BUDGET DEFICIT, CREDIT CREATION AND MONEY SUPPLY IN

ETHIOPIA
By
Wodaferahu Mulugeta
Forthcoming monograph

Abstract
This study investigated the interdependence among the budget deficit, credit
creation and money supply in the Ethiopian economy. The models are made
up of seven long run structural and two behavioral equations linking fiscal
policy, monetary policy, aggregate demand, and the external sectors of the
economy. The motivation for the study is derived from the fact that there is
rapid expansion of fiscal deficit and the desire to evaluate the impact of this
phenomenon on fiscal policy, monetary policy, aggregate demand, and the
external sectors of the economy (current account balance) using a set of
standard behavioral equations developed by Egwahikhide, (1997) and
Pentecost (2000). Furthermore, the differenced static money supply helps to
test whether the credit counterpart synthesis hold in the case of Ethiopia or
not.

Annual data from 1970/71 to 2003/04 was used to estimate the seven
structural and two behavioral equations. Since our focus is on the supply side
of financial markets all magnitude are expressed in nominal terms. The
models were estimated using the cointegration technique. In all the
equations the stationarty of variables in the long run, short run equations
were first tested and found to be cointegrated of order one, I (1). Individual
equations of the model satisfied ahave all the desirable properties of OLS.

The results indicate that that total revenue from import duties related
directly to the value of aggregate real imports, revenue reacts significantly to
real imports; government revenue as a ratio of GDP and its own lagged value
on the other hand predicts ninety eight percent of the government receipt,
suggesting that as the economy grows, more revenue is likely to be
generated. Other government expenditures also respond to increases in total
revenue and to the previous year’ level of expenditure significantly. The
result of the non- coffee exports indicates the positive coefficient of relative
prices, in conformity with theoretical specification. Though having the
expected sign the impact of economic growth was found to be statistically
insignificant.

The second policy experiment considered the effect of budget deficit on

credit expansion. The result seems to indicate that budget deficit affects
domestic credit expansion significantly in the long run than the short run,
suggesting since the government appropriates a significant part of bank
credit at fairly low rate of interest output could reduce and very little
improvement in the net foreign asset position of the economy in the long run.

The result from the short run dynamics of domestic credit also supports the
above finding that credit counterpart synthesis holds in Ethiopia. That is the
increase in domestic credit to the government to finance budget deficit will
have crowding-out effect on private investment. Finally, the result from the
static money supply indicates that money supply has only temporary
effects/shock in the economy in the sense the deterioration of the balance of
payments due to high import demand in the long run will eventually help the
movement towards equilibrium by offsetting the initial increase in money
supply.

One important implication of this result is that sound macro economic

management that contains domestic agricultural output to increase will boost
the production of export products in the long run. Another important policy
implication of the study is that domestic credit priority to the government
accompanying credit restraint (shortage) to the private sector, increasing
money supply, the rise in the relative domestic price level, and devaluation
should be scrutinized carefully as credit restraint may result in reduced
output without much improvement in external balance of the economy