The relationship of inflation and economic growth in Ethiopia

TABLE OF CONTENTS

LIST OF TABLES

LIST OF FIGURES

LIST OF APPENDICES

ACRONYMS/ABBREVIATIONS

ABSTRACT

1: INTRODUCTION
1.1. BACKGROUND OF THE STUDY
1.2. STATMENT OF THE PROBLEM

2: LITRATURE REVIEW
2.1. DEFINITION
2.2. THEORETICAL LITRETURE
2.3. EMPIRICAL LITRETURE
2.3.1. GLOBAL EMPIRICAL LITERATURE REVIEW
2.3.2. EMPRICAL LITERATURE REVIEW ON ETHIOPIA

3: METHODOLOGY
3.1. MODEL SPECIFICATION AND DESCRIPTION OF VARIABLES
3.2. SOURCE OF DATA
3.3. ESTIMATION METHOD

4: RESULTS AND DISCUSSION
4.1. DESCRIPTIVE ANALYSIS
4.2. ECONOMETRIC ANALYSIS
4.2.1. UNIT ROOT TEST AND CO-INTEGRATION ANALYSIS
4.2.2. VECTOR ERROR CORRECTION MODEL
4.2.3. MODEL STABILITY AND DIAGNONASTIC TESTS
4.2.4. GRANGER CAUSALITY TEST
4.2.5. ESTIMATION OF THRESHOLD INFLATION

CHAPTER FIVE: CONCLUSION AND RECOMMENDATION
5.1. CONCLUSION
5.2. RECOMENDATION

REFERENCE

APPENDICES

LIST OF TABLES

Table 1: Descriptive summary

Table 2: ADF Unit root test result

Table 3: Lag Order Selection Criteria

Table 4: Unrestricted Co- integration Rank Test (Trace)

Table 5: Unrestricted Co-integration Rank Test (Maximum Eigen-value)

Table 6: Long-run Co-efficients

Table 7: Short- run Co-efficients

Table 8: VEC residual LM test

Table 9: VEC Residual Heteroskedasticity test

Table 10: VEC residual Normality test

Table 11: par-wise granger causality test

Table 12: Estimation of inflation threshold

LIST OF FIGURES

Figure 1: Conceptual framework

Figure 2: Inverse roots of AR characteristic polynomial

LIST OF APPENDICES

Appendix One: Computing quarter GDP from annual GDP

Appendix Two: Vector Error Correction Estimates

Appendix Three: VEC residual Heteroskedasticity tests

Appendix Four: VEC residual normality tests

Appendix Five: Pair-wise granger causality tests

ACRONYMS/ABBREVIATIONS

Abbildung in dieser Leseprobe nicht enthalten

ABSTRACT

The purpose of the study is to examine the relationship between inflation and economic growth in Ethiopia over the period of 1991/92- 2014/15 by using data at quarter base. The study was employed Johansen method of co-integration and vector error correction model and a technique of conditional least square. The result shows that both in long-run and short-run the relationship between inflation and economic growth is positive. Despite to this, the granger causality test tells us bi- directional causation between these two variables. The result also revealed that threshold level of inflation beyond on which inflation negatively affects economic growth of Ethiopia is 5 percent. Therefore, co-ordination between macro- economic policy makers is vital and should have to raise their hands and put their eyes on measures that keep down inflation below 5 percent to have sustainable economic growth in the country.

Key words: Co-integration, Economic growth, Inflation, Threshold level of inflation & Vector error correction model

1: INTRODUCTION

1.1. BACKGROUND OF THE STUDY

Now a day, developing countries like Ethiopia have a strong objective to achieve and maintain sustainable economic growth of the country. To realize and maintain continuous economic growth macro-economic stability is significant. Unemployment, business cycle, output growth and inflation are the major indicators of macro-economic stability. Macro-economic stability requires knowing and creating a smooth relationship between these variables in a country. Thus, one of the most relevant debatable issues in macro-economists is the relationship between inflation and economic growth. Policy makers and national banks commonly faced with difficulties to attain simultaneously price stability with sustained economic growth. Before we are going to see the relationship between these variables historically in detail, defining two terms is significant. Economic growth can be defined as an increase in the productive capacity of a nation measured by percentage changes in gross national product (GNP) or gross domestic product (GDP) in some particular period of time. In other words, it is an increase in inflation adjusted market value of goods and services produced by an economy over a time usually measured a percent increase in real Gross domestic product (GDP) while inflation is a sustained decrease in purchasing power of currency over time or a sustained increases on average price of goods and services over time(Christianson, 2008).

There is no clear theory which states fixed relationship between inflation and growth. Controversy by quantity and institutional inflation theories also confirm this. According to quantity theorists, there is a long-run trade-off between inflation and economic growth but the supporters of institutional theory of inflation, are less sure about presence of negative relationship about inflation and growth. They agree that price level rises have the potential to generate inflation and that accelerating inflation undermine economic growth(Colander, 2004). Thus, the relationship between inflation and economic growth is debatable both in the world and specifically to Ethiopia.

