Abstract:
Economic growth is a primary issue in both developing and developed nations. The two important
elements for measuring the macroeconomic performance of a country are inflation and exchange
rate. The economic growth in Ethiopia in the last decades has been affected by inflation and
exchange rate levels, but the magnitude and direction of short-run and long-run causalities, and
the statistical significance of those relationships, have not been properly addressed. The objective
of this study was to investigate the interdependencies among exchange rate, inflation rate, and
economic growth in Ethiopia for 31 years from the period 1991 to 2021 by using a simultaneous
equation model. The main econometric problem that may rise when estimating a simultaneous
equation model is endogeneity problems. Additionally, the diagnostic test should be tested for
endogeneity before analytical techniques of simultaneous equation model were applied. In this
study there are three equations in a simultaneous equation model were identified in both rank and
order condition. The reduced form model shows that there are 21 reduced form parameters as
against 17 structural parameters, which implies that the model is over-identified. The estimated
results indicated that there is a negative and statistically significant relationship between the
exchange rate and economic growth, and there is a positive and statistically significant
relationship between the inflation rate and economic growth. In addition, in the exchange rate
model, there is a positive and statistically significant relationship between the exchange rate and
inflation rate, and there is a positive and significant relationship between the exchange rate and
economic growth. The findings support a bidirectional relationship between economic growth and
exchange rate. Unidirectional relationship between inflation rate and economic growth, as well
as between exchange rate and inflation rate. This study recommended that monetary and fiscal
policies that stabilize the inflation rate, and economic reform is required to complement the
exchange rate policy adopted.
