Deficit Financing, Money Supply and Inflation in Ethiopia

This paper has examined the causal link among budget deficit financing, money supply (M2), and inflation, in Ethiopia using time series annual data over the period 1974/75 2013/14. In analyzing the data, cointegration approach under the framework of the vector error correction model was employed. The model has supported several statistical tests and hence it is robust. The study concluded that domestic sources of budget deficit financing and money supply (M2) growth were long term determinants of inflation. In the short run, in contrast, inflation inertia and local currency depreciation were found the prime sources of inflation. The policy recommendations arising from the study are, intensify policies to achieve food security, boosting revenue generation through a comprehensive tax reform (expanding the tax base, improving tax administration and collection), improve the financial markets of the country and rely on it (as a sources of financing deficit) rather than on debt monetization and enhancing credibility and transparency of the national Bank of Ethiopia to curb inflationary expectations.