COLLLEGE OF AGRICULTURAL AND ENVIRONMENTAL SCIENCE

SCHOOL OF AGRICULTURAL ECONOMICS AND AGRI BUSINESS

DEPARTIMENT OF AGRICULTURAL ECONOMIC S

A seminar on THE EFFECT OF INFLATION ON ECONOMIC GROWTH IN ETHIOPIA Submitted to the

Department of Agricultural Economics in partial fulfillment of the requirement for
Bachelor of Science in Agri-Economics

BY : Ashabir Girma
ID NO:1100/10

ADVISOR:Malkamu Girma [MSC]

FEBUR ARY,2021

HARAMAYA, ETHIOPIA
TABLE CONTENT
1. INTRODUCTION.............................................................................................................................................1
1.1 OBJECTIVE OF THE SEMINAR ……………………………………………………………………………………………………………………….3

1.1.1 General objectives..........................................................................................................................................3

1.1.2 Specific objectives.........................................................................................................................................3
2. LITERATURE REVIEW....................................................................................................................................4
2.1 Theoretical Literature Review...........................................................................................................................4
2.1.1 Concept and Measurement of inflation..........................................................................................................4
2.1.2 Kinds Of Inflation ……………………………………………………………………………………………………………...........................6

2.1.3 Causes Of Inflation……………………………………………………………………………………………………………….......................6

2.1.3.1 Demand Pull Inflation.................................................................................................................................6
2.1.3.2.Cost- Push Inflation....................................................................................................................................7
2.1.4 Theories Of Inflation......................................................................................................................................8
2.1.5 Effects of inflation on economic growth......................................................................................................13
2.1.5.1 Positive effects of inflation........................................................................................................................14
2.1.5.2. Negative effects of inflation.....................................................................................................................15
2.1.6. Controlling methods of inflation.................................................................................................................16
2.1.6.1 Monetary policy........................................................................................................................................16
2.1.6.2 Fiscal policy..............................................................................................................................................17
2.1.6.3 Wage and price control.............................................................................................................................18
2.1.6.4 Fixed exchange rates.................................................................................................................................18
2.2 Recent Inflation Rate In Ethiopia....................................................................................................................19
2.3 Empirical Literature Review............................................................................................................................20
2.4 Conclusion......................................................................................................................................................24
3.Recommendation ..............................................................................................................................................26
4.Reference………………………………………………………………………………………………………………………………………………………28

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 1. INTRODUCTION

Now a day, developing countries like Ethiopia have a strong objective to achieve and maintain sustainable
economic growth of the country. To realize and maintain continuous economic growth macro-economic stability
is significant.
Unemployment, business cycle, output growth and inflation are the major indicators of macro-economic stability.
Macro-economic stability requires knowing and creating a smooth relationship between these variables in a
country. Thus, one of the most relevant debatable issues in macro-economists is the relationship between
inflation and economic growth.
Policy makers and national banks commonly faced with difficulties to attain simultaneously price stability with
sustained economic growth. Before we are going to see the relationship between these variables historically in
detail, defining two terms is significant. 

Economic growth can be defined as an increase in the productive capacity of a nation measured by percentage
changes in gross national product (GNP) or gross domestic product (GDP) in some particular period of time.
In other words, it is an increase in inflation adjusted market value of goods and services produced by an economy
over a time usually measured a percent increase in real Gross domestic product (GDP) while inflation is a
sustained decrease in purchasing power of currency over time or a sustained increases on average price of goods
and services over time(Christianson, 2008)

There is no clear theory which states fixed relationship between inflation and growth. Controversy by quantity
and institutional inflation theories also confirm this. According to quantity theorists, there is a long-run trade-off
between inflation and economic growth but the supporters of institutional theory of inflation, are less sure about
presence of negative relationship about inflation and growth.
They agree that price level rises have the potential to generate inflation and that accelerating inflation undermine
economic growth(Colander, 2004). Thus, the relationship between inflation and economic growth is debatable
both in the world and specifically to Ethiopia.

The nexus of inflation and economic growth is one of the most important macro-economic policy
problems that take the attention of researchers, policy makers and different scholars. Initially, inflation -
economic growth nexus means dilemma on the relationship between inflation and economic growth. As
far as we see in different areas and places of study on the relationship between inflation and economic
growth, there are two major problems:

- First, there is no single clear cut theory which shows fixed relationship between inflation and
economic growth to implement in the country to achieve its objective of sustainable development.
- 2nd, Even if moderate inflation is an inevitable consequence of economic growth, determining and
maintaining inflation on its moderate level is a headache for countries like Ethiopia.

One of the most serious problems on economic growth of Ethiopia is the continuous rise in general
price level of goods and services which come to be known as “inflation” (Mankiw,1995).

According to him, inflation in general affects the living standard of peoples residing in the countries. In
addition to him, various economists attempts to explain in that why inflation occurs among some of
which, the most dominant frequently happening is an increase in the nation’s money supply that leads
to cause the increase in the average price level of goods and services through decreasing purchasing
power of money, (World and Bank encyclopedia, 1992).

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The other factors that cause the general price rise is the increase in demand for goods and service which
is greater than amount supplied. Many years ago, even if there is a little rise in the average price rise
level of goods and services, it doesn’t highly affect the economic performance of the country, i.e. a
little rise in the average price is important for the economy. After the years of 1999 up to present, the
average price rise is alarmingly increasing through raising the price of consumer adnoun-consumer
goods in Ethiopia.(Johannes and Birr, 2010)

The survey also tells us that, an average price rise is not only occurred on the consumer and non-
consumer goods and services. But on other additional activities such as renting houses, transportation
costs, cost of raw materials and etc. (CSA survey 2008). Furthermore, it tells us that the main reason for
the rapid increment of continues price rise in Ethiopia is due to the increase foreign exchange of
currencies, acre: dollars, pounds, Euros and etc.Ethiopia is one of the (LDCs) of the world.
Despite, it’s rich and varied endowment of natural resource base and also agriculture still employs the
great majority of the labor force in rural areas of Ethiopia, and the modern sector is small.

The main stay of the country’s economy is agriculture in which more than 80 percent of the population
is engaged either directly or indirectly. So agriculture is a lion’s share to GDP contribution (i.e., 45.3%
of GDP) and is the most important export item both by volume and value 81% of total exports originate
from this sector (CSA survey, 2014/15).

