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Inflation and Economic Growth Essay

1. Introduction Moderate inflation is an inevitable consequence of sustained economic growth. It can enhance economic growth by monopolizing the resources of a country. And it is one of the most closely watched measures of an economy. Most economists think that a little inflation is necessary in a growing economy, but high inflation rates are harmful to most people and to governments. For the last five years, Ethiopia has recorded sustaining economic growth. However, inflation in Ethiopia is beyond the break-even point.

Instead of stimulating economic growth, inflationary pressure in Ethiopia seems to be on the verge of distorting the allocation of resources and is likely to be a deterrent to undertaking productive investments. It is quite clear that the main determinants of inflation in Ethiopia are imports, depreciation of the Ethiopians birr, and a decline in the domestic lending interest rates or an increase in broad money supply the Ethiopians monetary authorities need to tighten the stock of money in the country. A tight monetary policy could serve as an anchor for inflationary pressure in Ethiopia.

Thus, it is absolutely vital that economic policymakers design strategies that could curtail the on-going erosion of arching power to curb inflation before it deepens

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the economic crisis and contributes to political instability. By and large, Ethiopia has recorded seventeen years of economic stagnation under the leadership of The Deer, a military government. In 1990/91, the growth rate of the Ethiopians Gross Domestic Product (GAP) was -3. 2 percent, cyclical unemployment was about 12 percent, the rate of inflation was about 21 percent, and the country’s budget was at a deficit of 29 percent of GAP.

For the last five years, contemporary Ethiopia has gathered momentum by recording a steady economic growth. Along with this growth, however, the country has seen an accelerated, double-digit increase in the price of goods and services. Thus, inflation has remained a scourge of the Ethiopians economy (Susann, 2002; Deadest, Demise, Good, 2008). Stated in simple words, Ethiopia at this Juncture is faced with an overheating economy. With the global soaring price of oil, wheat, corn, and minerals, this condition cannot be regarded as unique to the Ethiopians situation.

What makes this a special case is that Ethiopia is a low-income country. The increase in National Consumer Price Index (the main gauge f inflation) has become very detrimental to the low-income groups and retirees who live off a fixed income. The risk of inflationary pressure is reducing the purchasing power of the Ethiopians birr. Since the current inflation rate in Ethiopia was “almost 40 percent year-on-year in May 2008, driven largely by rapidly rising domestic food prices” (MIFF,2008), therefore an item which used to cost one birr a year ago now costs one birr and 40 cents.

That is, the value of one birr is approximately 71 Given that a large portion of county’s population lives in absolute poverty (I. E. , less than one dollar Inflation and Economic Growth By freewheel be contributing to inflation in Ethiopia. Also, it is absolutely vital that economic policymakers design strategies that could curtail the on-going erosion of purchasing power to curb inflation before it deepens

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the economic crisis and contributes to political instability (Tests, 1993). The focus of this study is to examine both the main causes and the consequences of existing inflationary pressure in Ethiopia.

The first section provides the literature review, which briefly discusses the theoretical formulations of inflation The final section contains the summery and conclusion of he study and provides some suggestions on how to control the current inflationary pressure in Ethiopia and prevent the resurgence of inflation at a minimum cost in terms of output loss. 2. Review of literature 2. 1 . Determinants of Inflation There are various theories proposed by various economists to explain the determinants of inflation.

In this study, the various theories of inflation are grouped into 1) inflation as an economic growth phenomenon, 2) demand-pull and cost-push theories of inflation 3) the monetarist explanation of the causes of inflation, and 4) fiscal budget deficit as a source of inflationary pressure. . 1. 1 Inflation as an Economic Growth Phenomenon From theoretical and empirical perspective, determining the direction of causality between economic growth and inflation in the developing countries is very controversial ( Hosing & Chowder, 1996).

