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BUDGET DEFICIT, CREDIT CREATION AND MONEY SUPPLY IN

ETHIOPIA

By

Wodaferahu Mulugeta

Forthcoming monograph

Abstract

This study investigated the interdependence among the budget deficit, credit

creation and money supply in the Ethiopian economy. The models are made

up of seven long run structural and two behavioral equations linking fiscal

policy, monetary policy, aggregate demand, and the external sectors of the

economy. The motivation for the study is derived from the fact that there israpid expansion of fiscal deficit and the desire to evaluate the impact of this

phenomenon on fiscal policy, monetary policy, aggregate demand, and the

external sectors of the economy (current account balance) using a set of

standard behavioral equations developed by Egwahikhide, (1997) and

Pentecost (2000). Furthermore, the differenced static money supply helps to

test whether the credit counterpart synthesis hold in the case of Ethiopia or

not.

Annual data from 1970/71 to 2003/04 was used to estimate the seven

structural and two behavioral equations. Since our focus is on the supply side

of financial markets all magnitude are expressed in nominal terms. The

models were estimated using the cointegration technique. In all the

equations the stationarty of variables in the long run, short run equations

were first tested and found to be cointegrated of order one, I (1). Individual

equations of the model satisfied ahave all the desirable properties of OLS.

The results indicate that that total revenue from import duties related

directly to the value of aggregate real imports, revenue reacts significantly to

real imports; government revenue as a ratio of GDP and its own lagged value

on the other hand predicts ninety eight percent of the government receipt,

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suggesting that as the economy grows, more revenue is likely to be

generated. Other government expenditures also respond to increases in total

revenue and to the previous year level of expenditure significantly. The

result of the non- coffee exports indicates the positive coefficient of relative

prices, in conformity with theoretical specification. Though having the

expected sign the impact of economic growth was found to be statistically

insignificant.

The second policy experiment considered the effect of budget deficit on

credit expansion. The result seems to indicate that budget deficit affects

domestic credit expansion significantly in the long run than the short run,

suggesting since the government appropriates a significant part of bank

credit at fairly low rate of interest output could reduce and very little

improvement in the net foreign asset position of the economy in the long run.

The result from the short run dynamics of domestic credit also supports the

above finding that credit counterpart synthesis holds in Ethiopia. That is the

increase in domestic credit to the government to finance budget deficit will

have crowding-out effect on private investment. Finally, the result from the

static money supply indicates that money supply has only temporary

effects/shock in the economy in the sense the deterioration of the balance of

payments due to high import demand in the long run will eventually help the

movement towards equilibrium by offsetting the initial increase in money

supply.

One important implication of this result is that sound macro economic

management that contains domestic agricultural output to increase will boost

the production of export products in the long run. Another important policy

implication of the study is that domestic credit priority to the government

accompanying credit restraint (shortage) to the private sector, increasing

money supply, the rise in the relative domestic price level, and devaluation

should be scrutinized carefully as credit restraint may result in reduced

output without much improvement in external balance of the economy

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