To sum up the current effects of inflation or the general rising of average price level of goods and
services, food and nonfood items become a serious problem on peoples those have fixed income or
their income is not changed with increase rise in price of commodities this became the core problem
on the living standard of individual as well as a society and also decline economic growth and
economic development of Ethiopia Ruther than increasing.
Today inflation became the most serious problem on economic growth and development of Ethiopia
FDRE., (2007). It also prohibits the nations from consumption of goods and services due to the
sustainable increase in the average price level of commodities in Ethiopia.
The nations of the countries who are highly affected by the problem of inflation are those who have low
level of income or fixed income, un employed portion of the population, peoples whose income
increases in a lower rate than the increasing rate of increase in general price level, individuals whose
income increase proportion to the general price rise and etc.
The effect of inflation also reduces the level of investment and a reduction in investment adversely
affects economic growth of the country due to sharp increase in the cost of their investment projects
(Barro, 1995).

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In other hands, inflation increases economic growth by shifting the income distributions in favor of
higher saving capitalists that increases saving and raising the rate of profit, thus leading to increasing
private investment. (Mallik and Chowdhury, 2001)
In such away, if this inflation continually increases in the all of the countries it affects peoples through
decreasing their productive abilities and living standards of the society which directly result in
decreasing the economic performance of the nations. (AlemandKohlin, 2013)

1.1 Objective of the seminar

1.1.1 General objectives

@.The main objective of this seminar paper is to review the effects of inflation on economic growth
of Ethiopia

1.1.2 Specific objectives

1. To review the cause and effect of general price rise of goods and services in the Ethiopia
2.To review some theories and controlling methods of the general price rise in the Ethiopia
3.To review the effects of inflation on economic growth of Ethiopia
4. To review empirical result on the effects of inflation on economic growth in Ethiopia

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 2. LITERATURE REVIEW

2.1 Theoretical Literature Review

2.1.1 Concept and Measurement of inflation

Different economists define inflation in various ways. Milton Friedman writes “By inflation I shall
mean a steady and sustained rise in price.” Whereas, Samuelson puts it as “Inflation occurs when the
general level of prices and costs is rising.” Mankiew, define inflation as an increase in the average
price and the rate at which money is exchanged for a good or eservice.

In general, inflation can be defined as a sustained or continuous rise in the general price level or a
sustained or continuous fall in the value of money. There are key terms in the definition of inflation.
First, inflation refers to the movement in the general level of price not the changes in one price relative
to other prices. Second, the prices are those of goods and services not asset. The third and most
important thing is the rise in price has to be continuous over a long period of time. (Labette, 2011)

Inflation measurement is the process through which changes in the prices of individual goods and
services are combined to yield a measure of general price change (Elbow and Rudd, 2006). The
common measures of inflation used to detect the extent of inflationary pressure include: Consumer
Price Index (CPI), Producer Price Index (PPI) and GDP- deflator. CPI is expressed as the ratio of
average prices currently paid by consumers to the average prices paid in a reference or base period. It
takes the change in the price of consumer goods and services. On the other hand, PPI are used to
estimate prices received by domestic producers of goods at various levels of processing. It takes the
change in the price of raw materials used by producers. The last one i.e. GDP deflator is the ratio of
nominal and real GDP. CPI measures the change in the price of consumer goods and services
assuming fixed basket of commodity and it also includes the change in the price of imported goods
and services. But one of the major weakness of CPI is it doesn’t include the change in the price of raw
materials that are used by the producer. PPI address this problem but it only includes the price of raw
materials. Whereas GDP- deflator takes only locally produced goods and services. Most studies use
CPI to measure inflation because it represents the majority of economic actors i.e. consumers.
(Mackie, 2006)

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Grime, (2012) studies the relationship between inflation and economic growth in Ethiopia he entitled
that economic growth was severely affected by drought (in 1985) and war times (1991/2) which
resulted in high levels of inflation and Economic growth causes inflation.
Whereas Inflation does not have any significant effect on economic growth in the short run and also,
Increase in money supply results in a high inflation, whereas an increase in exchange rate does not have
a significant effect on inflation. Inflation and economic growth respond significantly to their own
shocks. In order to tackle inflation, GDP should increase from non-inflationary sources. As Ethiopian
Inflation is highly driven by the price of food staples, policy measures to enhance agricultural growth
have an immense importance to tackle inflation.
There are several channels that can produce inflation. One of these possible factors that could bring
about inflation is the overheating in the labor market. When the economy is overheated, there will be
pressure for the real wages to increase. Increases in the commodity prices or utility prices will push up
the cost faced by the firms, and eventually forcing a consumer prices to increase.

The second cause of inflation is the price of imports in particular commodities. The third one is the
increase in the price of utilities. The other source of inflation is the financing of public deficit, meaning
financing of fiscal deficit by printing of money.Yemane .M, (2008)

Price stability is important in setting favorable environment for investment and economic growth. In
Ethiopia the major causes were the then high fuel and food prices shocks, weaker foreign exchange
earnings, and rising demand for imports that depleted international reserves of the country. The highest
price increase was observed in food, housing, fuel and transport services, making the urban poor the
most vulnerable to the impacts of inflation. UNDP (2014)

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 2.1.2 Kinds of inflation
There are four common types of inflation in an economy these are listed below :
Mild inflation is a type of inflation that occurs when the price level increase s from 2% to 4% each
year. Here, if wage increases faster than prices. The workers have greater purchasing power. However,
mild inflation usually last when employees eek larger profit during periods of economic growth and
unions, bargain or (cooperate) for higher wages. As a result price rise even, further and leads to create
inflation. (Encyclopedia, 1912)

Moderate inflation is a kind of inflation that occurs when the annual rate of inflation ranges from 5%
to 9%. During the period of moderate inflation, price level increases more quickly than wages and so,
the purchasing power declines which in turn increases the demand for goods and services that bring
the further price rise (Encyclopedia, 1912)

Severe inflation is a type of inflation that occurs when the annual rate of inflation is 10% or greater
which is also called “double digit inflation”. During the period of Severe inflation, price rise much
faster than wages and then, the purchasing power rapidly decrease which directly results in the
existence of general price .(AyalewBiru, Y., 2007)
Hyperinflation is the last type of inflation which is rabid and uncontrolled one or can destroy the
nation’s economy, in this type of inflation money lose its value and many people exchange goods and
service instead of using currency, (Woldamechael, A., 2008)
In general the inflation rate in Ethiopia was recorded at 10 percent in November of 2015, but it does
vary from year to year and so the economic country is characterized by severe inflation. CSA, (2015

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 2.1.3 Causes of inflation
Generally, economists have classified the cause of inflation into two broad categories; demand pull
inflation and cost push inflation (Atari et al. 2011). Those are broadly discussed below in the following
ways.

