Exploring the link between exchange market pressure and monetary Policy in Ethiopia

Entrusted with the responsibilities of maintaining exchange rate stability, the central bank Ethiopia, namely, the National Bank of Ethiopia (NBE) has paid more attention to the maintenance of exchange rate stability in the formulation and implementation of monetary policy during the past years. These considerations often prompted the NBE to intervene in the foreign exchange market so as to influence exchange rate developments. A recent study that estimated an index of the Exchange Market Pressure(EMP) for Ethiopia over the period November, 2001 to December, 2005, on the other hand, reveals that in majority of the cases (in 42 months out of 49 months considered) the Ethiopian foreign exchange market was characterized by depreciation pressures (Abebe, 2006). According to a monetary model of exchange market pressure, an increase in domestic credit (expansionary monetary policy) will increase the EMP by decreasing foreign reserves, or by causing a depreciation of the exchange rate, or some combination of the two (Kim, 1985). The objective of this study is, therefore, to examine empirically the existence of such link between EMP and monetary policy in Ethiopia using the Girton-Roper monetary model of exchange market pressure and VAR technique. The result of the single equation model reveals that measure of the stance of monetary policy, i.e domestic credit growth, has a significant and positive impact on EMP. The VAR test provides further evidence supporting the claim that domestic credit has a positive impact on exchange market pressure. The estimated impulse response function (IRF) as well indicates a positive response of EMP due to a shock in domestic credit, implying that an expansionary monetary policy increases EMP in line with the traditional theory.