An Investigation into the Causes and Dynamics of Price Inflation in Ethiopia A Macro-Econometric Approach [1980 – 2012]

In the earlier periods, Ethiopian inflation was not a serious problem and had an immense association with agriculture and food supply shock. Major inflationary episodes were happening during conflict, war and drought times. However, the recent inflation trajectory seems a new phenomenon. Since 2004, the economy had been continually facing unprecedented and double digit inflation growth, as some commentators said one of the most affected economy in the world. The nation’s inflationary pressure was predominantly attributed to the effect of highly volatile food price. In this instance, the overall aim of this study is to investigate the key sources of price inflation and their dynamic interaction with other macroeconomic indicators involving the structure and or domestic, monetary and external factors. The empirical strategy in this paper combines two separate estimation methods: the vector error correction model (VECM) and a multi factor single-equation model. The single-equation model, augmented with error correction terms was estimated to identify the relative importance of the key inflationary factors and their dynamic behavior. Using annual data over the past three decades (1980 till 2012), the preliminary test for model specification reveals that all the series are non-stationary in level and stationary in first difference. Subsequently, the Johansen co-integration test affirmed the existence of one co-integrating vector in each error correction representation. Hence, the dynamic model verified the existence of short term adjustments and long-term dynamic relationship among the co-integrated series. More decisively, the post estimation specifications revealed that our VECM are highly parsimonious and appear to be reasonably well specified. Our main finding reveals that money market, agricultural market and external market determines price inflation in the long run. In the short run, there are several other factors that determine price inflation. Changes in inflation are highly sensitive to the change in money growth, the cost of capital, exchange rate and inertia. Principally, excess money growth has a detrimental effect on inflation. External factors such as the price of Fertilizer, an intermediate goods import, oil and Exchange rate are found to have a significant effect on the domestic price inflation. Out of the domestic supply side factors, the cost of capital largely matters and significantly explain price inflation in the short run. Apparently, the effect of supply side, monetary and external factors are highly significant through their long run cointegrating relationships. In sum, our result assures that a multipronged approach is very essential so as to successfully combat price inflation in Ethiopia. In view of that, Policies that geared towards concurrently maximizing agricultural growth, flourishing structural rigidities, monetary tightening and stable exchange rate polices may principally ensure stable inflation growth. Beside, effective fiscal management policies may also help to stabilize the effect of external price shock.