2.1.3. 1 Demand pull inflation

 inflation caused by aggregate demand. This inflation happens when spending in the economy is increasing more
quickly than output.

The demand-pull inflation situation occurs when a sustained increase in prices is preceded by a
permanent acceleration of the nominal gross domestic prices growth (e.g., Gordon, 2009).
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.
In general the inflation rate in Ethiopia was recorded at 10 percent in November of 2015, but it does vary from
year to year and so the economic country is characterized by severe inflation. CSA, (2015] The demand-pull
inflation arises due to the higher demand for goods and services, which means it occurs when aggregate
demand grows faster than the supply. (Asari et al. 2011).
The demand pull inflation in a full employment economy occurs due to an autonomous expansion of
desired export, investment, government and business expenditure followed by competitive price and
wage increases (Machlup 1960). Demand pull inflation is not as problematic as the cost push inflation.
It can be managed through contractionary (demand, reducing) fiscal or monetary policies
2.1.3.2 Cost-push inflation
inflation caused by an increase in aggregate supply. This is an inflation occur because of an increase in resource
prices in economy
The Cost-push inflation situation occurs when there is caused by an increase of one or more of the cost
or supply side factors such as the rising wages, input price (domestic or imported), interest rate, taxes,
and exchange rate. And also it is unlikely to be manageable through similar policy alternatives as
concurrent problems like unemployment and lower economic growth would be inevitable (ibid).

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Cost push theorists fundamentally emphasize “prevention” instead of “curing” so as to concurrently
achieve triple economic goals (healthy inflation, and high level of employment and growth) (Selden
1959). Embracing the disequilibrium systems of direct control (negotiation, wage and price fixing,
rationing, quotas) are the indispensable mechanisms while tackling cost-push inflation (ibid).

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 as 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.

In general the demand pull inflation occurs when the economy grows quickly and starts to ‘overheat’ –
aggregate demand will be increasing faster than aggregate supply, and cost push inflation is due to an
increase in the cost of production of goods and services. And also that occurs when there is a rise in the
price of raw materials, higher taxes and the like
While the demand-pull explanation suggests restrictive monetary and fiscal policies, the cost-push
theory endorses price formation and wage determination as stabilizing mechanisms. (Gordon, 2009)

2.1.4 Theories of inflation

Different economic theories are reviewed in this section regarding their views on the inflation and
growth.

The classical growth theory viewed saving as a creator of investment and hence growth. The link
between the change in price level (inflation) and its “tax” effect on profit and output were not
specifically articulated in this growth theory. But the relationship between the two variables is
implicitly suggested to be negative as indicated by the reduction in firms profit level through higher
wage costs (Gokal and Hanif, 2004)

According to classical, economic growth is an increase in per capita real GDP over time. Economic

8
growth occurs when the aggregate supply curve shifts to the right over time. Since for classical
aggregate supply curve is vertical, changes in aggregate demand will have no effect on real GDP, only
price level. Thus, the only way for economic growth to occur is to increase aggregate supply curve to
the right through changes in real variables that is why classical are a supply side model of economy.
Here, the aggregate supply curve may increase through improvements in labor market conditions, such
as increase in labor supply or demand, increase in production function which may occur through
increase in capital or technology. Shift in aggregate supply curve to the right will increase real GDP
and decrease in inflation.

Generally, the determinants of economic growth according to classical model are: quantity of labor,
marginal product of labor, quality of capital, marginal product of capital and technology

Especially the leader of classical theory Adam smith argued that growth was self-reinforcing as it
exhibited increasing return to scale. He viewed saving as a creator of investment and economic growth.
Therefore, he saw income distribution as one of the most determinants of how fast or slow a nation
would grow. He also says that profits decline not because of decrease in marginal productivity rather
completion of capitalist for workers will bid wages up (Gokal & Hanif, 2004).

In classical model, real interest rates (nominal interest rate minus rate of inflation) adjusted so that
saving equal to investment in the loanable funds market. An increase in real interest rate leads to an
increase in household saving. As increase in real interest rate increase in real cost of borrowing, so
investment expenditures decline as in real interest rate increase. In classical, an increase in government
spending is exactly offset by declines in private spending, so that over all change is zero. This is known
as crowding out effect. This effect will lead to increase in real interest rate causing investment and
consumption spending to decline. Additionally, classical believe that aggregate demand
(P=MV/Y) depends on quantity of money in circulation.

An increase in the money supply causes an increase in aggregate demand which leads to an increase in
price level (inflation) and no change in real GDP. So, change in money supply affect nominal variables
not real variables in classical model (Christianson, 2008). Therefore, even if the relationship between
inflation and economic growth is not clearly stated in classical model, it is expected to be negative

Keynesian theory states that excess demand is the major cause for the existence of inflation. Keynes
also believed that, the increased demand for a goods and services for the existence of inflation. He also
believed that the increased demand for a goods and services leads to bring the continuous price rise
which intern causes inflation to occur, (D.colader, 2004). The Traditional Keynesian model comprises
of the Aggregate Demand (AD) and Aggregate Supply (AS) curves, which aptly illustrates the inflation

9
– growth relationship. According to this model in the short run, the aggregate supply curve (AS) is
upward sloping rather than vertical, which is its critical future. If the AS curve been vertical, changes
on the demand side of the economy affects only prices. However if it is upward sloping, changes in
aggregate demand (AD) affects both price and output, (Dornbusch et.al, 1996).

This holds with the fact that many factors drive the inflation rate and the level of output in the short run.
These include change in: expectations, labor force, and price of other factors of production, monetary
policy and fiscal policy.

