Monetary, fiscal, and structural drivers of inflation in Ethiopia: new empirical evidence from time series analysis

• Published date: 01 May 2023
• Author: Léonce Ndikumana,Janvier D. Nkurunziza,Miguel Eduardo Sánchez Martín,Samuel Mulugeta,Zerihun Getachew Kelbore
• Date: 01 May 2023
• DOI: http://doi.org/10.1111/rode.12958

REGULAR ARTICLE

Monetary, fiscal, and structural drivers of

inflation in Ethiopia: new empirical evidence

from time series analysis

Léonce Ndikumana

1

| Janvier D. Nkurunziza

2

|

Miguel Eduardo S

anchez Martín

3

| Samuel Mulugeta

3

|

Zerihun Getachew Kelbore

3

1

Department of Economics, University of

Massachusetts Amherst, Amherst,

Massachusetts, USA

2

United Nations Conference on Trade

and Development (UNCTAD), Geneva,

Switzerland

3

The World Bank, Ethiopia Country

Office, Addis Ababa, Ethiopia

Correspondence

Léonce Ndikumana, Department of

Economics, University of Massachusetts

Amherst, Amherst, MA, USA

Email: ndiku@umass.edu

Funding information

World Bank Group

Abstract

This study empirically investigates the drivers of inflation

in Ethiopia using monthly data over the period July

1998 to September 2020. It explores short-run and long-

run effects of domestic and external determinants of

inflation—including demand-side, supply-side, and

structural factors—using the cointegration and vector

error-correction methodology. Four measures of infla-

tion are considered: cereals, food, nonfood, and all-

items Consummer Price Index (CPI) inflation. A key

contribution to the existing literature is the investiga-

tion of the role of the fiscal sector in modeling inflation,

a topic that has been neglected in the e xisting s tudies o n

inflation in Ethiopia. The empirical results show that

disequilibria in the monetary sector, grains sector, and

food markets have long-run effects on inflation. In the

short run, inflation is driven by structural factors (nota-

bly, cereal output gaps and imported inflation) as well as

demand-side factors (notably, money growth and public

sector borrowing). The results hold when analysis is lim-

ited to the high growth period from 2005 onward, fol-

lowing the end of the International Monetary Fund

(IMF) program in the country. The evidence provides

valuable insights in the context of ongoing macroeco-

nomic policy reforms in Ethiopia.

Received: 30 March 2022 Revised: 11 June 2022 Accepted: 17 October 2022

DOI: 10.1111/rode.12958

924 © 2022 John Wiley & Sons Ltd. Rev Dev Econ. 2023;27:924–962.wileyonlinelibrary.com/journal/rode

KEYWORDS

agriculture, Ethiopia, exchange rate, fiscal policy, inflation,

monetary policy

JEL CLASSIFICATION

C22, E31, E41, E542, E62, F31, O55

1|INTRODUCTION

Over the past two decades, high growth in Ethiopia has been accompanied by persistent inflation

and other macroeconomic imbalances (IMF, 2020). While the country recorded double-digit aver-

age growth rates since 2003, average inflation exceeded the 10% ceiling set in national develop-

ment plans during this period.

1

Between 2003 and 2020, Ethiopia recorded the highest level of

average annual inflation (15%) among all the countries growing at 5% or more. The high levels of

inflation have attracted attention from policy makers as well as the research community, since

high prices affect household purchasing power and overall welfare. Moreover, when it leads to

negative real interest rates, high inflation is a disincentive to saving (Alem & Söderbom, 2012;

Geiger & Goh, 2012; Ticci, 2011). Since 2021, the debate about inflation in Ethiopia has intensi-

fied, as inflation reached its highest levels since the 2012 drought. The attention to inflation has

been amplified by the adverse effects of the war in Ukraine on international supply for fuels and

cereals. This is critical for Ethiopia given its dependence on Russia and Ukraine for imports of

wheat, crude and refinedcooking oil, and agricultural inputs, like many other African countries.

The objective of this paper is to empirically investigate the drivers of inflation in Ethiopia,

building on the existing literature (Durevall, Loening, & Birru, 2013; Nell, 2004). The modeling

of inflation draws on structuralist approaches, given the country's dependence on shock-prone

agriculture and exposure to external shocks, while also incorporating demand-side factors,

namely monetary and fiscal variables. The empirical model includes the cereal output gap,

import prices (grains, food, nonfood, and oil), the exchange rate premium, money growth, and

public sector borrowing. Overall inflation is disaggregated in various components (cereals, food,

and nonfood) in addition to an overall Consummer Price Index (CPI)-based measure,

2

since

each one may be driven by different factors, as illustrated in earlier research (Durevall

et al., 2013). Long-run and short-run effects of both domestic and external factors are explored

using the cointegration and error-correction time series methodology.

