Inflation - Growth nexus in Ethiopia: Evidence from Threshold Auto Regressive Model

Abstract

Achieving high economic growth with stable and low inflation level has long been the macroeconomic policy objective of Ethiopia. The Ethiopian economy, however, has gone through different paths of inflation and growth relationship over the last four decades. Before 2003, Ethiopia was well-known as a low inflation country with marginal economic growth. After 2004, however, the country had been in general hovering around double digit inflation. During the same period economic growth averaged 10.7%. This seems to suggest that the two variables are positively related. Quite a large number of theoretical and empirical researches, however, suggest that there is a threshold effect in the relationship between inflation and growth such that high inflation has an adverse effect on economic growth. Against this background, this paper investigates whether there is a threshold effect between the two variables in Ethiopia for the period 1971 to 2013 using annual data and Hansen’s Threshold Autoregressive (TAR) model. The empirical result does not support the existence of threshold effect between the two variables in the period. The possible reason for the non-existence of non-linearity might be related to the absence of the absence market led economic system and the low financial sector development of the study period mainly in first 25 years. As a result the informational friction that interferes with the efficiency of the financial system which finally inhibits long-run growth might be absent in the study period. Due to the small number of observations, however, this result should be interpreted with caution.

Keywords: Inflation, growth and threshold autoregressive