British economist John Maynard Keynes (1936) was the leader of this approach and introducing a book on
“general theory of employment, interest and money” for the followers of neoclassical and the world as whole.
The Keynesian approach dominated macro-economic theory from 2nd world war to about 1970. Keynesians
widely believe that the government can promote economic growth while avoiding inflation through skill full
macroeconomic policies (Abel, Bernanke, & Croushore, 2008). Keynesians say that interventions in economy by
governments through expansionary economic policies will boost investment and promote demand to reach full
production. The promoted demand before full production is termed as effective demand which maximize the
utilization of limited resources, in contrary, the demand beyond full production is defined as excess demand. The
Keynesian model framework comprising of Aggregate Demand (AD) and Aggregate Supply (AS) curves. The
AS curve is upward-sloping rather than vertical in the short-run that implies changes in the demand side of the
economy resulting from expectations, labor force and policy actions such as discretionary monetary or fiscal
policies that affect both prices and output in the short run as predicted by the Phillips Curve (Froyen, 1990).
According to Keynesian model, an expansionary fiscal policy such as an increase in the rate of growth in money
stock will cause to shift aggregate demand to the right which leads output, price level, level of unemployment to
rise in short-run.

Therefore, the Keynesian model advocates that there exists a positive relationship between inflation and output.
But, in this Keynesian framework, it is not the case that inflation itself is a growth-enhancing force rather if
rising aggregate demand is leading to increased growth. The positive relationship between inflation and growth
shown in the short-run dynamics is differing in long-run Phillips curve which turns to be negative with high rate
of inflation.

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Quantity theory of money states that, inflation is always and everywhere a monetary phenomenon.
According to this model, inflation is caused by increase in the many supply. As a result, the theory state
that the price level varies with response to changes in a quantity of money, (D.Colader, 2004). In
general monetarist suggest that in the long run prices are mainly affected by the growth rate of money,
while having no real effect on growth and if the money supply growth is higher than the economic
growth, then inflation will occur (Grauwe and Polan,2005).
A professor of economics in Chicago University Milton Friedman, who was the most influential person in
monetarist thought, emphasized on several key long-run properties of the economy, including the Quantity
Theory of Money and the Neutrality of Money.

According to Quantity theory of Money, the relation between inflation and economic growth showed simply by
equating the total amount of spending in the economy to the total amount of money in the economy. Friedman
proposed that inflation was the product of an increase in the supply or velocity of money at a rate greater than the
rate of growth in the economy. In summary, Monetarism suggests that the long-run prices are mainly affected by
the growth rate of money but has no real effect on economic growth. If the growth in the money supply is higher
than the economic growth rate, it will result inflation. Additionally, they believe that changes in quantity of
money have the dominant influence on nominal income and as well as changes on real income in sort-run
(Froyen, 1990).

Neo classical theory explain that an increase in inflation immediately reduces people’s wealth by
making the rate of return on individuals real money balance to fall. A fall in real money balance will
have an effect on growth through its effect on saving and interest rate. (Sleeting, 2005). Tobin (1965)
explain that, when inflation increases the return to money falls this induce people to substitute money
(which has low return) with capital. That results in a higher capital stock which increases the level of
output. Stockman (1981) developed a model in which an increase in the inflation rate results in a
lower level of output and a decline in people welfare.

Neo-classical economists argue that having rational expectation there exist positive relationship
between price changes (inflation) and output changes (Froyen, 1990). Economists like Mendel and
Tobin have successfully explained the effect of inflation on economic growth based on neo-classical
growth theory.

According to Mundel (1963) model an increase in inflation or inflation expectations immediately

reduces people’s wealth. This works on the premise that the rate of return on individual’s real money
balances falls.

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To accumulate the desired wealth, people save more by switching to assets, increasing their price, thus
driving down the real interest rate. Greater savings means greater capital accumulation and thus faster
output growth. Tobin (1965) also argued that because of the downward rigidity of prices (including
wages) the adjustment in relative prices during economic growth could be achieved by the upward price
movement of some individual price.

As clearly written in Xiao (2009), the theoretical review demonstrates that models in the neo-classical
framework can yield very different results with regard to inflation and growth. Increases in inflation can
result in higher output (Tobin Effect) or lower output (Stockman Effect) or no change in output.

Neo-Keynesian theory state that, inflation depends on the level of actual output (GDP) and the natural rate of

unemployment. First, if GDP exceeds its potential and unemployment is below the natural rate of

unemployment, inflation will increase as suppliers increase their price and built in inflation worsen. Second, if

the GDP falls below its potential level and unemployment is above the natural rate of unemployment, inflation

will decelerate as suppliers reduce price as there will be excess capacity and this undermine built in inflation.

The final case is when GDP is equal to its potential and unemployment rate is equal to NAIRU, then the

inflation rate will not change as long as there is no supply shocks (Gokal and Hanif, 2004).

The neo- Keynesians are one group that have been attempted to express their view depending on ideas and

concepts of old Keynesians theory. Natural output was one of the major issues of developments under Neo-

Keynesian at the period that in other words we call potential output. Potential output is the level of output

produced on which the economy is its optimal level of production given the natural and institutional

constraints(Christianson, 2008). In other words, this is the level of output alien to natural rate of unemployment

or what we call it non-accelerating inflation rate of unemployment (NAIRU). NAIRU is unemployment rate at

which inflation rate is neither increasing nor decreasing or rising or failing. Depending on this theory, inflation
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is based on the level of actual output and natural rate of unemployment. In relation to this, there are three

common cases

1stly, if GDP exceeds its potential level of output and unemployment is below the natural rate of

unemployment, all else equal, inflation will accelerate as suppliers increase their price prices and worsens

inflation.

2ndly, if GDP falls below its potential level of output and unemployment rate is above natural rate of

unemployment, other things remains constant, inflation will decelerate as suppliers will try to fill excess

capacity, reducing prices and lowers existed inflation.

Finally, in absence of supply shock, if GDP is equal to potential output and unemployment is equal to

non-accelerating inflation rate of unemployment, the rate of inflation remains constant.

Institutional theory states that, the source of inflation is the price setting process of firms and it also

focuses on the institutional and structural aspects of the economy as well as the money supply as the

main important cause of inflation,(Pugel,T. and K.Odel,2006).

Endogenous growth theory Sometimes call the new growth theory. One important implication of
endogenous growth theory is that a country’s long-run economic growth rate depends on its rate of
saving and investment. This theory describe economic theory as being generated by factors within the
production process, for instance, economies of scale, increasing returns or induced technological
change. According to this theory, the economic growth rate depends on one variable: the rate of return
on capital. Variables like inflation decreases the rate of return and this in turn reduces capital
accumulation and hence reduces the growth rate. Other models of endogenous growth explain growth
further with human capital.

