Beyond Overheated Economy – Comparative Analysis of Ethiopian Fastest Growing Economy Recent Figures

By Grenchal Zharina
Feb 28, 2013

(IMF, 2012: Ethiopia Draft Review)

‘Tackling the opportunity cost of holding foreign exchange reserves given the returns in highly profitable infrastructure projects’

The term overheated economy in economics has two distinct avenues, but finally merged with same meaning. When fastest economic growth prolonged practice turned to high levels of inflation as per supply inefficiently to answer the economy demanded, it is taken as overheated economy. More simply, an overheated economy is the incompatibility of quick economic growth and the inability of supply to meet rising demand of goods and services.

On the other hand, the cause of overheated economy is mostly libeled to loose monetary policy over prolonged period of times. This is due to continuous low interest rate that stimulates credit in turn rapid money supply expansion extremely growing rapidly. The Asian financial crisis and the US sub-prim mortgage bubbles are best examples mentioned in many literatures of recent field economics. These studies assume that as money supply continues, it hampers GDP and the pressure of inflation results destroy a countries currency’s beyond marketable exchange rat to float. Such studies finally recommend ‘preventing an overheated economy through cooling measures like raising interest rates or putting more regulations on lending’.

However, the monetary policy of Federal Democratic Republic of Ethiopia is defined as ‘maintenance of price and exchange rate stability and creating conducive macroeconomic environment for continuous economic growth.’ Thus, the main operating tool for the implementation of monetary policy is sale of Treasury bills, setting of minimum deposit rate and reserve requirements. The attempts to slow down yearly inflation were done by the government not to have a loan of from National Bank of Ethiopia and foreign exchanges were set up to sale at satisfactory level.

Factors of broad money supply (M2) in Ethiopia are particularly domestic credit significantly claims on central government followed by net foreign assets shows momentous change in consecutive years. On the other hand, interest rate on both saving and time deposits had not significant change in the interest rate structure of the banking system. Though lending interest rate of commercial banks varies, the average point did not change that match among years. Significant difference observed among years in the exchange rate of birr per Dollar both in monetary policy decision (devaluation) and the market value deprecation of birr. The assignment thus tried to cover money supply market and foreign exchange rate Birr per Dollar in Ethiopia for the past five years both in short and long run.

The over all conceptual frame work in short run, the price P is sticky and the economy is not necessarily at full employment level of output (both P and Y exogenous). Thus, the interest rate R is the adjusting variable (equilibrating factor) of the money market. The temporary supply of money
by the Central Bank causes interest rate to fall in turn the domestic currency to depreciate in the foreign exchange market, and then investors buy foreign currency than depositing domestic currency.

On the other hand, the relationship among money supply, price and foreign exchange market is defined in long run where the price P is endogenous and taken as equilibrating factor. Because, in long run price P are flexible and the economy is assumed at its full-employment level of out put Y. In this case the interest rate R reached its real rate as well. Thus, the long run equilibrium level is just the value of P that satisfies the price level P depends on the ‘full employment ‘ of interest rate R and real out put Y. The domestic money supply and price level have proportional relationship.

P = Ms/L(R, Y) where L(R, Y) is aggregate money demand

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Beyond Overheated Economy – Comparative Analysis of Ethiopian Fastest Growing Economy Recent Figures