Following the failure of Derg regime in Ethiopia, the EPRDF (Ethiopian people’s revolutionary democratic front) came into power in may 1991 with the adoption of economic reform effort which supports the structural adjustment programs of World Bank and stabilization programs of IMF. The 1st phase of IMF/WB sponsored structural and economic reform programs was implemented in 1992/93-1994/95. Depending on these international institutions objectives, Policy measures were taken to improve the external imbalance, liberalize trade and financial sectors to remove fiscal and real sector constraints. This program also come up with liberalization of payments for invisible transactions and liberalization of foreign exchange market that devaluated Ethiopian currency which lower foreign direct investment that leads the country directly absence of structural transformation in the transition period (1991-1994). Specially, in 1994 Ethiopian government called international donor community for help following failures of the country to drought and famine. In 1994 both inflation rate and economic growth rate fail relative to previous year 1993 from 10 percent to 1.2 percent and 13.4 percent to 3.5 percent respectively(IMF, 2015).

EPRDF entered to 2nd phase of economic reform program (1994/95-1996/97) whose aim is limiting the role of state in economic activities and promotion of greater private capital participation. In the periods of 1995, 1996 and 1997 economic growth rate shows the positive trend but not progressive this is 6.1 percent, 13.2 percent and 3.5 percent respectively. Inflation for the year 1995, 1996 and 1997 accounts 13.4 percent, 1 percent and negative 6.4 percent respectively(IMF, 2015). In October 1996, a country entered to 3 years enhanced structural adjustment facility (ESAF) arrangement with IMF and start to apply a third phase of reform program that stayed from 1996/97- 1998/99 to achieve broad based economic growth with stable economic environment. In the period of 1998 inflation rate shows 3.6 percent but growth rate shows negative 4 percent as a result of Ethiopia and Eritrean war eruption which degrade economic growth of the country.

After the year 2000, Ethiopia was launching pro-poor growth that contains sustainable development and poverty reduction program (SDPRP) from 2002/03-2004/05 that the government tried to reduce poverty with sustainable macro-economic environment which set growth as a means to achieve it (MoFED, 2009/10). The 2nd was plan of action for sustainable development and eradication of poverty (PASDEP) from 2005/06-2009/10 and finally growth and transformation plan (GTP) for the period 2010/11-2014/15(MoFED, 2010).

Following the implementation of pro-poor growth, Ethiopia experienced a double digit economic growth specially started from 2003/04 to 2010/11 which was 10.4 percent annually on average(NBE, 2010/11). After implementation of millennium development goal (2000-2015) the maximum and minimum inflation rate registered in the year 2008 and 2001 that shows 44.4 percent and negative 8.2 percent respectively. But in those years i.e. 2001 and 2008 the growth rate was 7.5 percent and 11.2 percent(IMF, 2015).

At last, as we seen from above quantity and institutional theories of inflation and the experience of the country under neo-liberalization and pro-poor growth strategies the relationship between inflation and economic growth is not clear. In this regard, there exists controversy between inflation and economic growth which implies some believes positive while the others negative and the remaining latest economists and researchers also believe non-linear relationship between these two variables. Accordingly, the study set a model that helps to see the relationship between these two variables both in the long-run and shot-run by including the determinants of aggregate demand and use an estimation technique of co-integrated vector error correction model (VECM) with pair-wise granger causality test.

1.2. STATMENT OF THE PROBLEM

The nexus of inflation and economic growth is one of the most important macro-economic policy problems that take the attention of researchers, policy makers and different scholars. Initially, inflation -economic growth nexus means dilemma on the relationship between inflation and economic growth. As far as we see in different areas and places of study on the relationship between inflation and economic growth, there are two major problems:

- First, there is no single clear cut theory which shows fixed relationship between inflation and economic growth to implement in the country to achieve its objective of sustainable development.
- 2nd, Even if moderate inflation is an inevitable consequence of economic growth, determining and maintaining inflation on its moderate level is a headache for countries like Ethiopia.

Globally, both theoretically and empirically there is controversy about the relationship between inflation and economic growth; some say positive like Xiao (2009) while others negative such like Hossin (2015). Theories also confirm the controversy such as monetarists say that higher inflation retard economic growth where as what structuralisms’ advocates that inflation is necessary for economic growth(Raj, Mukherjee, Mukherjee, Ghose, & Nag, 2007). But recently some others empirically like Pahlavani and Ezzati (2011) shown non-linear relationship between inflation and economic growth. The relationship between two variables is positive below threshold level of inflation and negative beyond that level. Therefore, Ethiopia also needs to have sustainable growth and estimating threshold level of inflation is also significant to implement policies properly. Threshold level of inflation is an inflation rate at which structural break occurs(Aynalem, 2013).

