Modeling Inflation Volatility and its Effect on Economic Growth in Ethiopia

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Inflation volatility is a serious problem in the conduct of monetary policy. This is because it makes economic planning difficult, affects investment decision and hence growth. This study is aimed at modeling inflation volatility and analyzes its effect on economic growth in Ethiopia. The study uses quarterly data on Consumer Price Index (CPI) and Gross Domestic Product (GOP) for the period 1991 /92 -2010/ 11 . To model inflation volatility as time varying process an extended form of GARCH (Generalized Autoregressive Conditional Heterosedasticity) model i.e. Threshold GARCH is used. The study finds strong evidence for the existence of Freidman-Ball hypothesis. TGARCH model is used to allow for asymmetric effect of positive and negative inflationary shocks and the result indicates strong asymmetric effect of inflationary shocks on inflation uncertainty. Co integrated VAR model and granger causality test are also used to see the relationship between inflation, inflation uncertainty and growth. From the cointegrated VAR model the growth rate of GOP affects inflation positively in the long run and negatively in the short run. The granger causality result indicates that inflation granger causes inflation uncertainty positively and inflation uncertainty granger causes output growth negatively. To prevent the negative consequences of inflation including uncertainty problem National Bank of Ethiopia (NBE) should restore public confidence via credible policy instruments. Furthennore detennining the threshold level of inflation-gro:vth relationship is important • to know the type of relationship that exists between growtl'i and ~n.



Modeling Inflation Volatility, Economic Growth