Demand for Money and Inflation in Ethiopia

Abstract

One of the vital components of the macroeconomic model that helps policymaking is the demand for money function. Having reliable predictions on the money demand function helps in determining the optimum growth of money supply which is vital in controlling the inflation rate in the economy and also preventing monetary disturbances from affecting real output. In order to formulate and estimate the money demand function in Ethiopia, this study used quarterly data from 2000Q3 to 2021Q2 and employed the Ordinary Least Square method and Engle-Granger two-stage procedure for empirical analysis. The empirical result from the models indicates that, in the long run, all variables (real GDP, CPI inflation, real effective exchange rate, real interest rate and lagged real money balance) are significantly affecting the demand for money in Ethiopia. Whereas, the estimated coefficients of the short-run variable show that the real effective exchange rate, CPI inflation, and lagged real money balance are the main determinants of demand for money while the real GDP and real interest rate are insignificant. Another important finding is that absolute value of the coefficient of the error correction term implies that about 54.2% of the disequilibrium in real money demand is counter-balanced by short-run adjustment in each quarter. The study suggests that in conducting monetary policy, policymakers should consider not only the behavior of income and price but also the movement of exchange rates. The study also calls for appropriate formulation and estimation of the all-encompassing demand for money function that is capable of bringing stability to the growth of money coupled with sustainable economic growth.