2002/2003 inflation began to appear as a major problem following the government ’s move
towards less conservative monetary and fiscal policy and state activism as a developmental state
in the economy. During the same period, the economy was reported to have recorded a fast
growth, export receipts have increased substantially and domestic tax revenue has increased.
Government expenditure have grown considerably, there has also been fast increase in money
supply mainly as a result of growth in fiscal deficits. Studying the linkage between price
developments and various macro-economic variables, therefore enable us to understand the
causes of the current inflation in Ethiopia (Alemayehu G., 2011).

In recent times, Ethiopia has experienced far-reaching economic growth and development
changes. According to the World Bank report (2013), the country has achieved remarkable
economic growth averaging 10.6 percent for almost half a decade since 2004, which is twice
above the continental average (Mwanakatwe& Barrow, 2010). According to the report, the
expansion of the service sector and agricultural growth contributed most while the contribution
of the manufacturing sector was relatively modest.

Until recently, Agriculture is the most dominant sector in the Ethiopian economy and remains to
be the largest source of economic growth. The mounting infrastructural development supported
by the increasing flow of external aid and growing domestic revenue enabled the economy to
stimulate the outperforming growth (Mwanakatwe& Barrow, 2010). Despite the rapid economic
growth and poverty reduction progress, sustained fiscal imbalances and macroeconomic
instabilities mainly, inflation, had been constantly limiting the bouncing economy (Desta, 2008).
According to Mwanakatwe& Barrow (2010) as cited by Haptamu (2013), huge domestic
borrowings financing the mounting public investment programs constitute the most challenging
macroeconomic scenarios worsening inflation and deficits in the economy. The experience of
sustained inflation rate in Ethiopia had begun since 2003.The overall inflation rate recorded for
the year 2002 indicates below zero (i.e. Deflation). However, since 2004 the country faced a

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constantly increasing rate of inflation, which is historically unprecedented as most researchers
explained it. The average overall inflation rate in 2006 was 13.7 percent. This figure rose to 25.3
percent and 36.4 percent in 2007/08 and 2008/09 respectively (CSA, 2009). In July 2008,
inflation was at its peak of 64 percent, the biggest macroeconomic challenge in the history of the
county (Sisay, 2008). By the end of 2010, the rate has declined to 8.2 percent and then
accelerated to 18.1 percent in 2011and started to decline moderately afterwards. Its irregularity
and volatility nature has conveyed diversified macroeconomic risks and uncertainties (Eden,
2012). Firmly, the seriousness of the problem will necessitates sound empirical investigations
and policy responses.

1.2. Statement of the Problem

Historically, Ethiopian inflationary experience was moderate and not considered as series as the
issue of economic growth (Ayalew, 2007). Since 2003, however, the country has experienced
high and persistent inflation growth. Several macro-economic stabilization measures and
policies were implemented over the past and deemed to be completely failed (Barrow, 2010).
The booming economy has yet remained principally constrained by dual macroeconomic
problems i.e. Price inflation and low international reserves (Barrow, 2010).

There are enormous disagreements about the real causes of inflation and their magnitude of
effects. There existed a number of potential sources as explained by several scholars and
researchers. For instance, Government bodies, while expressing their solutions to the prevailing
high level of inflation, put certain factors as the basic sources of inflation. They have strong
conviction that the sustained economic growth could generate upper price hike i.e. the demand
pull inflation. Similarly, the World Bank report in (2013), declared that the main source of
inflation in the country is the mounting aggregate demand due to the growth of Private
consumption and public investment. Nevertheless, plenty writers have different views.
According to Loening (2009) as cited by Haptamu (2013), a large fraction of the county’s
inflation is explained by foreign price and agricultural supply shocks and money growth. Hassan
(2008) argued that the reasons behind the mounting inflation are neither the growing economy
nor the Ethiopian peasantry getting richer than before. He rather pointed out a number of
responsible factors, including money growth, lower interest rates, war expenditures, declining
foreign exchange reserves, budgets and current account deficits and so on.

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There is no agreement on the causes of the high inflation experienced in recent years in Ethiopia.
The government state supply bottlenecks, market structure, increased income in the rural sector
and international price development especially of petroleum to be the cause of inflation. On the
other hand IMF and most economists argue that inflation in Ethiopia is caused due to increased
demand caused by expansion in money supply and increased remittance. In short the
government attributes inflation to supply factors while international organization and most
economists attribute inflation to demand factors (Sisay M. 2008)

Sisay M. (2008) finds that inflation in Ethiopia is in the long run due to structural, monetary
expansion lending rates and expectation. Asayeheng D. (2009) finds that main determinant of
inflation in Ethiopia are real GDP, exchange rate, domestic landing interest rate. Kibrom T.
(2008) states that the most important determinant of inflation in the long run are mainly domestic
monetary development while cost push factors are the force behind short run inflation. He also
stated that in the long run domestic food price influenced mostly by income growth, inflation
expectation, money supply growth and increase in international food price. He also states in the
short run, both demand and supply appear important in the current inflationary process, with
supply factors having the edge over the demand factors.