The role of human capital and innovation are the reasons for not diminishing marginal productivity of
capital and the economy as a whole. The implication is that economic growth depends on the rate of
return to human capital as well as physical capital. Saving rate can affect long-run rate of economic
growth. The inflation acts as a tax and hence reduces the return on all capital and the growth rate (Abel
et al., 2008).

Generally, Keynesians say that there exists a long-run positive relationship between inflation and
growth where there is no visible short-run relationship. On the other side, monetarists believe that there

13
is no long-run relationship between the two variables but there positive relationship between them in
the short run until expectations is adjusted. New Classical say that anticipated inflation has neither
long-run nor short-run effect on growth. However, if inflation is unanticipated it has a negative impact
on the growth of the economy. While to new growth, inflation act as tax and reduce growth rate. Thus,
theories don’t tell us fixed relationship between these variables

2.1.5. Effects of inflation on economic growth

Inflation spread its effect particularly since 2006 resulting in a rapid phenomenon of double-digit price
hike reaching its peak of 36% in early 2012, but now declined to 10%. Five features describe
inflationary pressure in Ethiopia’s context. Firstly, the inflation occurs on a set of basket goods within
the household food category. Second, the inflation surfaces itself amongst rapid economic growth with
a double-digit rate; third, it mainly negatively affects the low-income group in mostly urban centers
including the state servant and pensioners, whose income is heavily elastic to price changes. Four,
inflation becomes a real price hike mostly periodically following the advents of public holidays.
Finally, setting price ceiling through negotiations with trader associations tended to positively affect
the fast pace of price hike in 2011 than setting price floors by the government. (Habtamu A, 2013).
When there is inflation in an economy; it is difficult for people to know what is and what a relative
price of commodity isn’t in a given period of time. Also causes a household to consume more rather
than waiting for the price rise due to the future expectation of inflation. Furthermore, also affects
people whose income doesn’t increase at the same rate with inflation, (Kamin, S., 1996).

A high rate of inflation is a sign of internal economic tension and of the inability or unwillingness of
the government and the central bank to balance the budget and to restrict money supply. The higher the
inflation rate, the more risky the government is perceived to be.
Generally, inflation affects the decision making process of consumer since it creates uncertainty about
the future price of goods and services that leads to distort economic values (Hagos Beyene,1999).
Inflation’s effects on an economy are various and can be simultaneously positive and negative.

2.1.5.1Positive effects of inflation.

There are some positive effects of inflation such as labor market adjustment. Keynesian’s believe that
nominal wages are slow to adjust down wards. This can leads to prolonged disequilibrium and high
unemployment in the labor market, since inflation would lower the real wage of nominal wages is kept
constant, Keynesian argues that inflation is good for the economy. Inflation is also positive effect if

14
the people holding bonds or treasury notes.
This fixed price assets only give a fixed return each year, (Pearson, 2008).
High inflation increases the opportunity cost of holding cash balance and can induce people to hold
greater portion of their assets in interest paying accounts. With high inflation, firms must change their
prices often in order to keep up with economy. It can benefit the inflators (those responsible for the
inflation) it be benefit early and first recipients of the inflated money (because the negative effects of
inflation are not there yet).it can benefit the cartels (it benefits big cartels, destroys small sellers, and
can use price control set by the cartels for their own benefits. (Mankiw, N.Gregory, 2007).

There are also arguments for the positive effect of inflation on growth. Tobin (1965) indicated that the
demand for money, the substitute for capital, is motivated by the optimistic speculation on the positive
effect between inflation and output. Hence the higher accumulated capitals would lead to higher
economic output. In effect, inflation exhibits a positive relationship to economic growth. However, the
effect on output growth is temporary. Inflation initially motivates capital accumulation which will
contribute to higher growth. But the impact of inflation on growth is only temporary since this trend
works only until the return on capital falls.
According to Fischer (1995), optimal inflation ranging from 2–3% is good for economic growth. It
increases the employment opportunities in the countries, increases the economic activities, and
encourages investment and production by raising the rate of profit.

2.1.5.2 Negative effects of inflation

A high or unpredictable inflation rate are regarded as harmful to an overall economy they add in
efficiency in the market, and makes it difficult for companies to plan long term. Inflation can impose
hidden tax increases as inflated earnings push tax payers in to higher income.
With high inflation, purchasing power is redistributed from those on fixed nominal income. It also
makes traders from an increased instability in currency exchange price caused by unpredictable
inflation.(Mankiw,N.Gregory, 2002
In195, economist A.W Phillips published a research paper entitled :” the problem and relationship
between inflation and unemployment” united kingdom states that, inflation a rises due to the rate of
change of money wages which usually leads to increase the price of food and nonfood items, goods
produced and services rendered in an economy.(Birr Y.A (2009).

15
Fikirte, T (2012) has studied about the inflation and economic growth entitled that the channel through
which inflation affect economic growth and inflation negatively affects growth by reducing
investment, and by reducing rate of productivity growth. Fisher also argues that inflation distorts price
mechanism, and this will affect the efficiency of resource's allocation and hence influence economic
growth negatively.

In general sustained inflation has harmful effects on societal welfare and income inequality in such a
way that the income distribution tends to be skewed and also decrease in the real value of money and
other monetary items overtime, uncertainty over future inflation may discourage investment and
savings, and high inflation leads to shortages of goods if consumers begin hoarding out of concern that
prices will increases in the future. (Loaning, 2007).

2.1.6. Controlling methods of inflation

The ultimate policy objective of any country in general is to have sustainable economic growth and
development. Policy measures are geared at achieving moderate inflation rate, keeping unemployment
rate low, balancing foreign trade, stabilizing exchange and interest rates, etc and in general attaining
stable and well-functioning macro-economic environment. In this process, a variety of policies have
been used to control inflation.

2.1.6.1 Monetary policy

Today the primary tool of controlling inflation is monetary policy most central banks are tasked with
keeping the federal funds leading rate at a low level; normally to a target rate around 2% to 3% per
annum and within a targeted low inflation range somewhere from about 2% to 6% per annum. A low
positive inflation is usually target deflationary conditions are seen as dangerous for the health of
economy. There are a number of methods that have been suggested to control inflation.