After the coming of EPRDF into power Ethiopia was exercised different strategies under neo-liberalization regime (1991-2000) and pro-poor growth (post 2001). In this period Ethiopian economy showed a mixed performance of both positive and negative real GDP growth rate. In the periods of 1991 and 1992 growth rate of GDP showed negative 7.2 and 9 percent respectively whereas inflation showed more than one digit rate i.e. 20.9 % and 21 % respectively (IMF, 2015). This implies in the initial periods of transitional government, the country had relatively high rates of inflation with not good economic performance. After 1993 to 1997 the growth rate of GDP is positive which range 3.5 % relatively low (in 1994 because of drought) to 13.4 % the highest in 1993 but not sustainable in 1998 because of Ethio- Eritrean war which accounts negative 4 % growth rate. But, inflation from period of 1993-1998 was relatively good which accounted the maximum 13.4 % in 1995 and the minimum of negative 6.4 % in 1997 compared to 1991 and 1992. At the end of neo-liberalization period and at the beginning of implementation of MDGs in the years of 1999- 2001 growth and inflation rate on average accounts 6.4 % and 1 % per annum(IMF, 2015).

Following implementation of pro-poor growth, the growth rate of GDP averaged 11.2 percent per annum during 2003/04 and 2008/09 period placing Ethiopia, a double digit growth, among top performing countries in sub-Sahara Africa (NBE, 2013/14). But post 2003/04 high and sustained rise in inflation become a common feature such as in the period of 2008 and 2011 inflation rate accounts 44.4 % and 33.2 % respectively. As it was explained by Alemayehu and Kibrom (2008) before the year 2002/2003 inflation and economic growth have positive relationships. But, starting from the period 2003/2004 the co-movement of these two variables no longer continued rather reversed.

As indicted in Rutaysire (2013), it is now widely accepted by many policy makers, macro-economists and central banks the main objective of macro-economic policy is achieving high economic growth with low inflation rate and believed that higher level of inflation adversely affects economic growth of a country. High inflation causes the economy not to operate at its optimal level. Higher level of inflation have an adverse impact on economic growth by reducing the people’s confidence on economy, reduce productive investment in the way that seeking higher interest rate by lenders to protect themselves. Inflation beyond its threshold level will affect welfare negatively, raise current account deficit and reduce investment by lowering saving and consume more since real value of saving erodes over time and inefficient allocation of resources which in turn reduce economic growth of a country (Raj et al., 2007). Currently that is why Ethiopia is trying to maintain sustainable economic growth with single digit inflation rate like 8.5 % and 8.2 % which was registered in the year of 2009 and 2010 respectively (IMF, 2015). This requires estimating threshold level of inflation below which inflation is positively related to economic growth.

Having double digit growth solely is meaningless unless the country have moderate inflation rate that promote economic growth. Having moderate inflation rate and continuous economic growth is the major concern. But, the question is how can policy makers and researchers estimate and get the threshold level of inflation and holding below it to have positive relationship with economic growth.

To sum up, the statistical data reflect no clear relationship between inflation and economic growth for the periods 1991/92 to 2014/15. Even if some researchers try to see the relationship between these two variables like Kibrom (2008) who got positive relationship between them and Aynalem (2013) by using data from the period of 1974/75 to 2009/10 by using annual data, new research which uses quarter data under post-liberalization period is significant that account other economic variables to see the nexus of these two variables.

Generally depending on above reasons, the research tries to fill the following gaps:

1. It removes data mixing which only concerns on post-liberalization period.
2. It tries to reduce confusions created by different researchers on the nexus of two variables.
3. It examines the relationship between inflation and economic growth by taking in to account other economic indicators in the analysis of two variables relationship. Therefore, objective of the study is empirically to examine the relationship between inflation and economic growth in Ethiopia

2: LITRATURE REVIEW

2.1. DEFINITION

Before we are going to see the nexus of inflation and economic growth both theoretically and empirically, it is important to know some basic definitions and concepts about these two basic words i.e. inflation and economic growth.

A. INFLATION

The first variable we have to see now is inflation . Inflation is a continuous or a sustained increase in an average price of goods and services over time (Christianson, 2008). Here, inflation occurs when average level prices are rising but not necessarily all prices. And also, arise in price of a single item is not necessarily inflation. If price level is rising, the value of currency is falling. Thus, according to Christianson (2008) another definition of inflation is: it is a sustained decrease in domestic value (or purchasing power) of currency over time. For him there are four primary ways of measuring inflation:

I. GDP price deflator: a price index that measures the price of all goods and services included in gross domestic product. In other words, it is a flexible weight price index since the weights attached to the categories of goods will fluctuate as consumption patterns in the economy change. It is calculated by the formula:

illustration not visible in this excerpt

II. Personal consumption expenditure (PCE) price index: it sometimes called as a flexible weight price. PCE measure the change in the prices of personal consumption expenditures. It is also flexible weight price index.

III. Consumer price index (CPI): CPI measures the price of a selected bundle of goods and services purchased by typical urban households in a given country. It is a fixed weight price index, only measures the price of same bundle of goods and services over the periods.

IV. Producer price index (PPI): it measures goods and services first step transaction in the given economy. In other words, it measures the prices received by producers in an economy for goods and services to the economy as a whole and different commodities and industries. It is similar to CPI except that it measures wholesale prices rather than retail prices. .

In general, both CPI and PPI use base year for price index calculation. Price index calculated as follows:

illustration not visible in this excerpt

Causes of inflation: From macro- economic point of view there are two basic reasons why inflation may occur in the economy (Christianson, 2008).

1st, demand pull inflation : inflation caused by aggregate demand. This inflation happens when spending in the economy is increasing more quickly than output.

