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Explaining macroeconomic fluctuations in Ethiopia: the role of monetary and fiscal policies

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Abstract

A structural VAR approach is used to examine the role of monetary and fiscal policies in explaining macroeconomic fluctuations in Ethiopia. The main results are that an increase in government spending has an expansionary effect on output, while shocks in net taxes have a contractionary effect, with relatively small and statistically significant spending and net tax multipliers; that fiscal shocks are shown to have no significant effect on the exchange rate and a statistically significant effects inflation; that contractionary monetary policy is associated with a fall in output; and that the contributions of fiscal policy shocks are larger than that of monetary policy shocks in explaining movements in output, with roughly equivalent contributions coming from shocks in fiscal policy components. Moreover, the effect of fiscal and monetary policy shocks on output improved qualitatively and quantitatively when both policy variables were jointly examined rather than estimating them separately, suggesting the importance of joint analysis.

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Notes

  1. These sectors include agriculture and food security, roads, water and sanitation, education and health (Zerihun et al. 2016).

  2. Different identification schemes yield very similar results for government spending shocks (Caldara and Kamps 2008).

  3. Much of these findings in the literature have been for the United States (Cloyne and Hurtgen 2016).

  4. This exercise, not shown here to save space, shows that ignoring the net tax-government spending mix of fiscal policy reduces the effects of fiscal policy.

  5. The standard lag length selection criteria were used to choose the optimum lag length in the empirical model. Based on test results for serial correlation, model stability and other diagnostic tests, the lag length is set to four lags and robustness checks were also performed for higher lag orders. The VAR diagnostic test results are not reported in the paper in order to save space, and these results can be made available upon request.

  6. Moreover, an alternative monetary policy indicator is also estimated by factor analysis using 13 variables reflecting monetary conditions in Ethiopia in the spirit of Kucharčuková et al. (2016). The results based on this factor analysis are not presented here in order to save space and can be obtained upon request.

  7. The absence of contemporaneous response of fiscal shocks to exchange rate innovations is justified on the grounds of the home bias of public spending items (De Castro and Fernandez 2013; De Castro and Garrote 2015).

  8. Full computations of these elasticities can be obtained from the author upon request. The output elasticity of net taxes is comparable with (0.56) output elasticity of net tax for Ethiopia in Geda (2011).

  9. Elasticity of net taxes with respect to output and price from the literature

    Country

    U.S.

    Canada

    U.K.

    Argentina

    Brazil

    South Africa

    Author

    Perotti (2005)

    Ilzetzki (2011)

    Cerdiro et al. (2010).

    Ilzetzki (2011)

    Output

    1.95

    1.92

    0.79

    0.78

    0.45

    0.76

    1.18

    Price

    1.23

    1.09

    1.17

    –

    –

    –

    –

  10. Detailed descriptions of this approach were not presented here to save spaces and can be available upon request.

  11. In the baseline model, interest rates are used as monetary policy indicator, while monetary aggregates are used in the robustness check.

  12. The choice of the confidence interval width is standard in this kind of SVAR literature, following, e.g., Blanchard and Perotti (2002), Claus et al. (2006), Heppke-falk et al. (2006), Kim and Roubini (2008), Caldara and Kamps (2008), Cloyne and Hurtgen (2016), Buckle et al. (2007), Ramey (2011) and Fisher et al. (2016), who also chose a 68% confidence band to discuss their results.

  13. Favero and Giavazzi (2007) show that spending shocks have no significant effect on inflation.

  14. Different identification methods used in the literature yield very similar results for government spending shocks. However, these results for shocks in net taxes are mixed (Caldara and Kamps 2008).

  15. See Ilzetzki (2011) and Ilzetzki et al. (2013) for a similar way of defining multipliers. Since the analytical definitions of fiscal multipliers here are presented for government spending, the short-term impact and cumulative multipliers for net taxes can be defined following the definitions for government spending.

  16. Tax revenue to GDP ratio is 18 percent in sub-Saharan Africa (Zerihun et al. 2016).

  17. To check the sensitivity of baseline results to different alternative specifications, the model is re-estimated using alternative short-term interest rates and an alternative measure of monetary policy, monetary aggregates. The impulse responses, not reported here to save space, substantially confirm the baseline specification.

  18. Monetary policy shocks are represented by interest rate shocks and named as monetary policy effect (MPE). Government spending shocks and net tax shocks are aggregated to form a total fiscal policy effect (FPE).

  19. The relative contributions of fiscal policy components to output fluctuations, the relative importance of fiscal and monetary policy shocks to inflation movements and the contribution of each of six shocks to output fluctuations and inflation movements are also estimated using the same approach. However, in order to save space, these results are not reported here and can be obtained from the author upon request.

  20. Some authors also checked the sensitivity of the results for setting both to zero (\({\beta }_{tg}={\beta }_{gt}=0\)), see Ilzetzki (2011). These options were also checked in this paper, and the result confirms the insensitivity of findings to these possibilities.

  21. Blanchard and Perotti (2002) also showed that estimating a co-integrated SVAR model or a SVAR model in the first differences did not make any substantial differences.

  22. The robust results of the macroeconomic variables in Ethiopia during the global financial crisis should not be surprising as the financial markets in the country have been closed, and the capital market is also at its infant stage. Indeed, the government opened the financial markets very recently, just 2 weeks ago.

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Acknowledgments

I am very grateful to Emanuele Bacchiocchi for his insightful comments and suggestions, and I thank Massimiliano Pisani from the Bank of Italy, and participants of the 6th SIdE Workshop for Ph.D. students in Econometrics and Empirical Economics (WEEE), and of the department seminars of University of Milan and Pavia, for their helpful comments and discussions. I am also grateful to the participants of the seventeenth international conference on the Ethiopian Economy. The views expressed in this paper are those of the author and do not necessarily reflect those of the University of Milan and Pavia.

Funding

This work was supported by University of Milan and Pavia (Grant numbers R11772).

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Authors and Affiliations

  1. Department of Economics, Addis Ababa University, Addis Ababa, Ethiopia

    Alemu Lambamo Hawitibo

  2. Department of Economics, Management and Quantitative Methods (DEMM), University of Milan, Milan, Italy

    Alemu Lambamo Hawitibo

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Appendices

Appendix A: Diagnostic test results

See Tables 2, 3, 4 and 5.

Table 2 Co-integration test: number of co-integrating relations
Full size table
Table 3 Augmented Dickey–Fuller test results
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Table 4 ARDL bounded co-integration test
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Table 5 Zivot–Andrews (1992) test
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Appendix B: Impulse responses

See Figs. 6, 7, 8, 9, 10, 11 and 12.

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Hawitibo, A.L. Explaining macroeconomic fluctuations in Ethiopia: the role of monetary and fiscal policies. Econ Change Restruct 56, 1033–1061 (2023). https://doi.org/10.1007/s10644-022-09459-4

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