Haben T. (2015) studied that general inflation, imported inflation, money supply, food prices and
real GDP are the key determinants of inflation on the Ethiopian economy. So far, there is no
strong consensus on the key sources of inflation in the country. Some argued that the principal
sources of inflation are supply side and external factors; whereas others proclaimed the demand
and monetary factors. Thus, the general theories proposed by various economists to explain the
determinants of inflation are; inflation as an economic growth phenomenon, the monetarist
(quantity theory of money) theory, imported inflation theory, Keynesian theory and purchasing
power parity theory explanation of the causes of inflation, and fiscal budget deficits, cost push
inflation and demand pull inflation are a source of inflationary pressure. This paper will be aimed
at making an empirical investigation on the key determinants of inflation on the Ethiopian
economy. Therefore, the study will makes empirical investigation on the causes of inflation in
the Ethiopian economy by incorporating real lending interest rate, budget deficit, real exchange
rate and imported inflation, money supply, food prices and real GDP.

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1.3. Objectives of the Study
1.3.1. General Objectives
The general objective of the study is assessing the key determinants of the general inflation in
Ethiopia.

1.3.2 Specific Objectives

 Analyzing the trend of inflation in Ethiopia.

 Identifying the variables that determine inflation in Ethiopia.

 To identify which theory does more explain the recent inflation scenario in ethiopia

1.4. Research Question

 What looks like the trend of inflation in the Ethiopian economy?

 what are the variables that determine inflation?

 which theory does more explain the recent inflation scenario in Ethiopia?

1.5. Hypothesis of the Study

Based on different theories and findings all independent variables will have been significant
effect on the general inflation, some independent variables affect general inflation positively like
food inflation rate, growth rate of budget deficit including grants, growth rate of real lending
interest rate, depreciation of exchange rate, import inflation rate and On the other hand
independent variables growth rate of real GDP and affect general inflation negatively.

1.6. Sources of Data and Methodology

In order to examine the main determinants of inflation, the researcher will be used secondary
data and collect data from National Bank of Ethiopia (NBE), Central Statistical agency (CSA),
Ethiopian Economic Association (EEA), International monetary fund (IMF) and World Bank
Publications. The data type the researcher will use for this study will annual time series data for
the periods from 1981 to 2017.

In identifying the determining factors of inflation in the Ethiopian economy both descriptive and
regression analysis ranging from the long run regression model of OLS technique up to the short
run model of inflation using error correction model is employed.

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1.7. Scope of the Study
Inflation is a multidimensional macroeconomic phenomenon. The ultimate focus of this study
will be to examine the causes of inflation economically. The study will not consider the effects
of non-economic aspect of socio-cultural and political causes of inflation. The study will focuses
only on the quantitative variables. This study will specifically focuses on the trends of inflation
in Ethiopia and the effects of the variable those are general inflation rate, food inflation rate,
growth rate of real lending interest rate, growth rate of budget deficit, depreciation of exchange
rate, growth rate of real GDP, import inflation rate and lagged growth rate of real GDP. On the
other hand due to limited the data availability and sensitivity nature of the indicators from the
general macroeconomic point of view, the study may not carry out a thorough examination of
each macro-economic indicator; perhaps principally focus on exploring the key determinants of
inflation on the Ethiopian economy. This paper delimits its study in Ethiopia and cover the time
period from 1981 to 2017.

1.8. Significance of the Study

Most importantly, the study is expected to raise the interest of scholars as input for world
research to work on inflation since inflation has a wide range of impact on the economical,
socio-economic and political system of the country. It also serves as starting point for students
working on inflation. The study also serves as a mirror in showing the policy direction of the
government to mitigate inflation.

1.9. Organization of the Study

This paper has five chapters. The first chapter briefly outlines the introduction part of which
mainly contains background of the study, statement of the problem, objectives, research question,
hypothesis part of the research, type and sources of data, scope, significance, and organization of
the study. The next chapter deals with review of related theoretical and empirical literature and
the third chapter gives methodology of the research. The fourth chapter mainly deals with time
schedule and it's budget plan.and finaly the fivth chapter is also about conclusion and
recommendation .

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 Chapter Two; Review of Related Literature

2.1 Theoretical Literature

2.1.1 Definition of Inflation
The concept of inflation is defined by different economists across time in different ways.
Inflation, which is commonly measured by consumer price index, is a continuous and sustained
rise in the general price levels or a continuous fall of value of money (mishkin, 1997) as cited by
Haben T. (2015). Inflation reflects a situation where the demand for goods and services exceeds
their supply in the economy (Hall, 1982). Inflation is neither the increasing of price for a
particular product nor for a short period of time. Inflation is always and everywhere a monetary
phenomenon (Friedman, 1976).