2nd, cost-push inflation: inflation caused by an increase in aggregate supply. This is an inflation occur because of an increase in resource prices in economy.

B. ECONOMIC GROWTH

The 2nd issue that we have to see is economic growth. Economic growth is the principal source of improving standards of living over time. Economic growth is an increase in per capita real GDP over time or an increase in the amount of goods and services produced per head of the population over a period of time. Per capita real GDP= real GDP/population Where: real GDP= Nominal GDP/ (GDP deflator/100).

While some economists use changes in real GDP (the market value of final goods and services produced in an economy usually stated in the prices of a given year) as a primary measurement of economic growth and defined from this angle i.e. it is an increase in real GDP or an increase in national output and national income (Colander, 2004).

While others defined economic growth as an increase in the inflation adjusted market value of goods and services produced by an economy over time. It can also measure in nominal terms which include inflation but it is better if measured in real terms which are adjusted for inflation. Here, our concern examining the long-run and short-run relationship between inflation and economic growth. Higher inflation affects economic growth of the country negatively. According toTeshome (2011), Continuous and persistence inflation above threshold level may affect investors spending and consumer purchasing power that affect economic growth directly. Threshold level of inflation is an inflation rate at which structural break occurs or the level of inflation that clearly identifies non-linear relationship between these two variables.

2.2. THEORETICAL LITRETURE

Macro-economists try to see the relationship between inflation and economic growth stating from classical economist. The following are some of theories that show the relationship between inflation and economic growth.

A. Classical growth theory

According to classical, economic growth is an increase in per capita real GDP over time. Economic growth occurs when the aggregate supply curve shifts to the right over time. Since for classical aggregate supply curve is vertical, changes in aggregate demand will have no effect on real GDP, only price level. Thus, the only way for economic growth to occur is to increase aggregate supply curve to the right through changes in real variables that is why classical are a supply side model of economy. Here, the aggregate supply curve may increase through improvements in labor market conditions, such as increase in labor supply or demand, increase in production function which may occur through increase in capital or technology. Shift in aggregate supply curve to the right will increase real GDP and decrease in inflation. Generally, the determinants of economic growth according to classical model are: quantity of labor, marginal product of labor, quality of capital, marginal product of capital and technology.

Especially the leader of classical theory Adam smith argued that growth was self-reinforcing as it exhibited increasing return to scale. He viewed saving as a creator of investment and economic growth. Therefore, he saw income distribution as one of the most determinants of how fast or slow a nation would grow. He also says that profits decline not because of decrease in marginal productivity rather completion of capitalist for workers will bid wages up (Gokal & Hanif, 2004).

In classical model, real interest rates (nominal interest rate minus rate of inflation) adjusted so that saving equal to investment in the loanable funds market. An increase in real interest rate leads to an increase in household saving. As increase in real interest rate increase in real cost of borrowing, so investment expenditures decline as in real interest rate increase. In classical, an increase in government spending is exactly offset by declines in private spending, so that over all change is zero. This is known as crowding out effect. This effect will lead to increase in real interest rate causing investment and consumption spending to decline. Additionally, classical believe that aggregate demand (P=MV/Y) depends on quantity of money in circulation. An increase in the money supply causes an increase in aggregate demand which leads to an increase in price level (inflation) and no change in real GDP. So, change in money supply affect nominal variables not real variables in classical model (Christianson, 2008). Therefore, even if the relationship between inflation and economic growth is not clearly stated in classical model, it is expected to be negative.

B. Keynesian theory

British economist John Maynard Keynes (1936) was the leader of this approach and introducing a book on “general theory of employment, interest and money” for the followers of neoclassical and the world as whole. The Keynesian approach dominated macro-economic theory from 2nd world war to about 1970. Keynesians widely believe that the government can promote economic growth while avoiding inflation through skill full macroeconomic policies (Abel, Bernanke, & Croushore, 2008). Keynesians say that interventions in economy by governments through expansionary economic policies will boost investment and promote demand to reach full production. The promoted demand before full production is termed as effective demand which maximize the utilization of limited resources, in contrary, the demand beyond full production is defined as excess demand. The Keynesian model framework comprising of Aggregate Demand (AD) and Aggregate Supply (AS) curves. The AS curve is upward-sloping rather than vertical in the short-run that implies changes in the demand side of the economy resulting from expectations, labor force and policy actions such as discretionary monetary or fiscal policies that affect both prices and output in the short run as predicted by the Phillips Curve (Froyen, 1990). According to Keynesian model, an expansionary fiscal policy such as an increase in the rate of growth in money stock will cause to shift aggregate demand to the right which leads output, price level, level of unemployment to rise in short-run. Therefore, the Keynesian model advocates that there exists a positive relationship between inflation and output. But, in this Keynesian framework, it is not the case that inflation itself is a growth-enhancing force rather if rising aggregate demand is leading to increased growth. The positive relationship between inflation and growth shown in the short-run dynamics is differing in long-run Phillips curve which turns to be negative with high rate of inflation.

