Relationship between Inflation and Economic Growth in Ethiopia : An Empirical Analysis, 1980-2011

Abstract

Ethiopia’s recent growth performance and considerable development gains is challenged by macroeconomic problem of high inflation. The objective of this study is to analyze the relationship between economic growth and inflation using a VAR model for the period 1980-2011. It is shown that an increase in economic growth decreases inflation whereas inflation does not have significant effect on economic growth in the short run. Using a Granger Causality test, I showed that economic growth has forecasting power about inflation while inflation does not have predicting power about economic growth. The Impulse Response Function shows that economic growth does not indicate any response to impulse of inflation while the response of inflation rate to impulses in growth is effective up to seventh year in the future. The Forecast Error Decomposition supports the earlier conclusion which shows that more than 20 percent of inflation volatility is explained by output growth innovations. Cointegration test shows that there exist a long run relationship between economic growth and inflation in Ethiopia. Vector error correction estimates indicate that economic growth significantly reduces inflation in short run. If inflation had previously been larger than normal share, then economic growth causes inflation to be lower in the long run.