In sass, the Structuralism Economist view of inflation, as pioneered in Latin America, persuasively argued that moderate inflation and economic growth are positively related. This was in contradiction to the policy advice of the international lending institutions (Meier, 1995; Amelia & Chowder, 2001). Stated in simple terms, inflation stimulates the economy since nominal wages may lag behind prices, allowing for slower adjustment to wage expectation.

Similarly, the Keynesian economic perspective assumed that moderate inflation might accelerate economic growth by raising the rate of profit, thus increasing private investment Nouns & Marshall, 1986). According to Meier, inflation accelerates economic growth in two ways: “by redistributing income from workers and peasants, who are assumed to have a low marginal propensity to save, to capitalist entrepreneurs, who have assumed to have a high marginal propensity to save and invest; and by raising the nominal rate of return on investment relative to he rate on interest, thus promoting investment” (1995).

Capitalizing on the Keynesian theoretical framework, the ruling party in Ethiopia seems to attribute the surge in inflation to macroeconomic growth. As stated by Good, “The Ethiopians government admits that inflationary pressure has become very severe. However, it also claims that the economy has been growing at 10% for five consecutive years and it is healthy at present. ” (Hosannas, 2008). Using the full-employment model, it is possible to assume that if a nation achieves full employment, economic growth is likely to precipitate an inflationary situation.

Since the 10 percent increase in nominal GAP cannot keep pace with a 40 percent inflation rate, the acceleration of economic growth seems to be nothing but a clear sign of an unhealthy economy (Good, 2008). As persuasively argued by Barron, the inflationary situation in a country could have a negative- structural-break effect on economic growth, if the sustained increase in prices is more than 15 percent (1996). The inflationary economic growth process generates distortions in the allocation of resources under the free market system.

It may not bear fruit if the Ethiopians citizens do not “have confidence in the stability of the value f money, and … If inflationary financing is not accompanied by governmental policies of holding down the wage and interest costs of business enterprises” (Meier, 1995, up. 180). It needs to be appreciated that following a rise in the Consumer Price Index, the Ethiopians government not only scrapped taxes on flour and grains but also started selling edible food items at subsidized prices in order to repress inflation.

The government claims “greedy’ businesses and speculators are the cause of the inflation. They subsidize food to placate the vulnerable urban poor and the salaried government employees. The efforts of the Ethiopians government to curtail inflation are in the right direction. However, the governmental subordination programs may be effective only for a short period of time. They are likely to result in shortages; inefficient production and distribution; and black markets.

To suggest possible solutions for curtailing inflation in the long run, the articulation and discrimination between aggregate demand and aggregate supply will be investigated. Additionally, the monetary policy Ethiopia will be assessed in relation to the chronic inflation that has manifested in the country. 2. 1. The Demand-Pull and Cost-Push Factors for Inflation Keynesian economists often classify inflation according to the source of the inflationary pressures. The most straightforward method defines inflation in terms of sustained pressure from the demand side of the market or the supply side of the market.

By and large, a rampant inflationary situation in any country occurs because of an imbalance between demand-pull and cost-push factors. The demand-pull inflation scenario occurs when a sustained increase in prices is preceded by a permanent acceleration of the nominal gross domestic prices growth ( Gordon, 009). Stated differently, inflation occurs when increases in total spending are not offset by increases in the supply of goods and services. When many consumers are trying to buy the same good, the price of that good inevitably increases, as there is a limited supply.

Also, demand-pull inflation could be a result of an increase in consumer and business confidence, an increase in the money supply, and/or government budget deficits. On the other hand, cost-push inflation is an increase in production costs that force firms to raise prices to avoid losses. In broad aggregate terms, these could be s a result of increase in wages, energy shocks, weather shocks, increase in the prices of agricultural inputs, or import price hikes, which might cause exchange rate depreciation or a decline in land holding sizes.

While the demand-pull explanation suggests restrictive monetary and fiscal policies, the cost-push theory endorses price formation and wage determination as stabilizing mechanisms. According to Monetarist economists, in every case where the inflation rate of a country is high for any sustained period of time, its rate of money supply growth is also high ( Friedman, 1959). In accordance with this, the National Bank of Ethiopia has recently responded by tightening the monetary policy in order to tackle the chronic level of inflation.