C. Monetary theory

A professor of economics in Chicago University Milton Friedman, who was the most influential person in monetarist thought, emphasized on several key long-run properties of the economy, including the Quantity Theory of Money and the Neutrality of Money. According to Quantity theory of Money, the relation between inflation and economic growth showed simply by equating the total amount of spending in the economy to the total amount of money in the economy. Friedman proposed that inflation was the product of an increase in the supply or velocity of money at a rate greater than the rate of growth in the economy. In summary, Monetarism suggests that the long-run prices are mainly affected by the growth rate of money but has no real effect on economic growth. If the growth in the money supply is higher than the economic growth rate, it will result inflation. Additionally, they believe that changes in quantity of money have the dominant influence on nominal income and as well as changes on real income in sort-run (Froyen, 1990).

D. Neo-classical growth theory

Neo-classical economists argue that having rational expectation there exist positive relationship between price changes (inflation) and output changes (Froyen, 1990). Economists like Mendel and Tobin have successfully explained the effect of inflation on economic growth based on neo-classical growth theory. According to Mundel (1963) model an increase in inflation or inflation expectations immediately reduces people’s wealth. This works on the premise that the rate of return on individual’s real money balances falls. To accumulate the desired wealth, people save more by switching to assets, increasing their price, thus driving down the real interest rate. Greater savings means greater capital accumulation and thus faster output growth. Tobin (1965) also argued that because of the downward rigidity of prices (including wages) the adjustment in relative prices during economic growth could be achieved by the upward price movement of some individual price.

As clearly written in Xiao (2009), the theoretical review demonstrates that models in the neo-classical framework can yield very different results with regard to inflation and growth. Increases in inflation can result in higher output (Tobin Effect) or lower output (Stockman Effect) or no change in output.

E. Neo-Keynesian theory

The neo- Keynesians are one group that have been attempted to express their view depending on ideas and concepts of old Keynesians theory. Natural output was one of the major issues of developments under Neo-Keynesian at the period that in other words we call potential output. Potential output is the level of output produced on which the economy is its optimal level of production given the natural and institutional constraints(Christianson, 2008). In other words, this is the level of output alien to natural rate of unemployment or what we call it non-accelerating inflation rate of unemployment (NAIRU). NAIRU is unemployment rate at which inflation rate is neither increasing nor decreasing or rising or failing. Depending on this theory, inflation is based on the level of actual output and natural rate of unemployment. In relation to this, there are three common cases:

1stly, if GDP exceeds its potential level of output and unemployment is below the natural rate of unemployment, all else equal, inflation will accelerate as suppliers increase their price prices and worsens inflation.

2ndly, if GDP falls below its potential level of output and unemployment rate is above natural rate of unemployment, other things remains constant, inflation will decelerate as suppliers will try to fill excess capacity, reducing prices and lowers existed inflation.

Finally, in absence of supply shock, if GDP is equal to potential output and unemployment is equal to non-accelerating inflation rate of unemployment, the rate of inflation remains constant (Gokal & Hanif, 2004).

F. Endogenous growth theory

Sometimes call the new growth theory. One important implication of endogenous growth theory is that a country’s long-run economic growth rate depends on its rate of saving and investment. This theory describe economic theory as being generated by factors within the production process, for instance, economies of scale, increasing returns or induced technological change. According to this theory, the economic growth rate depends on one variable: the rate of return on capital. Variables like inflation decreases the rate of return and this in turn reduces capital accumulation and hence reduces the growth rate. Other models of endogenous growth explain growth further with human capital. The role of human capital and innovation are the reasons for not diminishing marginal productivity of capital and the economy as a whole. The implication is that economic growth depends on the rate of return to human capital as well as physical capital. Saving rate can affect long-run rate of economic growth. The inflation acts as a tax and hence reduces the return on all capital and the growth rate (Abel et al., 2008).

Generally, Keynesians say that there exists a long-run positive relationship between inflation and growth where there is no visible short-run relationship. On the other side, monetarists believe that there is no long-run relationship between the two variables but there positive relationship between them in the short run until expectations is adjusted. New Classical say that anticipated inflation has neither long-run nor short-run effect on growth. However, if inflation is unanticipated it has a negative impact on the growth of the economy. While to new growth, inflation act as tax and reduce growth rate. Thus, theories don’t tell us fixed relationship between these variables.

2.3. EMPIRICAL LITRETURE

When we come to empirical part of the literature, different researchers come up with different results on the relationship between inflation and economic growth and up to now there is still no conclusive argument about the nature of the inflation – economic growth relationship from previous empirical studies. Thus, this section briefly tries to show review on the nexus of inflation and economic growth both in the world and specifically on Ethiopia.

2.3.1. GLOBAL EMPIRICAL LITERATURE REVIEW

Fisher (1993), Depending on growth accounting method with empirical data by calculating Solow residual and make regression on economic growth and other elements of economic-growth based on inflation show that inflation affects economic growth not only through total factor productivity but also through capital accumulation. Then, he concludes that the negative relationship exists between inflation and economic growth and still put points low inflation is not sufficient condition for economic growth. Many empirical studies support this opinion, though that high inflation is bad for growth is not doubtful, few results show a causal phenomenon that lower inflation will lead to higher growth.

