The Behavior of Money Supply in Ethiopia

<p>There is now a consensus that monetary authorities in developing countries should control the supply of money. This is especially strengthened by the fact that in those countries the Keynesian transmission fails to work due to the thinness of financial markets (Khan and Knight, 1981). This makes the quantity theory of money attractive. However, monetarism as a tool of monetary policy rests on two preconditions in that the demand for money function should be stable and the money supply controllable (Bolnick, 1975). There are several literatures done in many countries emphasizing on the money demand function and its stability assuming the money supply as an exogenous policy variable, which can effectively be controlled by the monetary authorities. There is, however, an ongoing debate among monetarists and non-monetarists regarding the monetary authorities’ ability to control the money supply.</p> <p>According to monetarists, monetary authorities can have effective control over the supply of money. They argue that the behavioral pattern of the public and the banking system are stable and predictable enough to allow the monetary authorities to control the stock of money. Others, on the other hand, argue that the determination of the stock of money is part of the simultaneous solution for all variables in the financial and real sectors of the economy. Brunner and Meltzer (1972), for example, while criticizing Friedman’s monetary theory, argued that the stock of money can be expressed as a function of a few variables such as income and interest rate and hence money supply is an endogenously determined variable in macro-economic models of nominal income. Shetty (1990) describes this development as follows: “New fluctuating relationships between monetary and real variables have given rise to fresh debate regarding the causality between money, output and prices, that causality is not uni-directional, that money stock does adjust to price changes, that bi-directional causality does exist between money and nominal income." (p.355) Specifically, some authors also have doubted the ability of monetary authorities control on money supply in developing countries under conditions of limited capital markets, fixed exchange rate regime, large non-monetized sector, fluctuating exports and exchange inflows (Furness, 1975, Shetty, 1990). For example, Yohannes (1996) indicated in his study of “Foreign Exchange Inflow as a challenge to Monetary policy---” that foreign exchange inflows can have impact on the ability of monetary control in Ethiopia taking the 1994/95-coffee boom as an example. The significant rise in export proceeds challenged the monetary authorities’ control over the money supply and in consequence to this the general price level rose dramatically. Hence, apart from checking the demand for money and its stability, there should be studies on the behavior of money supply to identify its determinants and its controllability. Although the monetary authorities’ ability to control money supply in developing countries is doubtful, so far research focus in developing countries including Ethiopia has been placed only on analyzing money demand taking money supply as exogenously given variable that does not affect the effectiveness of monetary policy.&nbsp;</p>