A Dynamic Monetary Model of Ethiopia
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Date
2003-07
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Addis Ababa University
Abstract
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
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Keywords
Stabilization policy, Monetary Model, Cointegration, Simulations, Devaluation, Monetary Restraint