Sarel (1996), has discovered the possibility of non-linear effects of inflation on economic growth. He used annual joint panel database for 87 countries for the period of 1970-1990 for ordinary least square regression. The study founds 8 percent of inflation as a significant structural break point in the function that relates economic growth to inflation. Consequently, below that structural break inflation has slightly positive effect on growth but after 8 percent inflation, it has powerful negative effects on growth.

Using a small sample data for OECD (organization for Economic Co-operation & development and Asian countries, Malla (1997) has studied how inflation affects the rate of economic growth. Growth equation explained by labor force and capital accumulation served as a base for Asian and OECD countries study. The results clearly told us no relationship exists between inflation and economic growth for 11 OECD countries. Opposed to this, Strong negative relationship between inflation and economic growth exists for Asian countries.

Mallik and Chowdhury (2001) Were examined the relationship between inflation and economic growth in four South Asian countries namely Bangladesh, India, Pakistan and Sri Lanka. The long-run and short-run relationship between the two variables was examined using Johansen and Juselius co-integration test and the Engle and Granger Error Correction Model (ECM). Accordingly, the empirical finding revealed that the two variables are co-integrated showing a positive long-run relationship between them for all four countries. However, Mallik and Chowdhury did not prescribe an increase in the rate of inflation to secure sustainable growth rather they suggested that the four economies under study are at a knife edge i.e. any level of inflation above the current level may lead them to higher economic recession.

Carneiro and Faria (2001), were investigated the relationship between inflation and output in the context of an economy facing persistent high inflation that was analyzed in the case of Brazil. The paper addressed the question through statistical investigation of the relationship between inflation and real output during the period of 1980-1995. Then, the paper found that inflation does not affect real output in the long-run or a zero long-run response output but in short-run inflation affects output growth negatively. Thus, the results could be considered as further evidence against the view that inflation and output growth are reliably related in long-run.

Khan and Senhadji (2001) Were examined a threshold effects of inflation in the relationship between output-growth and inflation. They not only examined the relationship of high and low inflation with economic growth but also suggested the threshold inflation level for both industrialized and developing countries. They conducted a study using panel data for 140 developing and industrialized countries for the period of 1960-98. Their results strongly suggested the existence of a threshold level of inflation beyond which the inflation exerts a negative effect on economic growth. As to them the threshold estimates were 1-3 percent and 7-11 percent for industrial and developing countries respectively.

Sweidan (2004), assessed the effects of inflation on economic growth for the period between 1970- 2003. As a whole the relationship between these two macro-economic variables is negative. However, he found non-linear relationship between these two variables using the methodology of structural break point. Thus, inflation and economic growth are positively related below 2 percent inflation rate but beyond 2 percent negatively related in the case of Jordan economy.

Lee, C. & Wong, S. (2005) were used a threshold regression model to investigate the existence of inflation threshold effects in the relationship between financial development and economic growth in the case of Taiwan and Japan. The result shows that there is one inflation threshold value in Taiwan while Japan has two. Empirical finding suggested that low and moderate inflation promote economic growth. Besides, threshold level of inflation below which financial development significantly promotes economic growth was estimated at 7.25 percent for Taiwan and 9.66 percent for Japan. The empirical findings from the threshold regression model indicate that inflationary threshold for both countries occurred in high inflation period of the world energy crisis in 1970s.

Using an annual data from the period of 1973- 2000, Mubarik (2005) has estimated the threshold level of inflation for Pakistan. The granger causality test implemented revealed that the presence of causality from inflation to economic growth but not from growth to inflation. Later on he found 9 percent as threshold level of inflation for Pakistan economy. As a result, he suggested inflation below 9 percent is important and create favorable condition for Pakistan economic growth and has a negative impact above. Finally, the sensitivity analysis that conducted for robustness of the model also confirms the same level of threshold inflation rate.

Ahortor and Adenutsi (2009) Were studied relationship between inflation, capital accumulation and growth separately for import dependent developing countries to seen impact clearly. In order to see the relationship among the variables under study, a hexa-variate vector autoregressive (VAR) model was used with inflation, investment, growth, import, money supply and exchange rate variables. Samples of 30 import dependent countries are studied in the paper. Co-integration test and the associated error correction model were used to see the long-run and short-run relationships between the relevant variables. The findings of the study indicated that capital accumulation and economic growth have a long-run negative impact on the level of inflation. But in the short-run, real exchange rate has a positive impact on the growth rate while it negatively affects the level of inflation. The authors also recommend that inflation should be controlled in the short-run using tight monetary policy. According to the authors, to control inflation in the long-run both demand management and supply side policies must be carried out.

Pypko (2009), investigated the growth- inflation interaction by using a data set of six CIS countries from the period of 2001-2008. The empirical results found shown that threshold level exists in non-linear inflation growth association. Moreover, inflation has a significant positive effect on growth if it is less than this threshold level and impedes growth otherwise. According to the paper, computed threshold level equals to 8 percent. Threshold level of inflation is estimated using a non-linear least squares technique and inference is made by applying a bootstrap approach. The non-linear growth inflation interaction is quite robust to the estimation (conditional least square) and specification.