However, to examine if a relaxed monetary policy has been the source of inflation in Ethiopia, the role played by financial and non-financial intermediaries in the supply of money stock needs to be factored out. In Ethiopia, financial intermediaries may accelerate inflation if the National Bank of Ethiopia relaxes its financial and monetary policies that regulate the Ethiopians financial intermediaries to maintain the statutory liquidity requirement of demand and time deposits.

In addition, an in money supply could accelerate inflation if the central bank substantially reduces the discount rate or buys existing government bonds from investors. The discount rate is the interest rate charged by the National Bank of Ethiopia when member banks borrow from it. Ethiopia seems to have been driven into an inflationary trap because there was an increase in the country’s broad money supply (I. E. , currency in circulation, demand deposits, savings deposits, and time deposits) from 19. 4 percent in 2002 to 23. 3 percent in 2006.

That is, Ethiopians banks adopted a relaxed monetary policy to help promote the financial markets. Ethiopians banks overused their reserve facilities to boost their credit portfolio (Toothsome, 2008). The excess reserve in Ethiopia occurred due to more savings. As persuasively argued by Demise, “The demand for bank credit rose sharply to finance large-scale investment projects by the public enterprises and the rapidly expanding private sector. Substantial negative real interest rates and commercial banks” excess reserves facilitated the rapid expansion of credit” (2008).

From 2002 to 2006, Ethiopians real GAP increased by 6. 8 percent Instead of adjusting the money stock with the increase in GAP, the country’s money supply accelerated by bout 18 percent, contributing to an average 12 percent increase in the rate of inflation. The link between money supply and other determinants of growth is not an automatic process. However, if we abide by the principles of the transmission mechanism, we might argue that the increase in money supply in Ethiopia might have contributed to an increase in investment.

However, the problem of inflation in the Ethiopians environment cannot be tackled without addressing the large budget deficit Table 1: Ethiopians GAP, Inflation, Broad Money, Public finance, Investment, Savings, and Current Account Balance, 2001-2007 ear Real GAP Growth rate (%) Inflation rate (%) Government budget/GAP (%) Gross Capital Formation, % GAP Domestic Saving, % GAP Current Account Balance (%)/ GAP 2001/02 1. Ad 9. AAA 19. 4 b 2002/03 -4. 5 b 15. 1 b 12. 3 b 2003/04 11. B 8. 6 b 20. 0 b -7. 4 d 12. 4 d 5. 4 d OIC 9. 2 c 16. 4 b -5. 8 d 11. Ad 2. 6 d -9. 1 a 2005/06 9. 7 c 9. C 23. 3 b 5. 2 d -10. 2 a 9. 7 5. 8 d 2. 0 d 2 . 1 do 4. 4 a outlook. Ell-J Views Wire. B International Monetary Fund (2008, April). International Financial Statistics. C The World Bank Group (2007, April). Ethiopia. World Development Indicator Database. L International Monetary Fund (2007, June 15). do BFD/COED (2007). African economic outlook: Ethiopia 2. 1. 4 Fiscal Deficit and Inflation Tax levy in underdeveloped countries is generally very low. In addition, a government cannot or does not find it politically feasible to raise taxes when it needs to increase government spending.

During wartime, the need to rapidly increase military spending results in government expenditures rising faster than tax revenues. The desire of the government to reduce taxes in the face of a continued high level of spending can lead to large budget deficits. Large budget deficits can be the source of inflationary monetary policy. As argued by Meier, “When financing of government expenditures by money creation exceeds the non-inflationary limit, total spending in the country becomes greater than production valued at stable prices (1995, up. 76; see also Johnson, 1966). To promote more investment; to maintain law and order within its highly volatile domestic environment; and to ascertain peace and tranquility with its neighbors, the Ethiopians government has been running a budget deficit of between five and six percent of GAP per year. Government deficit could be financed by selling government paving bonds (modernization of the debt) if there is a highly developed capital market. However, capital markets barely exist in Ethiopia.