2.1.2 Measures of Inflation;

There are various price indexes which are used to measure inflation. The following are the
major ones stated by Dornbusch et al. (2001).

Consumer Price Index (CPI); It is the most measurement that mostly used to measure inflation.
Inflation is measured by weighted average of the percentage change in the prices of a given
basket goods over time as compared to the price in the base year. In Ethiopia the central
Statistical Authority computes the CPI. The authority makes house hold expenditure survey
every five years.

GDP Deflator; The GDP price deflator is an economic metric that accounts for inflation by
converting output measured at current prices into constant-dollar GDP or simply it is the ratio of
nominal GDP to real GDP. It includes all the goods produced in a country but excludes imports.
The GDP deflator shows how much a change from the base year's GDP relies upon changes in
the price level so, it measures the change in prices that has occurred between the base year and
the current year.

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Producer Price Index (PPI); It is a measure of the cost of given basket of goods; however, it
differs from the CPI partly in its coverage, which includes raw materials and semi-finished
goods.The Producer Price Index (PPI) is a weighted index of prices measured at the wholesale or
producer level while the Consumer Price Index measures the cost at the consumer or household
level.

2.1.3 Types of Inflation

According to Dutta (2015), Inflation can be classified into various categories based on different
grounds.

Speed or Intensity based classification; It is based on the rate of change in prices within a
given nation.

Creeping Inflation; Circumstance where the inflation rate of a nation increases gradually and
continually over time. Continuous rise in price level of less than 3% per annum is characterized
as creeping or mild inflation.

Walking Inflation; When the rate of rising prices is more than creeping inflation, it is known as
walking inflation when prices rise by more than 3% and less than 10% per annum.

Running Inflation; A rapid acceleration in the rate of rising prices is termed as running inflation.
When prices rise by more than 10% and less than 20%, running inflation occurs.

Galloping Inflation; When prices rate of increase is greater than 20% and less than 100%, it is
galloping type of inflation. It is also known as jumping inflation. The case of inflation in India
after the second five year plan has shown such type of inflation.

Hyper Inflation; Hyper- inflation refers to a situation where price rises at highly an alarming
rate. The price rises so fast that it becomes very difficult to measure its magnitude. During the
worst case scenario of hyper-inflation, the value of national currency or money tends to zero.
Two worst examples of hyper- inflation recorded in the world history are these experienced by
Hungary in year 1946 and Zimbabwe during 2004-2009 under Robert Mugabe’s regime.

Based on Government Reaction to the Inflation

Government and monetary authorities react to the inflation level based on the economic system
they follow.

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Open Inflation; According to Milton Friedman open inflation refers to the inflationary process
in which prices are allowed to rise without being suppressed by government price control. If the
inflation was not checked by the government policies, the creeping inflation would had been
changed to walking to running to galloping and finally to hyper-inflation. However, this type of
inflation may prevail well without negatively affecting the economy in the market economy
where the price mechanism works efficiently but price always fails for various reasons.

Suppressed Inflation; Suppressed inflation refers to a situation in which the government

intervenes directly to control the price system through various measures because no government
can allow the price to rise beyond limits; especially during war periods the researcher find that to
avoid the harmful effects of rising prices, controls and rationing may be imposed which prevent
households and firms from buying as many goods and services as they would like to buy at
existing price and income levels. In general, if existing inflation is disguised by government
price control or other interferences in the economy such as subsidies is called suppressed or
repressed inflation.

Based on causes of inflation

A. Currency Inflation; This type of inflation is caused by the printing of currency notes.

B. Credit Inflation; Being profit making institutions; Commercial banks provides more loans
and advances to the public than what the economy requires. Such credit expansion leads to a rise
in the price level.

C. Deficit Induced Inflation; The budget of a government is called deficit if the expenditures
exceeds the revenue. To meet this gap, the government may ask the central bank to print
additional money. Since pumping of additional money is required to meet the budget deficit, any
price rise as a result of this is called deficit induced inflation.

D. Demand Pull Inflation; Demand-pull inflation is a type of inflation that occurs when the
demand for goods and services in an economy exceeds its supply. This leads to an increase in
prices as businesses raise prices to meet the high demand. Demand-pull inflation can be caused
by factors such as strong consumer spending, government spending, or investment spending that

9
outpaces the economy's capacity to produce goods and services. It is often associated with
economic growth and can lead to a rise in overall price levels.

E. Cost Push Inflation; Cost-push inflation is an economic phenomenon in which the overall
price level in an economy is driven up by increases in the cost of production for goods and
services. This type of inflation occurs when businesses face rising input costs, such as wages,
raw materials, or energy prices, and pass on these increased costs to consumers through higher
prices. Cost-push inflation can lead to a decrease in purchasing power, reduced consumer
demand, and potential economic instability if left unchecked.