Xiao (2009) Was used co-integration and error correction models accompanying with correlation matrix and the Granger Causality Test to examine the inflation-economic growth relationship of China using annual time series data from 1978 to 2007. The results show that in the long run inflation positively relate to economic growth in bi-direction. Besides, high speed increase of investment would cause inflation in short-run.

The study of Dholakia and Sapre (2011) examined the trade-off between inflation and economic growth in India for the period 1950 – 2009. Specifically the study aims to estimate the short-run aggregate supply curve, analyze the inflation unemployment trade-off and address inflationary expectations. To estimate the short-run trade-off between inflation and growth, the regular Phillips Curve based on adaptive expectations is used. For the period under study, a trade-off between the two variables exists in India enabling them to capture the speed of the recovery. The finding of the analysis also reveals that there exists a positively sloped short-run aggregate supply curve responsive to market prices showing that the economy is being more exposed to the international market.

Using panel data for 120 developed and developing countries for the period after the Second World War Ibarra and Trupkin (2011) together found that inflation positively affect economic growth up to 4.1 and 19.1 percent inflation rate for industrialized and non-industrialized countries respectively. But beyond threshold levels, inflation affects economic growth negatively. Generally, the relationship between these two variables is positive up to certain threshold level of inflation and negative beyond that level.

Pahlavani and Ezzati (2011) were explored the relation between inflation and economic growth in Iran using annual data for the period 1959-2007 to check whether this relation has a structural breakpoint effect. The results indicate that for the Iranian economy the threshold level of inflation above which inflation significantly slows growth is between 9-12 percent and that monetary policy aimed at keeping inflation within this range may be helpful for economic growth in Iran.

The study of Fikrte (2012) has investigated the relationship between inflation and economic growth. The study used panel data which includes 13 Sub Saharan African countries from 1969 to 2009 and fixed effect was used for estimation. To analyze the data the model was formed by taking economic growth as dependent variable and four variables (i.e. inflation, investment, population and initial GDP) as independent variables. The result indicated that there is a negative relationship between economic growth and inflation. This study was also examined the causality relationship between economic growth and inflation by using panel Granger causality test. Panel granger causality test shows that inflation granger causes economic growth for all countries in the sample, while the opposite is only true for two countries (i.e. Congo and Zimbabwe).

Kasidi and Mwakanemela (2013), were examined the impact of inflation on economic growth and established the existence of inflation growth relationship. To seen the impact of inflation on economic growth time series data from 1991-2011 were used. Co-relation co-efficient and co-integration technique established the relationship between inflation and growth and co-efficient elasticity were applied to measure the degree of responsiveness of change in GDP to change in price levels. The findings suggested that inflation has negative impact on economic growth. Additionally, there was no co-integration between inflation and economic growth within the period of the study. Then, there was no long-run relationship between these two variables in Tanzania.

Baglan and Yoldas (2014), were estimated a flexible semi-parametric panel data model that shown non-linear effect of inflation on economic growth depending on developing countries data. The paper concluded that inflation is associated with significantly lower growth beyond twelve percent which notably lower than the comparable estimate obtained from a threshold model. Generally inflation is a significant determinant of economic growth and the relation ceases to be significant at very high levels of inflation. Estimation for partial effects indicates a larger impact of inflation on economic growth than the estimates obtained under parametric functional form assumptions.

Kaouther and Besma (2014), Were examined the relationship between economic growth and inflation taking into account other economic indicators in the analysis of this relationship. The study uses the random effects model of panel data applied to a sample of four countries on the south side of the Mediterranean during the period that runs from 1980 to 2008. The analysis concludes that, in general, the Relationship between the variables appears particularly if inflation or hyper-inflation. Indeed, if a country prices rise faster than in other countries, it would increase in imports and a decline in exports.

2.3.2. EMPRICAL LITERATURE REVIEW ON ETHIOPIA

Alemayehu and Kibrom (2008) Were studied the galloping inflation in Ethiopia by using VAR model for estimation and quarter data for the period 1994/95 to 2007/08 of Ethiopia. The result shows in long-run the main determinants of inflation for food sectors are money supply, inflation expectation and international food price hike while for non-food sectors money supply, interest rate and inflation expectation. Additionally, in short-run wages, international prices, exchange rates and constraints in supply are the main source of inflation. To sum up, even if the determinants of inflation are different for food and non-food and short-run and long-run, they showed that inflation and economic growth have positive relationship in long-run.

As summarized by Teshome (2011) in his study of sources inflation and economic growth in Ethiopia for the year 2004 to 2010: Ethiopia experienced an average of 11 percent economic growth` and 16 percent inflation rate. But, higher inflation rate did not significantly reduce economic growth of the country which implies in some years inflation and economic growth had positive relationship. Since, for that specified period higher consumption spending desire and increasing imported goods price considered as a major source of inflation in the country.

One of the recent study on Ethiopia using annual data from 1974/75 to 2009/10 by Aynalem (2013) has examined the relationship between inflation and economic growth. The study has employed co-integration and error correction models having with correlation matrix and Granger Causality test by using annual data set that are collected from MoFED, NBE and CSA. The empirical evidence demonstrates that there exists a statistically significant long-run and short-run negative relationship between inflation and economic growth for the country. He found 4-percent as the threshold level of inflation above in which inflation adversely affects economic growth.

