The Impact of Inflation on Economy and Finacial Sector

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1.1 background
A large body of facts associates’ financial sector development leads to boost the Ethiopian economic growth or vice versa, yet the channels through which inflation affects this relationship are not as much of systematically explored. The effect of inflation occurs through a wide variety of direct and indirect channels. Inflation increases transactions and information costs which directly inhibit economic development. For example, economic agents will find planning difficult when inflation makes nominal values uncertain. Firms and individuals will be reluctant to enter contracts when inflation is imperfectly predicted and judgments about absolute and relative prices are uncertain. The reluctance to enter contracts over time will inhibit investment and entrepreneurship, which will affect resource allocation and economic growth.

The extent that high inflation disrupts the smooth operation of a nation’s financial markets and institutions, it also discourages their integration with the rest of the world. Since high inflation is often variable inflation as well, there will be considerable uncertainty about future prices, interest rates, and exchange rates, which in turn increases the costs of hedging financial risks among potential trade partners. If inflation also increases a currency’s vulnerability to speculative attack, hedging instruments will become even more expensive and difficult to price. All of this will discourage trade and inflows of foreign capital. (Bruno and Easterly, 1998)

A few studies examine the inflation-finance-growth nexus. Haslag and Koo (1999) and Boyd et al. (2001) show that inflation is associated with financial repression. Rousseau and Wachtel (2002) identify an inflation threshold for the finance-growth relationship, finding that finance affects growth positively only when annual inflation can be held below a threshold that lies between 13 and 25 percent for the world, depending on the measure of financial depth that is chosen. They also find that disinflations are related to strong positive effects of finance on growth.

1.2 Historical trend overview of inflation, economic growth and financial sector development In Ethiopia
In this study year 2006 is used as a reference period (i.e. December 2006=100). Similarly Central Statistics Agency (CSA) uses this year for CPI computation and we also follow the same year for other economic variables like for GDP, private credit, population, net export and capital formation. This is not without reasons it is after 2006 that many macro variables changes in different ways example inflation soared relative to the years before and inflation is one of the main indicator of macroeconomic stability of the economy. And inflation is one of the main indicators of macroeconomic stability Therefore it is convincing to use this period as references period and adjust other variable by the same year and all are converted into index number.

Figure 1.1 below illustrate the fact that from the year 1993 – 2003 inflation is in the range of 5% and 10%, hence GDP and CPI goes together that is they are related positively this might be due to the fact at low level of income inflation positively affects growth or else according to Keynesians school inflation may relate positively if inflation emerges as a byproduct of increasing aggregate demand. In this Keynesian framework, it is not the case that inflation is itself a positive engine of growth, certainly not a primary growth-inducing force. The point is rather that, if rising aggregate demand is leading to increased growth, then some inflationary pressures are likely to emerge in this scenario as a relatively benign byproduct (Robert Pollin et al 2005). And a structural break happens before the eve of Ethio-ertrian war in the year 1997 and 1998 due to good harvest because of good rain or supply shocks. Government has no policy at that time to avoid price fall such as price...
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