A Dynamic Monetary Model of Ethiopia

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Addis Ababa University


The paper has developed a very small monetary model of the Ethiopian economy. The model is made up of five behavioral equations linking the monetary sector, aggregate demand and supply, and the external sectors of the economy. The motivation for the study is derived from the desire to present a model that would help us analyze the behavior of key macroeconomic variables in Ethiopia and help us address the effectiveness of stabilization policy. The model was estimated using the cointegration technique.. In all the equations the variables in the long run equations were first tested and found to be cointegrated of order one. The integrated series of variables were then tested for cointegration by the Johnsen Cointegration test. Annual data from 1965/66 to 2001/02 was used to estimate the behavioral equations of the model. Individual equations of the model satisfied a number of statistical diagnostic tests and the model as a whole was found to be stable with very good within sample tracking performance. Two dynamic counterfactual simulations were carried out using the model. The first simulation tried to assess what the performance of the Ethiopian economy would have been without the 1992 devaluation. The results indicate that without the devaluation, the performance of the external sector would have been very poor. The overvalued exchange rate would have resulted in a deteriorated trade balance, on average by 26 percent per year. The second policy experiment considered the effect of sustained credit contraction. The results seem to indicate that sustained domestic credit contraction could reduce output with very little improvement in the net foreign asset position of the economy. The policy implications that could be derived from the study are that overvalued exchange rate adversely affects economic performance. This empirical finding is similar with the findings of Ghura and Green(1993). Another important policy implication of the study is that policies accompanying devaluation i.e. such as domestic credit restraint should bescrutinized carefully as credit restraint may result in reduced output with out much improvement in external balance of the economy. Keywords: Stabilization policy, Monetary Model, Cointegration, Simulations, Devaluation, Monetary Restraint



Stabilization policy, Monetary Model, Cointegration, Simulations, Devaluation, Monetary Restraint