The main contribution of this paper to the literature on inflation in Ethiopia is the incorpo-

ration of the role of the fiscal sector in modeling inflation, a factor that has been neglected in

the existing literature. The fiscal theory of inflation suggests that the budget deficit may affect

the price level through its impact on money demand and consequently the equilibrium in the

money market (Cat˜

ao & Terrones, 2005; Gordon & Leeper, 2006). Monetary expansion resulting

from government borrowing to finance the budget deficit creates pressure on the price level and

exacerbates the effects of other drivers of inflation. This modeling innovation is motivated by

several factors, namely evidence of financial repression, the dominance of public sector borrow-

ing in Ethiopia's financial system, and the active role of the central bank in financing govern-

ment deficits. The latter operates both directly through advances to the Treasury and indirectly

through lending by the state-owned Commercial Bank of Ethiopia to state-owned enterprises

(SOEs) (Geiger & Goh, 2012).

NDIKUMANA ET AL.925

The empirical results show a strong positive impact of public sector borrowing on inflation

in the short run. The results from cointegration analysis indicate that, in the long run, a 1%

increase in the deficit increases real money stock by 1.02%, and a 1% increase of public credit

increases real money stock by 0.36%. The effects of the error-correction (EC) term for the fiscal

sector turns out to be smaller compared with those of the error-correction term for the mone-

tary sector, possibly reflecting the fact that fiscal deficits mostly affect money growth, thereby

affecting inflation indirectly. This result deserves further investigation in future studies.

As a second contribution, the paper finds that monetary factors have significant effects on

inflation both in the short run and the long run. This contrasts with the results in Durevall

et al. (2013), which found that disequilibria in the money markets have no impact on inflation

in the long run.

A third contribution to the existing literature is that the study covers a longer sample period

(July 1998 to September 2020) than preceding studies, such as Durevall et al. (2013) which cov-

ered only the 2000s. This is important given changes in the macroeconomic policy regime over

the past decade—notably, a significant increase in credit to the public sector as financial repres-

sion was ramped up, an increase in the parallel market premium since 2014 due to foreign

exchange shortage, reduced volatility of inflation as a result of interventions by the government

and donors that helped cushion the effects of droughts on prices (e.g., in 2015), and the end of

the International Monetary Fund (IMF) program in 2004.

This analysis tests the robustness of the results and the stability of the inflation models by

estimating them over the period 2005–2020, which corresponds to the high-growth regime and

the end of the IMF program. The regression results over this shorter recent period are consis-

tent with those covering the longer period.

As in previous studies, the results in this paper confirm that disequilibria in the grains and

food sectors have long-run effects on cereal, food, and overall inflation. Moreover, in the short

run, inflation is driven by structural factors, notably cereal output gaps and prices of imported

goods (i.e., grains, oil, and nonfood items). The results also suggest that inflation exhibits iner-

tia, with price shocks leading to high inflation, especially in the cases of food and nonfood infla-

tion. Among all inflation measures, nonfood inflation exhibits a smoother pattern, and it is not

affected by either money growth or public sector borrowing. This could be due to the fact that it

is the indicator used by the monetary authority to track and control inflation, and that the index

includes items for which prices are controlled or closely monitored by the government, such

as fuel.

The remainder of this paper is structured as follows. Section 2provides a brief review of the

related literature on inflation. Section 3presents stylized factsand salient patterns, as well as rela-

tionships among key variables used in the regression analysis. Section4describes the specification

of the empirical inflation models and the main potential determinants of inflation. The empirical

methodology is presented in Section 5. The regression results are discussed in Section 6,and

Section 7concludes with a summary of the findings and some policy implications.

2|RELATED LITERATURE ON INFLATION

This section provides a review of the empirical literature on inflation in Ethiopia, while drawing

on the broader literature as appropriate. The review covers factors arising from the demand side

and the supply side, as well as from structuralist analyses of inflation. This discussion motivates

the modeling approach developed in Section 4.

926 NDIKUMANA ET AL.