1.1. Background of the Study
Price stability and achieving sustainable economic growth are the major goals of macroeconomic policy and the key indicators of macroeconomic stability. It is widely accepted that the pursuit of price stability is primary to long-run growth and development; it should be the concern of every economy. Given this scenario, the focus of monetary policy is primarily to be narrowed to the pursuit of moderate inflation rather than output or unemployment (Odusanya I. A. and A.A. Atanda, 2010).
Inflation is a sustained rise in general price level of goods and services in a given economy. The definition of inflation concern neither increase in price of particular commodity nor for particular period of time. For an inflation to be happened, the rise in the general price of goods and services should be sustained. Inflation takes a crucial role in the healthy functioning of a countries economic performance. It is commonly recognized that an unpredictable fluctuation in the rate of inflation is considered a major indicator of the instability of economic activity of a country (Mishkin, 2010).
Economic growth is an increase in the production of economic goods and services, compared from one period of time to another. It is a complex, long-run phenomenon, subjected to constraints like: excessive rise of population, limited resources, inadequate infrastructure, inefficient utilization of resources, excessive governmental intervention, institutional and cultural models that make the increase difficult. (Haller, 2012)
Every country of the world both developing and developed achieving sustainable and high economic growth with moderate inflation is their most fundamental macroeconomic policy. However, the relationship between inflation and economic growth has remained speculative till now. Specially, the question of whether or not inflation is harmful to economic growth has been a subject of intense debate among policy makers, central monetary authorities and macroeconomists. The debate originally evolves from the controversy of the structuralisms’ and the monetarist. The structuralism advocates believe that inflation is essential for economic growth while monetarists argue that inflation is detrimental to economic growth. (G. Mallik and A. Chowdhury, 2001).
In Ethiopia the history and trend of inflation shows that prior to 2002 inflation has remained more or less stable. During the Derg regime, price was controlled by the government, viz, had kept price stable. The government was also rationing goods at fixed price to the public which in turn had contributed to the lower inflation attaining during the Derg regime. In the same case, the country had not suffered from high inflation and annual average inflation was only 5.2 percent during 1980–2002(WB, 2010; NBE, 2010). During the earlier years of the current government, inflation rate was low despite the huge inflow of money by International Monetary Fund(IMF) and World Bank(WB).This happens because of the displacement of former governments and layoffs of workers due to structural adjustment policy (SAP)followed by the country had depressed demand (Sisay, 2008)
However, in the post 2002/03, the situations have been dramatically changed. Inflation started to increase. During the same period, the economy has recorded fast growth rate (On average 10.5 percent GDP growth) and continued growing consecutively for the last eight years, according to reports (WB, 2010; NBE, 2010). In 2000 and 2001, the inflation rate was negative 7.2 and 8.5 percent respectively. However, in 2002, the inflation rate had been increased to 15.1 percent. But the recovery of the agricultural production and general economic growth has reduced the inflation rate to 6.1 percent in 2004. In 2004, the inflation rate declined by 60 percent as compared to 2002. After 2004, the inflation rate could not show any sign of declining till 2008. In 2008, the inflation reached its highest 36.4 percent (NBE, 2010).
In 2010 the annual average general inflation at the close of the fiscal year 2010/11 was 18.1 percent, 15.3 percentages point higher than the preceding year level. This was predominantly due to the hike in the prices of food items that contributes the lion’s share of 14.1 percentage point of the total annual change in headline inflation while non-food items made up the remaining 1.2 percentage point (NBE, 2010). But the average annual inflation has declined to 8.1 in 2013/14 due to the slowdown in both food & non-alcoholic beverages and non-food inflation by 6.7 and 3.9 percentage points, respectively.
Inflationary pressure was contained by imports and cross-regional redistribution of domestic market purchases of foodstuffs supported by a restrictive monetary policy stance. From an 11.9 percent peak in 2015, headline inflation receded to 7.5 percent by 2016, driven by food price moderation (International Monetary Fund, 2016).
Ethiopia has registered remarkable economic performance with annual growth averaging 10.9% over the past ten years. In recent years, the Ethiopian economy continued to register a notable growth even when the world faces challenging macroeconomic and social conditions owing to the outbreak of COVID-19 pandemic. In 2019/20 fiscal year, real GDP grew by 6.1 percent compared to 3.5 percent average growth estimated for Sub - Saharan Africa (World Economic Outlook, 2019). The Ethiopian economy recorded 8.2 percent average growth rate per annum during the GTP II period (2015/16-2019/20) which was 2.8 percentage point lower than the average growth target set for the plan period (World Economic Outlook, 2020).
Though Ethiopia has experienced a low inflation, recently, double digit inflation has become worrisome for policy makers as well as the society. (Nandeeswara R. and Abate Y., 2015). Abate (2015) 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 1974–2012 inflation level of about 9–10 percent is optimal for Ethiopia. Any inflation level, greater or less than the estimated threshold level, may not allow long-term and sustainable economic growth. 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. Therefore, studying the possibility of controlling inflation is one of the themes to be addressed in Ethiopia.
