Budget Deficits, Money and Inflation: The Case of Ethiopia

The paper investigates the causal link among inflation, money and budget deficits in Ethiopia for the period 1964 to 2003 using the bounds test approach to cointegration due to Pesaran et al. (2001) and using a modified version of the Granger causality test due to Toda and Yamamoto (1995). To check the robustness of the bounds test, we also used two additional long run tests: the dynamic ordinary least squares (DOLS) due to Stock and Watson (1993) and the fully modified ordinary least squares (FMOLS) due to Phillips and Hansen (1990). The empirical evidence shows that there was a long run cointegrating relationship among the series with a unidirectional Granger causality running from money supply to inflation and from budget deficits to inflation. In contrast, fiscal policy does not seem to have any impact on the growth of money supply. The implication is that fiscal balance and the control of the money supply are essential policy tools for the long-run macroeconomic stability of Ethiopia.