2.1.4. Theories of Inflation

2.1.4.1. The monetarist versus structuralist theories of inflation with respect to developing
countries.
The monetarist thinking (Quantity Theory of Money)

Monetarist thinking, particularly the Quantity Theory of Money, is a school of thought in

economics that emphasizes the relationship between the money supply in an economy and the
overall price level. According to monetarists, changes in the money supply have a direct and
proportional impact on the price level in the long run.

The Quantity Theory of Money is often summarized by the equation MV = PQ, where M
represents the money supply, V represents the velocity of money (how quickly money circulates
in the economy), P represents the price level, and Q represents the quantity of goods and services
produced. Monetarists argue that changes in the money supply (M) will lead to changes in the
price level (P) over time, assuming that velocity of money (V) and real output (Q) remain
relatively stable.

Monetarists believe that controlling the growth rate of the money supply is crucial for
maintaining price stability and promoting long-term economic growth. They advocate for central
banks to focus on managing the money supply through monetary policy tools, such as setting
interest rates and open market operations, to achieve stable inflation and sustainable economic
growth.Overall, monetarist thinking emphasizes the importance of controlling inflation through
prudent monetary policy and maintaining a stable and predictable macroeconomic environment
to support economic stability and prosperity.

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The Structuralist Thinking

Structuralist thinking, particularly in the field of economics, views inflation as a complex

phenomenon that is influenced by various structural factors within an economy. Structuralists
focus on understanding the underlying causes of inflation, rather than just looking at short-term
fluctuations in prices.

Some key views of structuralist thinking on inflation include:

 Structural Factors: Structuralists emphasize that inflation is influenced by structural

factors such as supply constraints, market power, and institutional arrangements within
an economy.

 Distributional Effects: Structuralists highlight the distributional effects of inflation,

pointing out that different groups within society may be affected differently by rising
prices.

 Global Factors: Structuralists also consider global factors in their analysis of inflation,
recognizing that international trade, capital flows, and exchange rate movements can
impact domestic price levels.

Overall, structuralist thinking on inflation emphasizes the importance of understanding the

underlying structural features of an economy and addressing them to effectively manage
inflationary pressures.

2.1.4.2 The Keynesian theory of Inflation

J.M. Keynes (1940) is known as the father of modern economics in his theory of inflation. The
main point of the Keynesian theory of inflation is that inflation is primarily driven by changes in
aggregate demand in the economy. When total demand for goods and services exceeds the
economy's capacity to produce them, prices tend to rise. Keynesians emphasize the importance
of government intervention through fiscal policy to manage inflation and promote economic
stability. Overall, Keynesian economics offers a perspective that differs from structuralist
theories by focusing on demand-side factors in explaining inflation.

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 2.1.4.3 Imported Inflation Theory
The main point of imported inflation theory is that inflation in a country can be influenced by
external factors, such as changes in the prices of imported goods and services. This theory
emphasizes the impact of global economic conditions, exchange rates, and international trade on
domestic inflation levels. Policymakers need to consider these external influences when
designing strategies to manage inflation effectively.

2.1.4.4 Purchasing Power Parity Theory

The simplest approach to price determination in an open economy is that of purchasing power
parity (PPP). Absolute purchasing power parity (APPP) implies that price levels in different
countries move towards equality in common currency terms. The main point of Purchasing
Power Parity (PPP) theory is that in the absence of transaction costs and other barriers, exchange
rates between two currencies should adjust to equalize the purchasing power of each currency. In
other words, the exchange rate between two currencies should reflect the relative price levels of
goods and services in each country. This theory suggests that over time, exchange rates will
adjust so that identical goods cost the same in different countries when expressed in a common
currency.

2.1.4.5 Inflation as an Economic Growth Phenomenon

From theoretical and empirical perspective, determining the direction of causality between
economic growth and inflation in the developing countries is very controversial. In 1950s, the
Structuralist Economist view of inflation, as pioneered in Latin America, persuasively argued
that moderate inflation and economic growth are positively related. This was in contradiction to
the policy advice of the international lending institutions (Meier, 1995). Stated in simple terms,
inflation stimulates the economy since nominal wages may lag behind prices, allowing for
slower adjustment to wage expectation. Similarly, the Keynesian economic perspective assumed
that moderate inflation might accelerate economic growth by raising the rate of profit, thus
increasing private investment (Jung & Marshall, 1986).

2.2. Review of Empirical Literature

In this part, a review of empirical works on inflation will be done. The section is divided in to
three. The first section, World country’s experience, a review of literature on some European,
Asian countries will be made. In the second part literatures on African countries will be reviewed.
Finally, in the third section, a review of literature of Ethiopian inflation will be made.