16
High interest rate and low growth of the money supply are the traditional ways through which central
banks fight of prevent inflation, (de gregoro, 1996).Though, they have different approaches for
instance, some flow symmetrical inflation target while other only control inflation when it rises above
target, whether express or implied. Monetarism emphasizes keeping the growth rate of money steady
state and using monetary policy to control inflation (increasing interest rate slowing the rise in the
money supply).

Keynesian emphasizes reducing aggregate demand during economic expansion and increasing demand
during recession to keep inflation stable. Control of aggregate demand can be achieved using both
monetary policy and physical policy (increasing taxation or reduce government expending to reduce
demand) measure (Johnson h.g.1967). In addition to this there are some inflation methods such as fixed
exchange rate gold star etc.

For instance, during economic recession where output falls with a fall in aggregate demand, monetary
policy aims at increasing demand and hence production as well as employment will follow the same
pattern of demand.

In contrast, at the time of economic boom where demand exceeds production and treat to create
inflation, the monetary policy instruments are utilized that could offset the condition and achieve price
stability by counter cyclical action upon money supply (Johnston, and Sundararajan, 1999).

However, there is a doubt whether monetary policy can reverse inflationary situation in an economy
that is created due to cost-push rather than inflation of demand-pull like the one shown in the preceding
paragraph. Since monetary policy is more powerful on inflation driven by money stock rather than cost-
push, some economists even suggest direct control instead of conventional monetary policy (Munn, et
al, 1991).

In general the increase in money supply in Ethiopia might have contributed to an increase in investment
thereby leading to an acceleration of economic growth. In addition, though it is very difficult to
document, the inflow remittance through the informal channels from abroad might have contributed to
the soaring of prices in the Ethiopian market of goods and services. A tight monetary policy could serve

17
as an anchor for inflationary pressure in Ethiopia. However, the problem of inflation in the Ethiopian
environment cannot be tackled without addressing the large budget deficit.Teshome, (2008).

2.1.6.2 Fiscal policy

The government continued to pursue prudent fiscal policy better co-ordinate with monetary policy to
combat inflation, while maintaining the momentum of spending in physical and social infrastructure.
Fiscal policy has focused on strengthening domestic-resource mobilization (particularly tax collection)
and reducing recourse to central bank lending while, at the same time, increasing pro-poor spending
including investment in physical infrastructure.

Fiscal policy involves the government changing the levels of taxation and government spending in
order to influence Aggregate Demand (AD) and the level of economic activity that is used to stimulate
economic growth in a period of a recession, to keep inflation low or stable in the countries, and aims to
stabilize economic growth, avoiding a boom and bust economic cycle.(Mankiw, N, 2007)

Fiscal policy aimed at raising revenue and reducing fiscal deficit as a source of inflation, structural
reforms concentrated on lifting most domestic price controls, reducing import tariffs, and moving to a
market based system of foreign exchange allocation. (Addison and Alemayehu (2001).Fiscal policy is
often used in conjunction with monetary policy. In fact governments often prefer monetary policy for
stabilizing the economy.

2.1.6.3 Wage and price control

Another method attempted in the past has been wage and price control (“income policies”). (EDRI,
2007).Wage and price control have been success full in wartime environments in combination with
rationing. However, their use in other context is farmer mixed. Notable failures of their use include the
1972 imposition of wage and price control by Richard Nixon. More successful examples include the
prices and incomes according in Australia and the Wassenaar agreement in the Netherlands.

18
In general wage and price control regarded as a temporary and exceptional measure, only effective
when coupled with policy designed to reduce the underlying Cause of inflation during the wage and
price control regime. (Jimson, G, 2001). They often have perverse effect do to the distorted signals they
send to the market.

Artificially low price often cause rationing and shortage and discourage future investment, resulting in
yet further shortage the usual economic analysis is that any product of service that is underpriced is
over consumed if the official price of bride making by the market to satisfy needs, there by
exacerbating the problem in the long term(ahmed,s,2008)

2.1.6.4 Fixed exchange rates

Under a fixed exchange rate currency regime, a countries currency is tied in value to another single
currency to a basket of other currency (sometimes to another measure of value such as gold).
A Fixed exchange rate is usually used to stabilize the value of the currency, is-a-vies the currency it is
pegged to. It can also be used as a means to controlling inflation. (EDRI, 2007).
However, as the value of the reference currency rise and falls, so does the currency pegged to it.
This essentially means that the inflation rate in the fixed exchange rate country is determined by the
inflation rate of the country the currency is pegged to. In addition, fixed exchange rate prevents a
government from using domestic monetary policy in order to achieve macroeconomic stability.

2.2. Recent Inflation Rate in Ethiopia 

The national’s price level has been rising at an average rate of 0.5%during the period of 2015. This is
due to increase in the price level of food and nonfood items that have been increasing at the rate of
1.40% and 0.70%respectively (CSA, 2015). But recently released data from Ethiopian central
statistical agency confirms that, overall inflation rate rises in Ethiopia by 10% in November 2015.
According it the data, food prices rises by the rate of 4 .70% and the nonfood prices by the rate of
8.40% in November 2015. Here, the rapid increase in the price of nonfood items than food
commodities are due to the sustained increase in the prices of nonfood components like; prices of fuel,
clothing and footwear, contraction materials, house furniture’s, household goods and furnishings and
19
etc. But food inflation has decrease as compared to that of nonfood, due to a decline in prices of
cereals, pulses, vegetables and spices (specially Pepper whole).(CSA, 2015).

In general in Ethiopia, the inflation rate measures a broad rise or fall in prices that consumers pay for a
standard basket of goods. The inflation rate in Ethiopia was recorded at 10 percent in November of
2015, as reported by the Central Statistical Agency of Ethiopia in 2015.
.

