Short-Run and Long-Run Relationships between Economic Growth, Inflation, Exchange Rate and Remittance in Ethiopia: Application of Vector Error Correction Model Approach
Background: Economic growth is the central aim of countries worldwide. Sustaining economic growth is among the main challenges in Ethiopia. This could be attributable to the fluctuations in domestic inflation and exchange rate.
Objective: The objective of this study was to analyze the short-run and long-run relationships between economic growth, inflation, exchange rate and remittance in Ethiopia.
Materials and Methods: The yearly time series data from 1990 to 2020 (30 years) was used. The Augmented Dickey Fuller (ADF) and Phillips-Perron (PP) tests of unit root were employed to examine whether the series became stationary or not at level. The Johanson co-integration test was performed to determine the co-integration of the variables in the long-term. After stationarity and integration tests were performed, the Vector Error Correction Model (VECM) was employed to estimate the model.
Results: The trace statistic and the maximum eigen-value test of co-integration showed that at least one co-integrating vector (r>1) exists in the system at 0.05 level of significance. The results provided that for economic growth, the system corrects its previous period disequilibrium at the speed of 27.34% yearly in the long-run. For inflation rate, exchange rate and remittance, the system corrects its previous period disequilibrium at a speed of 3.58%, 5.38% and 9.84% yearly in the long-run, respectively. Economic growth was negatively affected by inflation rate and positively affected by remittance in the shot-run. Inflation rate was negatively affected by remittance in the short-run. The exchange rate was negatively affected by economic growth and inflation and remittance was negatively affected by economic growth in the short-run.
Conclusion: The short-run changes in inflation and remittance had a strong and significant effect on the changing economic growth in the long-run. The study recommended that a monetary policy be formulated with the objective of achieving and maintaining price stability, as opening the market for receiving remittance through increasing investment and human capital and to ensure inflation rate stability as well as enhance local production and export trade.