12
2.2.1 Empirical Finding in the World
Lim and Pap (1997) in their study of determinants of inflation in Turkey used the annual data
from 1970-1975 within the framework of multi-sector macro-economic model. The major
findings were that monetary variables (money supply and exchange rate), inflation inertia and
public budget deficit plays a central role in the inflationary process of turkey. Maliszewski (2003)
in his study titled modeling inflation in Georgia used monthly data from January 1996 to
February 2003. The researcher used a short run ECM and a long run co integration models. The
results from the short run model show that inflation in Georgia is determined by changes in
exchange rate and imported oil prices. The results from the long run model show that inflation in
the long run is determined by money supply, exchange rate and output but the exchange rate
variable is found to be dominant in explaining inflation.

Hossain (2013), in his study of examining the determinants of inflation in Bangladesh used the
data from 1990 to 2010. Ordinary Least Square (OLS) method has been used to explain the
relationships. The empirical results show that money supply, one year lagged value of interest
rate positively and significantly affect inflation.

Abdullah M. and Kalim R. (2010) investigated determinants of food price inflation in Pakistan
using time series data from 1972 to 2008 using Johansen’s co-integration technique. They study
inflation expectations, money supply, per capita GDP, support prices, food imports and food
exports. The result of the study support significant and positive relationship between inflation
and its determinants in the long run except money supply which they found insignificant with
positive sign. In the short run, using vector error correction model they found only inflation
expectations, support prices and food exports affect the food price inflation.

In general they found both demand and supply side factors are important while structuralist’s
point of view is insignificant.

2.2.2. Empirical Finding in Africa

According to chhiber (1992), the rate of inflation all over the world has the same trend up to
1975.It was 1975, when the average inflation in sub Saharan region exceeds above industrial and
Asian countries .From 1975-1988 average inflation in sub-Saharan region was 16.4% while it
was averaged 7% per annum in industrial countries leading to give attention on inflation.

13
Laryea and Sumalia (2001) in Tanzania examined the determinants of inflation using an error
correction model and OLS technique for the period of 1992-1998 was used. The result of the
econometrics analysis shows that inflation in Tanzania either in short or long term was
influenced by monetary factors and to less extent by volatility in output and depreciation of
exchange rate. The study covers the years from 1965-1988 and the multivariate econometric
model explains the growth of money supply and exchange rate affecting inflation significantly
and positively.

Ayinde O. E. et al (2010) study the determinants of inflation in Nigeria using co-integration

approach with time series data from 1970 to 2006. They investigated export, import, consumer
price index for food and annual agricultural output, annual interest rate, annual government
expenditure, annual exchange rates and annual crude oil exports as determinants of inflation.
They find that import, consumer price index, exchange rate has positively affect inflation while
interest rates and crude oil exports negatively affect inflation in Nigeria

Kabundi (2012) has tried to identify the main factors underlying inflation in Uganda, both in the
long - and short-rung, using monthly data from January 1999 to October 2011. It uses a single
equation Error Correction Model (ECM) based on the quantity theory of money including both
external and domestic variables. The main finding is that both external and domestic factors
explain dynamics in inflation in Uganda. Over the long-run, monetary aggregate, world food
prices, and domestic supply and demand effects in agricultural sector are main determinants of
inflation in Uganda. While money growth, world food prices, and energy prices, combined with
domestic food prices have short-term impact on inflation. Finally, the study finds evidence of
inflation inertia which can be attributed to expectations of agents and/or inflation persistence

2.2.3 Empirical Finding in Ethiopia

There was no much literature on Ethiopian inflation because of the low inflation experienced in
the past but now a day it is becoming one of the compulsory research issue.

During the Dreg regime, inflation has been low in Ethiopia for the reason that the price was
controlled by the government and the government itself was providing goods at fixed price to the
public. Further, the lower and fixed exchange rate has also contributed to the lower inflation rate.
Similarly, inflation rate has been low in the earlier years of the present government (Sisay, 2008).

14
However, in recent years inflation has been high in Ethiopia. Inflation rate in Ethiopia averaged
18.69 percent from 2006 until 2015, reaching an all-time high of 64.20 percent in July of 2008
and a record low of -4.10 percent in September of 2009 (trading economics). Though Ethiopia
has experienced a low inflation, recently, double digit inflation has become worrisome for policy
makers as well as the society.

Kibrom T. (2008) examines the sources of recent inflationary experience in Ethiopia between
1994/5 and 2007/8 using vector autoregressive (VAR) and single equation error correction
models. He finds that the determinants of inflation differ between sectors (food and non-food and
the time horizons under consideration. The most important forces behind food inflation in the
long run are real income, money supply, inflation expectation and international food prices. The
long run determinants of non-food inflation, on the other hand, are money supply, interest rate,
and inflation expectation. In the short run he found wages, international prices, exchange rates
and food supply are prime sources of inflation.