2.3. Empirical Literature Review

Alemayehu and Kibrom (2008) Were studied the galloping inflation in Ethiopia by using VAR model for
estimation and quarter data for the period 1994/95 to 2007/08 of Ethiopia. The result shows in long-run the main
determinants of inflation for food sectors are money supply, inflation expectation and international food price
hike while for non-food sectors money supply, interest rate and inflation expectation. Additionally, in short-run
wages, international prices, exchange rates and constraints in supply are the main source of inflation. To sum up,
even if the determinants of inflation are different for food and non-food and short-run and long-run, they showed
that inflation and economic growth have positive relationship in long-run

As summarized by Teshome (2011) in his study of sources inflation and economic growth in Ethiopia
for the year 2004 to 2010: Ethiopia experienced an average of 11 percent economic growth` and 16
percent inflation rate. But, higher inflation rate did not significantly reduce economic growth of the
country which implies in some years inflation and economic growth had positive relationship. Since,
for that specified period higher consumption spending desire and increasing imported goods price
considered as a major source of inflation in the country.
20
One of the recent study on Ethiopia using annual data from 1974/75 to 2009/10 by Aynalem (2013) has
examined the relationship between inflation and economic growth. The study has employed co-
integration and error correction models having with correlation matrix and Granger Causality test by
using annual data set that are collected from MoFED, NBE and CSA. The empirical evidence
demonstrates that there exists a statistically significant long-run and short-run negative relationship
between inflation and economic growth for the country. He found 4-percent as the threshold level of
inflation above in which inflation adversely affects economic growth

Abeba (2014), was studied the impact of inflation on economic growth between Ethiopia and
Uganda comparatively. The study employed annual time series data of CPI as a proxy for inflation
and GDP at current price as a proxy to for growth from 1990-2012. The analysis adopted the
descriptive approach to show the trend and variability of inflation and growth for both countries to
have clear image on changes of variables through time. To check the stationary of the variables, ADF
and Phillip-Perron tests were conducted while Johansen test was applied to confirm the presence of
co-integration between inflation and economic growth. VECM also implemented after checking co-
integration to see the casual relationship between inflation and growth. Depending on the results
found, the co-efficient variation of the two countries shows that the variability of GDP and inflation
were larger for Ethiopia than Uganda.

VECM shows the existence of positive significant bi-directional relationship between inflation and
economic growth for Ethiopia both in long-run and short-run. However, in Uganda there exists only
unidirectional negative relationship between inflation and growth that runs from GDP growth to
inflation
Tewodros (2015) Was investigated the determinants of economic growth in Ethiopia from the period
of 1974-2013. He used Autoregressive Distributed Lag (ARDL) Approach to Co-integration and
Error Correction Model to investigate the long-run and short run relationship between the dependent
variable (real GDP) and its determinants (Physical capital, human capital, export, aid, external debt
and inflation). The result showed physical capital and human capital have positive impact on
economic growth while debt affects economic growth negatively and statically significant at one
percent. But, export of goods or services and foreign aid has statically insignificant effect on
economic growth in long-run.

21
The same to foreign aid and export, inflation have insignificant impact on economic growth of
Ethiopia. Then, the researcher concludes that inflation was not significantly harming the economic
growth of Ethiopia during the study time period. This implies studies in the country hadn’t show a
fixed relationship between inflation and growth in Ethiopia

Mosayed and Mohammad (2009) examined the determinants of inflation in Iran for the data from
1971 to 2006. The study adopted Autoregressive and distributed lag model (ARDL) and concluded
that money supply, exchange rate, gross domestic product, change in domestic prices and foreign
prices, a variable that capture the effect of Iran or Iraq war are the major determinants of inflation in
Iran and all are positively contributing to the domestic prices in Iran. Olatunji et al. (2010) have
examined the recent factors which are affecting inflation in Nigeria. Time series data has been
selected for this particular study. The study reveals that the previous year total imports, previous year
consumer price index for food, previous year government expenditure, and previous year exchange
rate have negative influence on inflation rate. On the other side, previous year exports, previous year
agricultural output, previous year interest rate and crude oil exports have negative impact on the rate
of inflation in Nigeria. Khathlan (2011) examined the determinants of inflation in Saudi Arabia for
the period 1980 to 2009, both in the long run as well as in the short run, using cointegration method
developed by Pesaran et al. (2001).
The result shows that inflation in world economy, depreciation of domestic currency and supply
bottlenecks are the major factors influencing inflation in the long run. In the short run, money supply
and supply bottlenecks have been found to be the major factors influencing inflation in the country.
Shahadudheen (2012) analyzed the major determinants of inflation in India extracting 54 time series
quarterly observations. The study employed Johansen Juselius co-integration methodology to test for
the existence of a long run relationship between the variables. The error correction from the long run
determinants of inflation is used as a dynamic model to estimate the short run determinants of
inflation. The study concluded that the GDP and broad money have a positive effect on the inflation
in long run. On the other hand, interest rate and exchange rate has a negative effect. Ahmed (2007)
examined the determinants of inflation in Ethiopia and concludes “structural changes” such as
increasing bargaining power of farmers and monetary expansion are the main reasons of inflation in
Ethiopia. He argues that monetary expansion is largely dictated by credit expansion in both the
public and private sector. Credit expansion is explained on the public side, by decline in foreign
22
 finance flow, including a reduction foreign aid. At the same time, he points out private sector credit
expands substantially, which is supported by negative real interest rate and increased investment
demand. Durevall et al. (2010), using monthly data from 2000-2009, model inflation in Ethiopia by
including error correction mechanisms for food and non-food prices.
In contrast to other studies on inflation, they specify separate long-run relationships for the
monetary, domestic food, and external food and non-food sectors, though they ignore long-run
effects of energy prices. Their findings are that the external sector largely determines inflation in the
long run. Specifically, domestic food prices adjust to changes in world food prices, measured in local
currency (EBT), and non-food prices adjust to changes in world producer prices. Domestic food
supply shocks also have a strong effect on inflation but it is a short-run effect. The evolution of
money supply does not affect food prices directly, though money supply growth significantly affects
non-food price inflation in the short run. Hence, in the long run, money supply seems to be adjusting
passively to demand.

Khan and Senhadji (2001) are among the economists who examined the effects of the inflation on
economic growth and his empirical analysis of his study with high frequency data reveals that high
inflation (above 1% for industrialized countries and 11% for developing countries) negatively affects
the growth of the economy.
Barro (1995) is one of the economists to see the relationship between inflation and growth using
paneldatafrom100countriesovertheperiodof1960-1990. His finding reveals that inflation has a
statistically significant negative impact on growth and investment.
Inflation not only reduces the level of business investment, but also the efficiency with which
productions factors are put touse. According to the authors, the benefits of lowering inflation are great.
Because, the lower the inflation rate, the greater are the productive effects of a reduction
Mundell (1965) and Tobin (1965) predict a positive relationship between the rate of inflation and the
rate of capital accumulation, which in turn, implies a positive relationship to the rate of economic
23
growth. They argue that since money and capital are substitutable, an increase in the rate of inflation
increases capital accumulation by shifting portfolio from money to capital, and thereby, stimulating a
higher rate of economic growth (Gregorio, 1996).

