Working Paper 151 - The Dynamics of Inflation in Ethiopia and Kenya
AbstractEthiopia and Kenya have experienced strong economic growth during the last decade. However inflation, which was thought to be under control, reached 40 per cent in Ethiopia and 20 per cent in Kenya during 2011. The rise of inflation in Ethiopia and Kenya was not an isolated event; other African countries also experienced increased inflation. There are many potential causes for these increases, but recent swings in international food and energy prices are likely to have affected inflation in countries that depend on agricultural production and imported energy. Yet, there is no consensus on the causes of the rise in inflation: a common view is that expansionary monetary policy, primarily due to large government expenditures, is the main cause, possibly in combination with negative domestic food supply shocks. This paper presents an econometric analysis of the main drivers of inflation in Ethiopia and Kenya during the last decade. The approach is to apply vector error correction models to different sub-sections of the economies, which in the end are combined into a single inflation equation for each country. The data is monthly and spans 1999:11 to 2010:05 for Ethiopia and 1999:01 to 2011:11 for Kenya.� � The contribution of this paper is that it takes into account key sources behind the increase in inflation. There are, in principal, three potential drivers of inflation. The first is excess supply of real money balances. This can be caused by expansionary monetary policy or through central bank financing of government bonds. The second is external (imported) inflation and its effect on domestic prices: rapid surges in international food and energy prices are likely to spill over into domestic prices. The third is domestic supply shocks that create deviations between the current output and the optimal long-run growth path. In developing countries, such as Ethiopia and Kenya, agricultural supply shocks can create large disturbances to the domestic economy and inflation rates.� � Our approach is to investigate these three sources separately for each country; first by identifying deviations from long-run equilibrium relations and then bringing the results together in one model of consumer price inflation. For each of the three sub-sectors we formulate vector autoregressive models to test for long-run economic relations. After identifying long-run relations, we use single-equation error correction models to empirically determine the sources of inflation. Our models embed different theoretical propositions through the inclusion of the estimates of deviations from long-run equilibrium relations. This procedure allows us to test various hypotheses concerning the sources of inflation. Two key variables are agricultural production and GDP. Since they are not available at a monthly frequency, we interpolate yearly and quarterly observations to monthly observations. The Hodrick-Prescott filters are used to separate short-run cycles from long-run trends in GDP and agricultural production. The outcome of interpolation is that we can measure trends and annual swings in output gaps (but not within-season changes) and their effects on inflation. To identify the role of money market imbalances we test for basic long-run money demand equations. There exists a long-run money demand expression for Ethiopia but we failed to estimate one for Kenya. Yet, excess money supply does not affect inflation in the final model. Foreign price shocks are investigated through testing for parity conditions between domestic price indices and world market food and energy price indices in local currency. For international food prices, there are strong effects on the inflation rates in both Ethiopia and Kenya. In Ethiopia there is a long-run relationship between the domestic consumer price index for cereals and world grain prices. In Kenya there is a long-run relationship between the domestic consumer price index for food and world food prices. We do not find a significant effect from international energy prices on local inflations rates. This is possibly because the impact is already captured by world food prices, or because the link between world and domestic energy prices is weak due to market regulation and market inefficiencies. Domestic food supply shocks are clearly important in Ethiopia, where large harvests reduce inflation through their effects on domestic food prices. The evidence for Kenya is not as strong, which probably is due to market integration: when the error correction term for world food prices is removed from the model for Kenya domestic food supply shocks become significant. Our results point to a lack of anchor for inflation in both countries, arising from clear and well-functioning monetary or exchange rate policies. This could be due to the manner in which the authorities have chosen to deal with inflationary shocks historically. In both countries there have been periods without firm policy responses. For example, in Kenya the monetary authorities seem to have expected that the commodity price increase in 2011 would soon revert and therefore delayed policy responses. Another possibility is that traditional monetary policy has little power, as might be the case in countries that lack well-functioning financial markets. For example, in Ethiopia bank-to-bank credit ceilings had to be introduced to rein in money supply as some banks had large excess reserves. The main messages of the study are that food price shocks are significant drivers of inflation and that improvements in monetary policy, and possibly financial sector reform, are required to reduce feedback effects and anchor inflation expectations. The differences between Ethiopia and Kenya should be acknowledged. Financial sector reform is needed in Ethiopia, since the monetary policy transmission mechanism is weak due to high concentration among banks and holdings of large excess reserves. In Kenya the Central Bank increased its policy interest rate sharply in late 2011, and the tight monetary policy seems to have reduced inflation, indicating that the monetary authorities have some clout.
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Date of creation: 09 Sep 2012
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This paper has been announced in the following NEP Reports:
- NEP-AFR-2012-09-22 (Africa)
- NEP-ALL-2012-09-22 (All new papers)
- NEP-DEV-2012-09-22 (Development)
- NEP-MON-2012-09-22 (Monetary Economics)
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