1.2. Statement of the Problem
Achieving high and sustainable economic growth with stable price level is one of the macroeconomic objectives of many developing countries. The relationship between inflation and economic growth remains a controversial issue in macroeconomic theory and a deliberated subject among the policy makers. In Ethiopia, despite the recent economic growth, the country still faces some structural weaknesses that present significant challenges in the medium term. Its growth performance and considerable development gains is challenged by macroeconomic problem of high inflation. Pressures on prices and the balance of payment heightened as a result of the global food and economic crisis. Ethiopia’s economy is highly vulnerable to exogenous shocks by virtue of its dependence on primary commodities and rain fed agriculture. It has experienced major exogenous shocks during the past five to seven years. These are notably droughts and adverse terms of trade in commodities like coffee and fuel (African Development Bank, 2012). There is a strong correlation between weather conditions and its growth performance.
High and unpredictable inflation has a negative impact on investment and economic growth by creating uncertainty to investors. Inflation can lead to uncertainty about the future profitability of investment projects especially when it is coupled with increased price variability. This lead investors to follow conservative investment policy, ultimately leads to lower level of investment and hence economic growth. Inflation may also reduce the international competitiveness of a nation by making its exports relatively more expensive, thus affecting the balance of payment.
High inflation can cause serious problems. It would bring a large distribution of income. Higher food price would hurt the urban poor who spend most of their income on food. Moreover, although it would have a positive effect on the rural food producers, it would have an adverse effect on the rural food buyers, which may consist of about half of population in the rural Ethiopia. Thus, higher inflation, particularly through higher food price, could worsen the economic inequality. High inflation would also increase uncertainty about future inflation (Fekadu, 2012)
Moderate inflation rates are desirable for the sustainability of output growth, while high and fluctuating rates of inflation has proven to be growth-retarding and inversely related to sustainable development. Nevertheless, an insignificant agreement exists in the literature on the exact link between inflation and output growth, and the determining factors of inflation which may affect the productivity level. Until recently, macroeconomist has adopted an econometrics technique which establishes that the effect of inflation on real output growth could be positive up to a certain threshold level, and beyond which, the effect turns to be negative. This, however, supports the argument of both the structuralists and the monetarists to a greater magnitude, meaning that, lower inflation rate is essential to output growth but once the economy attains a higher level of growth, then, high inflation becomes harmful for the sustainability of such output growth (Ahmed, 2005).
Over the years, there have been a considerable number of researches in the field of inflation and economic growth. (Singh and Kalirajan, 2003) using the annual data from India for the period of 1971–1998 analyze the threshold effect of inflation economic growth. The findings clearly suggest that the increase in inflation from any level has negative effect on economic growth and substantial gains can be obtained by focusing the monetary policy towards maintaining price stability.
(Hwang T. and Wu J., 2011) using growth accounting equation as basis of their model examine the possible threshold effect of inflation on economic growth in China. They find that the inflation threshold effect is highly significant and robust. Above the 2.50 percent threshold level, every 1 percentage point increase in the inflation rate impedes economic growth by 0.61 percent; below this threshold, every 1 percentage point increase in inflation rate stimulates growth by 0.53 percent. This indicates that inflation harms economic growth whereas moderate inflation benefits growth in China.
(Chimobi, 2010) try to ascertain if there is relationship between growth and inflation using Nigeria’s consumer price index from 1970–2005. He concludes that there is no long run relationship between inflation and economic growth in Nigeria but shows that inflation has an impact on growth. (Nell, 2000) studies the cost and benefit of inflation by dividing the South Africa’s inflationary experience into four episodes. The empirical results suggest that there is nonlinear relationship between inflation and economic growth. Within the single-digit zone inflation is beneficial to growth, while it costs in terms of slower growth at higher level. However, further results indicate that even during periods when deflationary policy yielded growth benefits as a result of a more stable economic environment, the costs of deflation outweighed the benefits.
(Teshome, 2011) explains the relationship between inflation and economic growth in Ethiopia using statistical analysis. The author states that it is difficult to specify the exact relationship between inflation and growth. By comparing the rate of inflation and economic growth of Ethiopia to that of Sub Saharan Africa, he explains how inflation affects economic growth through time. Using statistical comparison of the rate of inflation and economic growth, he tries to figure out the relation between them from 2004 to 2010. Accordingly, inflation affects economic growth nonlinearly in the country. Between 2004–2006 inflation and economic growth has positive relationship while from 2006–2008 they have negative relationship. Despite the variation in the magnitude between 2008 and 2010, he states that inflation and economic growth has positive relationship.
(Abeba, 2014) studied inflation and growth relationships: a comparative study of Ethiopia and Uganda by employing a vector error correction model. The author concluded the inflation-growth relationships in Ethiopia show the existence of a positive significant bi-directional feedback relationship between inflation and economic growth in both in the short run and in the long run. But for Uganda there exist only a unidirectional negative relationship between inflation and growth that runs from growth to inflation.
(Getachew, 2018) studied the relationship between inflation and economic growth in Ethiopia. The author concluded that the inflation rate has a serious negative effect on the growth of one country’s economy especially in Ethiopia, if inflation has a double digit of an annual growth. The author also concludes that if inflation grows in a single digit it has a positive effect on economic growth. He reasoned that rise in the price of goods and services promote the producers to produce more and maximize the welfare of the consumers by increasing their consumption habit.
Even though many researchers have undertaken a variety of researches regarding the nexus of inflation and economic growth in Ethiopia, they did not clearly put the relationships between inflation and economic growth in Ethiopia. This paper will try to fill the gap that has been seen in the above literatures.