The moderate inflation (the low and stable inflation) is helpful to faster the economic growth or
promotes economic growth (Mubarik, 2005).
Different studies have different findings in the relationship between inflation and growth.
However, most of the economists agree that the lower inflation promotes growth while higher
inflation discourages growth.

2.4.Conclusion
For more than two decades, the inflation rate has remained low, in contrast to the 1970s and
early 1980s. This is true regardless of which of the many available official price indices is used
to calculate the rate at which the price of goods and services rose.
A low inflation rate is especially significant since the U.S. economy was fully employed, if not
over fully employed, according to many estimates for the last three years of the 1991-2001
expansion and during 2006-2007.
Yet, contrary to expectations, the inflation rate accelerated only modestly. Keeping an
economy moving along a full-employment path without sparking higher inflation is a difficult
policy task.
During the last two recessions (2001 and 2007 to 2009), policymakers have been more
concerned about the threat of deflation (falling prices) than inflation, and they have pursued
unconventional policies to prevent it. Prices fell in 2009, but have risen at a low and stable
rate since. Given the relationship between inflation and the money supply, some economists

24
are concerned that the rapid growth in the portion of the money supply controlled by the Fed
since 2008 could cause rapid inflation. To date, those concerns have not been realized,
primarily because of the large slack in the economy
Because labor costs make up nearly two-thirds of total production costs, the rate at which they
rise is often regarded as an indication of future inflation at the retail level.
They tended to rise in the latter stage of the 1991-2001 expansion and to moderate during the
subsequent contraction, recovery, and expansion that ended in December 2007.
Rather than measure inflation by using the rate at which prices overall are rising, some
economists prefer a measure that reflects primarily the systematic factors that raise prices.
This yields the "underlying" or "core" rate of inflation. The overall inflation rate exceeded the
core rate in eight years during the 2000s.
Although economic theory does not prescribe an optimal rate of inflation, many economists
would support the goal of price stability, which former chairman of the Federal Reserve Alan
Greenspan once defined as existing when inflation is not considered in household and
business decisions.
Why should the United States be concerned about inflation? This study reports the distilled
knowledge of economists on the real cost to an economy from inflation.
These are remarkably more varied than the outlays for "shoe leather," long reported to be the
major cost of inflation ("shoe leather" being a shorthand term for the resources that have to be
expended on less efficient methods of exchanges ).
The costs of inflation are related to its rate, the uncertainty it engenders, whether it is
anticipated, and the degree to which contracts and the tax system are indexed. A major cost
is related to the inefficient utilization of resources because economic agents mistake changes
in nominal variables for changes in real variables and act accordingly (the so-called signal
problem). Inflation in the United States during the post-World War II era may not have been
high enough for this.
As known, day to day increment of price of goods and services is a key problem of economic
backwardness in Ethiopia to see the impacts of inflation on economic growth through assessing the
trends of general price rise from the year 1999-2015 E.C, and also describing its effects on the
living standards of the population that in turn affects their productive capacity and economic growth
in the Ethiopia.
Moreover, it also tries to review the recent average price level of goods and services and its causes
and, affects its overall effect on economic growth of Ethiopia, roles of the government in reducing
the problem severe price increase.
To summarize some measure of inflation, its causes in economic development, related theories
which define inflation, types of inflation and some controlling methods such as monitory policy,
fixed exchange rates and wages and prices control.
25
Lastly, to point out some policy that used to measure or to reduce its effects and causes on the
livelihood of the societies this leads to contribute the good economic performance of Ethiopia.
To some up, a close look at a resent average price rise in Ethiopia show that, a severe increase in
general price rise of goods and services became the chronic phenomenon on both living standard
of households and economic growth of Ethiopia which collectively leads to affect the economic
performance of the country as whole

3 Recommendation

 Generally depending on above reasons, the seminar tries to fill the

following gaps:
1.It removes data mixing which only concerns on post-liberalization period.
2. It tries to reduce confusions created by different researchers on the nexus of two
variables.
3. It examines the relationship between inflation and economic growth by
taking in to account other economic indicators in the analysis of two
variables relationship. Therefore, objective of the study is empirically to
examine the relationship between inflation and economic growth in
Ethiopia
26
 4. Inflation in Ethiopia is structural. Hence avoiding the structural
bottleneck of the economy should be given priority.

Most importantly structural bottlenecks of the agricultural sector shall be

removed, but at the same time removing the bottlenecks of the other
sectors also is important. In order to achieve this productivity must be
increased in the agricultural sector.

Since we have failed in feeding ourselves using small holder agricultural,

the government shall promote commercial farms (private sector).

5.Not only the government must improve productivity in agriculture, but due
consideration to increase the production of domestically consumed products
(i.e. Food items).

It is vivid that if productivity increases in flowers and coffee, then inflation

will rise despite the increase in agricultural output. So increasing productivity
of domestically consumed products must be done by providing incentives to
the farmer and in the private sectors.

6. Friedman states, inflation in Ethiopia is also a monetary phenomena. To

make money to contribute to the growth of the economy, but not to inflation,
it is necessary to anchor money supply growth in line with output growth. It
is also important to improve the national banks independence.

7 .Though budget deficit has been found to be in significant making a

detailed study of the impact of deficit on inflation should be done. Therefore
further study on the impact of deficit on inflation must be done.
8.There is still a controversy whether inflation is imported or not in Ethiopia. Even if
Gas Oil price has been found to be insignificant in affecting consumer price index in
Ethiopia in the findings of the study, it is impossible to make conclusions about the
impact of international price developments on Ethiopian consumer price index based on
Gas Oil prices. So it is important to make a detailed analysis of the impact of
international prices on Ethiopia CPI

27
9.Even though the study has not incorporated market structure variable, the recent act of
few traders on salt shows that a lot have to be worked to make the market more
competitive. Increasing access to information and avoiding oligopoly elements in the
economy must be given priority. In short a lot must be done to make the market as
competitive as possible

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