Central bank free essay sample

Moderate inflation is an inevitable consequence of sustained economic growth. It can enhance economic growth by mobilizing the resources of a country. and it is one of the most closely watched measures of an economy. most economists think that a little inflation is necessary in a growing economy, but high inflation rates are harmful to most people and to governments. For the last five years, Ethiopia has recorded sustaining economic growth. However, inflation in Ethiopia is beyond the break-even point. Instead of stimulating economic growth, inflationary pressure in Ethiopia seems to be on the verge of distorting the allocation of resources and is likely to be a deterrent to undertaking productive investments. It is quite clear that the main determinants of inflation in Ethiopia are imports, depreciation of the Ethiopian birr, and a decline in the domestic lending interest rates or an increase in broad money supply the Ethiopian monetary authorities need to tighten the stock of money in the country. We will write a custom essay sample on Central bank or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page A tight monetary policy could serve as an anchor for inflationary pressure in Ethiopia. Thus, it is absolutely vital that economic policymakers design strategies that could curtail the on-going erosion of purchasing power to curb inflation before it deepens the economic crisis and contributes to political instability. By and large, Ethiopia has recorded seventeen years of economic stagnation under the leadership of The Derg, a military government. In 1990/91, the growth rate of the Ethiopian Gross Domestic Product (GDP) was -3.2 percent, cyclical unemployment was about 12 percent, the rate of inflation was about 21 percent, and the country’s budget was at a deficit of 29 percent of GDP. For the last five years, contemporary Ethiopia has gathered momentum by recording a steady economic growth. Along with this growth, however, the country has seen an accelerated, double-digit increase in the price of goods and services. Thus, inflation has remained a scourge of the Ethiopian economy (Kassahun, 2002; Tadesse, Demissie, Goodo, 2008). Stated in simple words, Ethiopia at this juncture is faced with an overheating economy. With  the global soaring price of oil, wheat, corn, and minerals, this condition cannot be regarded as unique to the Ethiopian situation. What makes this a special case is that Ethiopia is a low-income country. The increase in National Consumer Price Index (the main gauge of inflation) has become very detrimental to the low-income groups and retirees who live off a fixed income. The risk of inflationary pressure is reducing the purchasing power of the Ethiopian birr. Since the current inflation rate in Ethiopia was â€Å"almost 40 percent year-on-year in May 2008, driven largely by rapidly rising domestic food prices† (IMF,2008), therefore an item which used to cost one birr a year ago now costs one birr and 40 cents. That is, the value of one birr is approximately 71 Given that a large portion of county’s population lives in absolute poverty (i.e., less than one dollar per day), it is time that the regime in power identifies the salient factors that might be contributing to inflation in Ethiopia. Also, it is absolutely vital that economic policymakers design strategies that could curtail the on-going erosion of purchasing power to curb inflation before it deepens the economic crisis and contributes to political instability (Desta, 1993). The focus of this study is to examine both the main causes and the consequences of existing inflationary pressure in Ethiopia. The first section provides the literature review, which briefly discusses the theoretical formulations of inflation The final section contains the summery and conclusion of the study and provides some suggestions on how to control the current inflationary pressure in Ethiopia and prevent the resurgence of inflation at a minimum cost in terms of output loss. 2. Review of literature 2.1. Determinants of Inflation There are various theories proposed by various economists to explain the determinants of inflation. In this study, the various theories of inflation are grouped into 1) inflation as an economic growth phenomenon, 2) demand-pull and cost-push theories of inflation 3) the monetarist explanation of the causes of inflation, and 4) fiscal budget deficit as a source of inflationary pressure. 2.1.1Inflation as an Economic Growth Phenomenon From theoretical and empirical perspective, determining the direction of causality between economic growth and inflation in the developing countries is very controversial ( Hossain Chowdhurry, 1996). In 1950s, the Structuralist Economist view of inflation, as pioneered in Latin America, persuasively argued that moderate inflation and economic growth are positively related. This was in contradiction to the policy advice of the international lending institutions (Meier, 1995; Mallik Chowdhurry, 2001). Stated in simple terms, inflation stimulates the economy since nominal wages may lag behind prices, allowing for slower adjustment to wage expectation. Similarly, the Keynesian economic perspective assumed that moderate inflation might accelerate economic growth by raising the rate of profit, thus increasing private investment (Jung Marshall, 1986). According to Meier, inflation accelerates economic growth in two ways: â€Å"by redistributing income from workers and peasants, who are assumed to have a low marginal propensity to save, to capitalist entrepreneurs, who have assumed to have a high marginal propensity to save and invest; and by raising the nominal rate of return on investment relative to the rate on interest, thus promoting investment† (1995). Capitalizing on the Keynesian theoretical framework, the ruling party in Ethiopia seems to attribute the surge in inflation to macroeconomic growth. As stated by Goodo, â€Å"The Ethiopian government admits that inflationary pressure has become very severe. However, it also claims that the economy has been growing at 10% for five consecutive years and it is healthy at present.† (Hassan, 2008). Using the full-employment model, it is possible to assume that if a nation achieves full employment, economic growth is likely to precipitate an inflationary situation. Since the 10 percent increase in nominal GDP cannot keep pace with a 40 percent inflation rate, the acceleration of economic growth seems to be overstated. In fact, it is possible to assert that double digit inflation in Ethiopia is nothing but a clear sign of an unhealthy economy (Goodo, 2008). As persuasively argued by Barro, the inflationary situation in a country could have a negative-structural-break effect on economic growth, if the sustained increase in prices is more than 15 percent (1996). The inflationary economic growth process generates distortions in the allocation of resources under the free market system. It may not bear fruit if the Ethiopian citizens do  not â€Å"have confidence in the stability of the value of money, and . . . if inflationary financing is not accompanied by governmental policies of holding down the wage and interest costs of business enterprises† (Meier, 1995, pp. 180).