THE RELATIONSHIP BETWEEN FOREIGN EXCHANGE RESERVE AND INFLATION IN ETHIOPIA

Abstract

There is higher inflation rate in Ethiopia that increase from time to time. Different studies identified different causes of inflation. Among these causes is foreign exchange reserve increase. But findings on relationship between inflation and foreign exchange are not conclusive. Therefore, this study was conducted with an objective of identifying the relationship between foreign exchange reserve and inflation in Ethiopia during the period of 1991 to 2018. The study data was collected from secondary sources. After checking stationarity of the data, the study has employed Autoregressive Distributed lag model (ARDL) model that the foreign exchange reserve (FER)is integrate at I(0) and Consumer Price Index (CPI) I(1). The study reveals that the relationship between change in foreign exchange reserves and inflation rate is positive in Ethiopia during the period of 1991 to 2018. The effect of foreign exchange reserve in short run estimation is insignificant. But in long run estimation, foreign exchange reserve and inflation are positively associated during the study period. The long run estimation is similar with the earlier studies and consistent with hypothesis of the study. From this, the study concludes that the increase of foreign exchange reserves results on sustained growth of general price level. The study recommends to improve sterilization policy of the country.