Emirta (2013) has studied the optimal level of inflation in Ethiopia around which inflation affect
economic growth optimally. The study has applied threshold approach. By doing so on the data
from 1971-2010 inflation level of about 8%-10% is optimal for Ethiopia. Any inflation level,
greater or less than the estimated threshold level, may not allow long-term and sustainable
economic growth. Since the level of income in Ethiopia is very low but expenditure on
consumption items such as food is very high, inflationary experience results in a low level of
welfare. Thus, it is essential that the government intervene to control the price trend in the
country. However, such intervention requires appropriate policies devised from careful
observation of the forces behind the price fluctuations

Loening (2008) analyzed short-run dynamics of inflation in Ethiopia, using a parsimonious error
correction model fitted with monthly observations from 1997-2008. The finding shows that
increased money supply and the nominal exchange rate significantly affect inflation in the short
run. Agricultural output shocks, proxies by a cereal-weighted agricultural production index, are
also important. The findings suggest that monetary policy in Ethiopia triggers price inertia,
which has large and persistent effects and simulation suggests that monetary policy alone may be
unfeasible to control inflation effectively.

15
Eden (2012) analyzed modeling inflation volatility and its impact on economic growth using the
annual data from 1991-2011 and co-integrated VAR model and Granger causality test was
employed. The major finding of the study was agricultural supply negatively and money supply
positively in the short run and exchange rate and real output positively in the long run.

Loening (2007) studied the inflationary expectation in Ethiopia using the quarterly data
from1995-2006 employing the error correction model. The finding shows that money supply,
nominal exchange rate, and interest rate affecting inflation positively while real output
negatively in the short run and interest rate in the long run positively.

Alemayehu and Kibrom (2008) studied the determinants of inflation in Ethiopia using data
from1994-2007.The study employed VAR model and the finding shows world commodity price,
wage and exchange rate are sources of inflation positively in the short run. Food price, real
output and money supply affects inflation positively in the long run.

Girma (2012) studied the relationship between economic growth and inflation using the annual
data of 1980-2011.The co-integrated VAR and vector of error correction (VECM) models were
employed and the finding reveals that money supply positively and real output negatively affects
the inflation process in the short run. In the long run exchange rate positively and real output
inversely play a central role in the inflation of Ethiopia.

Temesgen (2013) studied the determinants and impacts of inflation considering the data from
1998-2010 using Granger causality model approach. The finding shows as money supply, oil
price and nominal exchange rate are the main sources of inflation in the short run and real output
positively in the long run.

Haben T. (2015) studied the determinants of inflation considering the time series from 1974 to
2014 using ordinary least square method. His studied general inflation, imported inflation,
money supply, food prices and real GDP are the key determinants of inflation on the Ethiopian
economy. So the researcher will be intiated to fulfill the gap that were forgated by the last the
researcher.

16
 Chapter Three; Methodology

3.1. Data Type and Source

This study used secondary data which is time series data type from year 1981 to 2017, because
most of macroeconomic variables are time series in their nature. It enables to arrive at an
econometric model that would show the relationship between general inflation rate and other
variables such as food inflation rate, import inflation rate, growth rate of budget deficit, growth
rate of exchange rate, growth rate of real lending interest rate, growth rate of real GDP and
lagged growth rate of real GD. The data for all variables are collected from National Bank of
Ethiopia (NBE).

3.2. Method of Data Analysis

The study used both descriptive statistics like graph and table to analyze the trend of general
level of inflation in Ethiopia and time series econometrics regression analysis ranging from the
long run regression model of OLS technique up to the short run model of inflation using error
correction model in STATA software.

3.3. Theoretical framework

Several studies have been conducted to find out the key determinants of inflation on the
Ethiopian economy. Hossain (2013) study the determinants of inflation in Bangladesh used the
data from 1990 to 2010. He show that money supply, interest rate, fiscal deficit , nominal
exchange rate, one year lagged value of interest rate , one year lagged value of money supply and
one year lagged value of fiscal deficit are the determinants of inflation. Kibrom T. (2008)
examines the sources of recent inflationary experience in Ethiopia between 1994/5 and 2007/8
and he finds that the determinants of inflation differ between sectors (food and non-food) and the
time horizons under consideration. He shows that most important forces behind food inflation
in the long run are real income, money supply, inflation expectation and international food prices.
The long run determinants of non-food inflation, on the other hand, are money supply, interest
rate, and inflation expectation. In the short run he found wages, international prices, exchange
rates and food supply are prime sources of inflation.

