Effects of Transmission Mechanism of Monetary Policy Channels on Economic Growth in Ethiopia: Cointegration and Causality Analysis Approach

Abstract

The study aimed at investigating and analyzing factors those effects of transmission mechanism of monetary policy channels on economic growth in Ethiopia using a 36 years’ time series data. To this end, variables such as economic growth (dependent variable), and other regress variables such as real lending rate, real effective exchange rate, credit for private sector, consumer price index, trade of opens, gross capital formation, and money supply are considered. An empirical model linking the real GDP to its theoretical effects is then specified. This study had employed the co-integration and vector error correction model (VECM) analysis with impulse response and variance decomposition analysis to provide robust long run effects and short run dynamic effects on the real GDP. All variables under consideration are integrated of order one I (1) and also co-integrated. Vector Error Correction Model/VECM/ results show that real GDP was positively and significantly affected by the real effective exchange rate, money supply, gross capital formation (investment), credit for private sector, trade of openness over a period of long-run; while real leading interest rate and consumer price index (inflation) have significant negative effect. The estimate of the speed of adjustment coefficient found in this study indicates that about a 31 percent of the variation in the real GDP from its equilibrium level is corrected within a year. The study suggests that lowering the lending interest rate can encourage more private investment because it will encourage private investors to borrow more, which will increase investment in Ethiopia. Since investment is one of the factors that determine the gross domestic product, this will result in an increase in the GDP.