MODELING THE INTERDEPENDENCIES AMONG EXCHANGE RATE, INFLATION RATE, AND ECONOMIC GROWTH IN ETHIOPIA: APPLICATION OF SIMULTANEOUS-EQUATION MODEL

Abstract

Economic growth is a primary issue in both developing and developed nations. The two important elements for measuring the macroeconomic performance of a country are inflation and exchange rate. The economic growth in Ethiopia in the last decades has been affected by inflation and exchange rate levels, but the magnitude and direction of short-run and long-run causalities, and the statistical significance of those relationships, have not been properly addressed. The objective of this study was to investigate the interdependencies among exchange rate, inflation rate, and economic growth in Ethiopia for 31 years from the period 1991 to 2021 by using a simultaneous equation model. The main econometric problem that may rise when estimating a simultaneous equation model is endogeneity problems. Additionally, the diagnostic test should be tested for endogeneity before analytical techniques of simultaneous equation model were applied. In this study there are three equations in a simultaneous equation model were identified in both rank and order condition. The reduced form model shows that there are 21 reduced form parameters as against 17 structural parameters, which implies that the model is over-identified. The estimated results indicated that there is a negative and statistically significant relationship between the exchange rate and economic growth, and there is a positive and statistically significant relationship between the inflation rate and economic growth. In addition, in the exchange rate model, there is a positive and statistically significant relationship between the exchange rate and inflation rate, and there is a positive and significant relationship between the exchange rate and economic growth. The findings support a bidirectional relationship between economic growth and exchange rate. Unidirectional relationship between inflation rate and economic growth, as well as between exchange rate and inflation rate. This study recommended that monetary and fiscal policies that stabilize the inflation rate, and economic reform is required to complement the exchange rate policy adopted.