Sisay M. (2008) studies the determinants of recent inflation in Ethiopia. He studies using
quarterly data from third quarter of 1997/98 up to second quarter of 2007/8, real GDP, broad
money supply, exchange rate, lending interest rate, overall budget deficit, one period lagged

17
consumer price index, one period lagged money supply and price of gas oil are the key
determinants of inflation on the Ethiopian economy. Alemayehu and Kibrom (2008) studied the
determinants of inflation in Ethiopia using data from1994-2007.The study shows world
commodity price, wage and exchange rate are sources of inflation positively in the short run.
Food price, real output and money supply affects inflation positively in the long run. Haptamu
(2013) tried to investigate the cause and dynamics of inflation in Ethiopia using the annual data
of 1980-2012.The main finding reveals that money market, agricultural market and external
market determines price inflation. (Saini, 1982) money supply is one of the notable
macroeconomic factors explaining inflation in the developing countries. Temesgen (2013)
studied the determinants and impacts of inflation considering the data from 1998-2010. The
finding shows as money supply, oil price and nominal exchange rate and real output are the main
sources of inflation. Remembering that, the main point is analyzing the key determinant of
general inflation trend on the Ethiopian economy. Doing that entails specification of general
inflation. Both theoretical and empirical literatures propose a number of key variables that will
have significant effect on the general inflation. General inflation usually measured as the
percentage change in the prices of a given basket goods over time as compared to the price in the
base year. Based on Dornbusch et al. (2001) general inflation rate can be specified as;

Where; πt_ inflation rate (in percentage) at time t

Pt. _present price level

Pt-1 _is one period lag price level.

The study will focuses on demand side factors, supply side factors and external factors to
determine the key determinants of inflation on the Ethiopia economy. Many indicators have been
considered in the existing study by Haben T. (2015) like general inflation, imported inflation,
money supply, food prices and real GDP.

3.3.1. Model Specification

Though this particular study will attempts to determine inflation on the Ethiopian economy by
incorporating real lending interest rate, budget deficit, real exchange rate and lagged real GDP in
addition to general inflation, imported inflation, food prices and real GDP and the model is stated
as follow:

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GINFt = F (GINFt, GRERt, GRRLIRt, GRBDt, GRRGDPt, IMINFt, LGRRGDPt,)

GINFt= β0+β1FINFt+β2IMINF+β3GRERt+β4GRRLIRt+β5GRBDt+β6GRRGDPt+β7LGRRGDt+ Ui

Where GINF_ general inflation rate, FINF_ food inflation rate, GRBD_ growth rate of budget
deficit including grants, GRER_ growth or depreciation rate of exchange rate, GRRLIR_ growth
rate of real lending interest rate, GRRGDP_ growth rate of real GDP or economic growth rate,
IMINF_ import inflation rate, LGRRGDP_ one year lagged growth rate of real GDP, Ui_ error
term.

3.4. Description of Variables

1. General Inflation Rate (GINF): General inflation rate refers to the monthly or annual
percentage changes in the price of a fixed basket of goods and services. The Ethiopian inflation
rate is commonly measured by the percentage change of CPI, which is determined on the basis
of precise representation of the weighted price index.

2. Food Inflation Rate (FINF): It is the average general inflation level of food commodities.
Food CPI is expected to have a positive relationship with the overall inflation.

3. Import inflation rate (IMINF): Import inflation rate is the percentage change in import price
index. Import price index is an average price level of imported commodities adjusted for its
exchange rate and it is expected to have a positive relationship
4. Growth rate of Budget Deficit including grants (GRBD): Budget deficit is the excess of
government expenditure over government revenue including grants. Growth rate of budget
deficit is the percentage increase in the budget deficit account which can be financed through
printing resulting in inflation so it is directly related with the general inflation rate.

5. Growth or depreciation of Exchange rate (GRER): exchange rate is the price of one
currency in terms of another currency or the rate at which one currency can be exchanged for
another. Devaluation or depreciation of exchange rate speed up inflation rate whereas revaluation
or appreciation keeps inflation low, so it is expected to have a positive relationship.

6. Growth rate of real lending interest rate (GRRLIR): It is the interest adjusted for inflation
paid by the borrowers for the use of money borrowed from Commercial Bank of Ethiopia.

19
According to the Keynesian economic theory growth rate of interest rate is expected to have a
positive relationship with the general inflation rate.

3.5. Estimation techniques

For any given time series data out pressure for policy recommendation for derived conclusion,
it is mandatory to pass three stage techniques. Each of which tests the stationary of time series
variable, the committing of error in each stage cannot permit progress in to the next stage unless
the data are adjusted in a way to fulfill criteria of that particular stages of estimation technique.
3.5.1. Stationary test: Unit root test

The data is checked weather it is stationary or not before conducting any economic study. If the
variable under study are non- stationary then it may lead to spurious result so it is important that
rises of data is stationary (i.e., its mean, variance and co-variance are constant over time and the
value of covariance between two period depends only the distance or the lag between two time
period and not on the actual time at which covariance is computed (Gujarat, 5th edition)). In time
series econometrics time series has a unit root is known as random walk time series (green,
1990). Random walk is an example of non-stationary time series dickey fuller (DF) and
augmented dickey fuller (ADF) test are the two way of checking unit root tests.