Abeba (2014), was studied the impact of inflation on economic growth between Ethiopia and Uganda comparatively. The study employed annual time series data of CPI as a proxy for inflation and GDP at current price as a proxy to for growth from 1990-2012. The analysis adopted the descriptive approach to show the trend and variability of inflation and growth for both countries to have clear image on changes of variables through time. To check the stationary of the variables, ADF and Phillip-Perron tests were conducted while Johansen test was applied to confirm the presence of co-integration between inflation and economic growth. VECM also implemented after checking co-integration to see the casual relationship between inflation and growth. Depending on the results found, the co-efficient variation of the two countries shows that the variability of GDP and inflation were larger for Ethiopia than Uganda. VECM shows the existence of positive significant bi-directional relationship between inflation and economic growth for Ethiopia both in long-run and short-run. However, in Uganda there exists only unidirectional negative relationship between inflation and growth that runs from GDP growth to inflation.

Tewodros (2015) Was investigated the determinants of economic growth in Ethiopia from the period of 1974-2013. He used Autoregressive Distributed Lag (ARDL) Approach to Co-integration and Error Correction Model to investigate the long-run and short run relationship between the dependent variable (real GDP) and its determinants (Physical capital, human capital, export, aid, external debt and inflation). The result showed physical capital and human capital have positive impact on economic growth while debt affects economic growth negatively and statically significant at one percent. But, export of goods or services and foreign aid has statically insignificant effect on economic growth in long-run. The same to foreign aid and export, inflation have insignificant impact on economic growth of Ethiopia. Then, the researcher concludes that inflation was not significantly harming the economic growth of Ethiopia during the study time period. This implies studies in the country hadn’t show a fixed relationship between inflation and growth in Ethiopia.

3: METHODOLOGY

3.1. MODEL SPECIFICATION AND DESCRIPTION OF VARIABLES

In explaining the nexus of inflation and economic growth in Ethiopia we have theories mentioned above in theoretical part of literature. But for the purpose of simplicity first we stand on the basic model of Keynesian: according to them macro-economic equilibrium occurs when aggregate supply (AS) equal to aggregate demand (AD) that is AS is the level of output or income (GDP) and AD=C+I+G+NX. Thus, under Keynesian framework:

illustration not visible in this excerpt

Where: C= consumption spending by households

I= investment spending by business

G= government spending by agencies

NX=net export spending by the rest of the world (NX=Export-Import)

Consumption is one of the main important components for aggregate demand equation. An increase in consumption spending may be caused by increase in income or wealth and expectations for future price and a decrease in interest rate (Christianson, 2008). But income or wealth is already existed in above demand equation, expectation about future prices is considered as the main determinant of consumption and aggregate demand. According to Fisher equation [illustration not visible in this excerpt]

Where:[illustration not visible in this excerpt] = the expected real rate of interest, i = the nominal rate of interest and

[illustration not visible in this excerpt]= expected rate of inflation

In the presence of rational expectation, in long-run the economy turns into full employment level of output that real interest rate returns to the full-employment level (R*) and actual inflation converge [illustration not visible in this excerpt] and we can re write in long-run relationship. Generally, the fisher equation is: [illustration not visible in this excerpt]. As a whole we can say that consumption is determined by inflation and interest rate. Even if nominal interest rate is one determinant, appropriate way mostly applied in different researches is real interest rate (RIR).

illustration not visible in this excerpt

According to Keynesians, investment itself is determined by interest rate (average lending rate). Then, as to them interest rate is inversely related to investment. Thus, we can put interest rate in place of investment and re write as follows:

illustration not visible in this excerpt

Another issue in above equation is net export. Net export is determined and seen in relation to effective exchange rate, which is measured in real terms and symbolized as ‘REER’ in this paper that taken as another major determinant of international trade in open economy. Then, we can include the two variables in the model and written as:

illustration not visible in this excerpt

At equilibrium level, interest rate in IS curve equals to LM curve. Since M/P=f (r, y) and changing interest rate directly affects money market which we include money supply (MS) as one variable. And also, government expenditure is taken as exogenous variable which is set by government simply put as it is.

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Additionally, inflation is measured by consumer price index (CPI). So, we can say CPI is used as a proxy variable for inflation and economic growth also measured by real GDP (gross domestic product). Plus to that average lending rate is a proxy for real interest rate and broad money supply is a proxy for money supply. Thus, the equation is written as follows:

illustration not visible in this excerpt

Finally, all of the variables are transformed to natural logarithms because most of macro-economic variables become smooth and stationary after transformations.

As a whole in this paper to see the relationship between inflation and economic growth, the model is written as follows:

illustration not visible in this excerpt

RGDPt = real gross domestic product at time t

CPIt=consumer price index at time t

Gt= government expenditure at time t

BMSt= Broad money supply at time t

ALRt= Average lending rate at time t

REERt= Real effective exchange rate at time t and LN= Natural logarithm

Ut= Error term at time and B’s = coefficients to be estimated

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