Thus, the Ethiopians government has either depended on external sources of finance or has financed its budget deficit by printing high-powered money (currency and deposits at the N.B.), which serves as a reserve for commercial banks and allows commercial banks to expand their loans Monsoon, 1966; Meier, 1995, up. 177; Hosannas, 2008). Since donor funds have not greatly increased in 2007/08, it is reasonable to assume that the government’s commitment to finance large-scale capital projects and infrastructure improvements has contributed to the sustained inflationary period (BFD/COED, 2007). . Summary and Conclusion For the last five years, Ethiopia has recorded sustaining economic growth. Moderate inflation is an inevitable consequence of sustained economic growth. It can enhance economic growth by monopolizing the resources of a country. However, inflation in Ethiopia is beyond the break-even point. Instead of stimulating economic growth, inflationary pressure in Ethiopia seems to be on the verge of distorting the allocation of resources and is likely to be a deterrent to undertaking productive investments

The main determinants of inflation in Ethiopia are real GAP, percentage increase of the exchange rate (exchange rate of the Ethiopians birr against the US Dollar), and the successfully Jump out of the inflationary trap, the Ethiopians monetary authorities need to tighten the stock of money in the country. In other words, a tight monetary policy could serve as an anchor for inflationary pressure in Ethiopia. Therefore, as a partial solution to the inflationary pressure in Ethiopia, it could be suggested that let the National Bank of Ethiopia be allowed to function as an institutionally independent body.

That is, the National Bank of Ethiopia could be made to be immune from political pressures to tighten its monetary policy, such as auditing of financial institutions to maintain reserve requirements or forcing banks to indulge in prudent lending procedures. However, it needs to be underlined that granting legal independence to a central bank is not sufficient to keep monetary policy effective on a sustained basis unless the central bank also dominates the fiscal policy of the government. In other words, the framework of fiscal policy should result in a monetarily dominant regime.

Granting legal independence to the central bank, he fiscal policy regime must be such that it does not allow changes in the price level to become the mechanism through which the condition for government solvency is satisfied. With a substantial increase in prices, Ethiopians banks are on the verge of lending to the least solvent borrowers to keep from bankrupting themselves. In addition, as the value of the domestic currency depreciates, domestic savers may decide to invest abroad. Rampant inflation proliferates inefficiencies and disrupts investment.

It takes time and proper policy to adequately damp inflationary fires. The supporting price intros implemented by the Ethiopians Government as knee-Jerk responses to inflation might be effective for a short period of time. In fact, political and economic agitators may be calmed by government subsides, supplements, and price floors, as well as an increase in interest rates and reserve requirements. Banning speculators in futures trading of edible products and preventing rising prices with government subsides might not halt the rampant inflation.

Inflation creates more inflation unless long-term stabilization programs are pursued. Since current inflation causes inflationary expectations. The current inflation rate in Ethiopia can therefore be partly explained by its past history of inflation and the various relative price and institutional adjustments such as indexation of wages, government subsidies, financial contracts, monetary and exchange rate policies which the government might have taken over the years to deter inflation.

In other words, based on rational expectation theory we can assume that the Ethiopians people may use all available information including that about current policies to forecast the future. Therefore a stabilization program to mitigate the inflationary situation in Ethiopia ay include a drastic cut in the money supply, reducing government expenditures and a further devaluation of the currency. As shown above, the minor currency depreciation in Ethiopia has leads to a high cost of imported materials for production, which are ultimately passes onto higher prices for goods and services.

As indicated before, these policies can have their own inertia and usually induce an inflationary pressures encountered by the country However, since a large portion of inflation in Ethiopia is due to a price surge in edible and finished products, one of the Eng run strategies for suppressing inflation and increasing employment in Ethiopia is to balance the aggregate demand with long-run aggregate supply. Aggregate demand is a combination of the price level and real output at which the money and commodity markets are both in equilibrium.

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