3.5.2 Estimation of Long Run Model

i estimate variables which are stationary in the long run model using OLS model.

GINFt= β0+β1FINFt+β2IMINF+β3GRERt+β4GRRLIRt+β5GRBDt+β6GRRGDPt+β7LGRRGDt+ Ui

Where GINF_ general inflation rate, FINF_ food inflation rate, GRBD_ growth rate of budget
deficit including grants, GRER_ growth or depreciation rate of exchange rate, GRRLIR_ growth
rate of real lending interest rate, GRRGDP_ growth rate of real GDP or economic growth rate,
IMINF_ import inflation rate, LGRRGDP_ one year lagged growth rate of real GDP, Ui_ error
term.

3.5.3. Co integration test

After checking for unit root test the test of co-integration performed. Co-integration test tells
about whether the rise long term or not long term relationship between the variables. The
prerequisite of applying this test is first check unit root so that it is decide whether there is
stationary or not .

20
 3.5.4. Error Correction model
3.5.4.1. Estimation of short run model
An error correction model belongs to a category of multiple time series models most commonly
used for data where the underlying variables have a long-run stochastic trend, also known as co-
integration. The term error-correction relates to the fact that last-periods deviation from long run
equilibrium, the error, influences its short-run dynamics. Thus ECMs directly estimate the speed
at which a dependent variable general inflation rate returns to equilibrium after a change in other

variables. The short run model will be estimated by the error correction model

(ECM). The short run model can be stated as follow;

GINFt-1=β0+β1FINFt-1+β2GRERt-1+β3GRRLIRt-1+β4GRBDt-1+β5GRRGDPt-1+β6IMINFt-
1+β7LGRRGDt-1 +ɵUi-1 + Ui

Where GINF_ general inflation rate, FINF_ food inflation rate, GRBD_ growth rate of budget
deficit including grants, GRER_ growth or depreciation rate of exchange rate, GRRLIR_ growth
rate of real lending interest rate, GRRGDP_ growth rate of real GDP or economic growth rate,
IMINF_ import inflation rate, LGRRGDP_ one year lagged growth rate of real GDP, Ui_ error
term, Ui-1 _one year lagged error term.

21
22
 Chapter Four; Budget and Time Plan

4.1 Budget Plan

No Item Unit of Quantity Unit Cost Total Cost In Birr

measurement

1 Stationary Pen 30 10 300

Paper 3 pack 250 750

Flash disk 1 250 250

2 Print 3 1000

3 Transport _ - 400

4 Mobile - 300

5 Other 523

Total 3,523

23
4.2 Time Plan

Activities December January February March May

Background and statement Development √

literature review and Methodology √

development

Questionnaire development √

Submission and Correcting proposal √

comment

Distribution of the final questionnaire to √

the target population

Collection of distributed questionnaire √

Organization of collected data √

Analysis and interpretation of organized √

data

Submission of the final report √

24
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 Alain K. 2012, Dynamics of Inflation in Uganda, African Development Bank

Group, Working Paper.

 Alemayehu G. &Kibrom T. 2011, Galloping Inflation in Ethiopia: A Cautionary Tale

for Aspiring Developmental States in Africa, Institute of African Economic Studies.
 Ayalew, Y 2007, Explaining the Current Sources of Inflation in Ethiopia: A Macro-
Econometric Approach, Addis Ababa: National Bank of Ethiopia.

 Blume, Marshall. Inflation and Capital Markets. Ballinger, Cambridge, 1978.

 Dornbusch, R & Fisher, S (2001), Macroeconomics, (4th) Edition.

 Eden, S. 2012, Modeling Inflation Volatility and its Effect on Economic Growth
in Ethiopia.
 Girma F.D. 2012, Relationship between Inflation and Economic Growth in Ethiopia:
An Empirical Analysis, 1980-2011.
 Haben T. 2015, Determinants of Inflation on the Ethiopian Economy
 Haji J. &F. Gelaw (2012), Determinants of the Recent Soaring Food Inflation in
Ethiopia, Universal Journal of Education and General Studies.
 Hellerstein, Rebecca. “The Impact of Inflation,” Regional Review, winter 1997, Vol. 7,
No.1.
 Jhingan M. 1997, Monetary Economics, 4th edition.
 Keynes, M 1940, Theory of Inflation: General theory of employment, interest rate
and money.
 KotwalOdeh G. 1968, Definition, measure and theories of Inflation, a Critical Survey.
 Loening J. 2007, Inflationary Expectation in Ethiopia.
 Mankiw, N. G. (2001). The Inexorable and Mysterious trade-off between inflation and
unemployment.

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