Interaction of Ethiopian and World Inflation: A Time Series Analysis; VECM Approach

Arega Shumetie Ademe

The research had tried to identify co-integration of the domestic inflation of Ethiopia with the world level. Given this, the study considered effect of world oil price increment on Ethiopian inflation by considering time series data from 1981-2012 sourced World Bank. Vector Error Correction Model was employed to model long run co-integration of variables and to identify the significant independent variables as well as speed of adjustment of the long run equilibrium. Different tests that are pre-conditions for this model were done by having respective methods. Based on the result obtained in the long run co-integration model world oil price, household level and government expenditure of the country, world level inflation and money supply growth of the country affect the domestic inflation positively as well as significantly. Given this, world oil price and government expenditure of the country affects the domestic inflation positively and in a significant level even in the short run. Speed of adjust of deviation from the equilibrium trend is not as such fast enough. Domestic inflation of Ethiopia is very responsive to each shock in the world level inflation and world oil price as depicted by the impulse response graphs.