Macroeconomic Determinants of Economic Growth in Ethiopia. A Vector Correction Model

Thesis (M.A.), 2016

75 Pages, Grade: 3.89









1.1 Background of the Study
1.2 Statement of the problem
1.3 Objectives of the study
1.4 Justifications of the study
1.5 Significance of the study
1.6 Scope of the study
1.7 Limitations of the study
1.8 Organization of the paper

2.1 Theoretical Literature Review
2.2 Empirical Literature Review
2.3 Conceptual Frameworks

3. Research Design
3.1 Data Source
3.2 Model specification

4.1 Descriptive Analysis
4.2 Econometric Analysis
4.2.1 Unit Root Test for Stationerity
4.2.2 Selection of optimal lag length
4.2.3 Results of Cointegration Tests and Long run Estimation
4.2.4 Test for zero restriction on long run variables and interpretations of result
4.2.5 Model diagnostic tests
4.2.6 Short Run Error Correction Model
4.2.7 Stability condition of the model
4.2.8 Impulse response function
4.2.9 Forecasting

5.1 Conclusion
5.2 Recommendations




First and for most, I would like give my glory and praise to the almighty God who helped me in every action for conducting this paper. Next I would like to express my gratitude to my supervisor Dr. Zerayehu Sime for his valuable comments, guidance and encouragements that he gave me during my career.



Table 1. Average growth rate of GDP from 1974-2014

Table 2. Average saving to GDP ratio from 1974-2014

Table 3. Average growth rate of GDP in Ethiopia from 1974-2014

Table 4. Unit root test result

Table 5. Lag order selection criteria

Table 6. Rank of cointegrating vectors

Table 7. Long run coefficients

Table 8. Test for autocorrelation

Table 9. Short run dynamic coefficients



Figure 1. Interaction of variables in economic growth process

Figure 2. Trends of real GDP growth in Ethiopia from 1974-2014

Figure 3. Trends of real GDP and saving in Ethiopia from 1974-2014

Figure 4. Growth trend of export in Ethiopia from 1974-2014

Figure 5. Trends of FDI in Ethiopia from 1974-2014

Figure 6. Trends of government expenditure on health and education from 1974-2014

Figure 7. Trends of aid received by Ethiopia between 1974 and 2014

Figure 8. Growth trend of external debt in Ethiopia between 1974 and 2014

Figure 9. Unit root circle for stability


Abbildung in dieser Leseprobe nicht enthalten


The main objective of this study is to investigate the macroeconomic determinants of economic growth in Ethiopia from 1974-2014. A Vector Error Correction Model (VECM) to cointegration approach is applied in order to investigate the long run and short run relationship between real GDP and its macroeconomic determinants. The finding of the cointegration test shows that there is a stable long run relationship between real GDP, gross domestic saving, labor, human capital, export, FDI, foreign aid and external debt. The long run empirical result reveals gross domestic saving, human capital proxied by government expenditure on health and education, and labor force have positive and significant relationship with real output. However export and real GDP have positive but insignificant relationship. External debt, foreign aid and FDI have negatively significant relationship with real GDP during the study period. The short run dynamic results shows that human capital, saving and FDI have positive relationship with output growth whereas labor, export, aid and external debt have negative relationship with Real GDP. The coefficient of equilibrating error term (ECM) suggests that the speed of adjustment (feedback effect towards the long run equilibrium) takes few years for full adjustment when there is a shock in the system. In order to sustain long run growth the government or policy makers should design appropriate policies that results in the efficient use of resources contributing to economic growth and proper management of variables resulting to negative growth in order to reverse their effect on output.

Key words: Economic growth, Determinants, VECM


1.1 Background of the Study

The political economy of growth is sensitive and difficult subject in today’s Ethiopia because of lack of accurate information and uncertainty surrounding initiating dialogue on the subject. The history of Ethiopia has predominately been history of war/conflicts for the reasons like religion, land, nationality or mixture of these but mainly aimed at power and resource control.

Two opposing interest groups have characterized Ethiopian history prior to 1974 people’s revolution. The landlords and farmers with state (Alemayehu & Addis, 2014). Ethiopia has experienced three main political regimes with five economic policy shifts. The first was the imperial regime (1970-1974) which was a mixture of feudalism and capitalism as the main framework of the economy. During this regime the government attempted to launch a centrally administered development plan with the aim of building agro-industrial economy which in general was not successful. Onwards the government established three consecutive five year plans with the objectives of infrastructural development, enhancing commercial agriculture, agro-industry and manufacturing (Zerayehu, 2013).

The first five year plan (1957-1963) focused on industrialization and infrastructural development giving due attention to industries producing light consumer goods for domestic consumption. However the plan ignores agriculture which finally leads to failure. The second five year plan (1963-68) was launched with the objectives of building heavy industries that produce chemicals and metals. This time shows growth accompanied by increased investment, exports and employment. But the plan ends with failure for the same reason in the first five year plan. The other was the third five year plan (1969-1974) which favors commercial agriculture and industries. This plan didn’t give satisfactory result because of poor performance of agriculture and resource mobilization as well as high domestic transportation cost and natural disasters which leave the economy without transformation (Zerayehu, 2013).

After overthrowing the imperial regime the socialist government seized power in 1974. During this period colonialism in Africa had made Ethiopian independence besieged one. Hostile and powerful colonial powers have also encircled it. As a result Ethiopia emerged as a militaristic state (Alemayehu & Addis, 2014). The first action of this government was nationalization of emerging private industries and marginalization of private investors. The government has drawn a ten year perspective plan which has the major objective of improving communities’ wellbeing. However the economy’s growth rate was negligible because of war and conflict as well as natural disaster. Even the socialized industries with preferential right of banks credit were not efficient and profitable. Following this crisis and declining the ideology of socialism in especially in Soviet Union the government shifted its policy to mixed economic system in 1988. However the government was not able to bring economic growth rather retarded the growth rate back with 1.4 percent as well as acute shortage of foreign currency reserves.

The general growth rate of GDP, GDP percapita and population growth during derg regime was 1.6% 0.9 % and 2.5%. This overall growth rates of GDP and GDP growth rates are by far the lowest growth rate which never brings any economic improvement during the regime. However the population growth rate is very high which is beyond the absorption capacity of the economy during that time. On the eve of the revolution of February 1974 Ethiopia was in the final year of the implementation of the Third Five Year Plan (TFYP) and wrapping up the preparation of the Fourth Five Year Plan. During five years before revolution, the average rate of growth of gross domestic product (GDP) in real terms for the period 1967/68-1971/72 was 4 per cent per annum. In per capita terms the average growth rate was about 1.7 percent. However, in 1972/73 the GDP growth rate began to decelerate, amounting to 2.5 percent, which means that per capita GDP was stagnating in that year. The still lower performance of 1973/74 was mainly due to the revolutionary upheaval which created economic disruptions and uncertainties (Eshetu & Mekonnen, 1992).

Above all the average growth rate of population is greater than the growth rate of GDP which is an indication of very low growth rate. The growth rate of GDP during 19-85 was highly negative because of catastrophic drought and famine in the region during the period (Eshetu & Mekonnen, 1992).

Ethiopia experienced very high growth rate during the derg regime between the periods of 1986- 87 which was 7.9 % per annum. During this period the average percapita GDP growth rate is 4.7 % and the average population growth rate is 3.2 %. This achievement is because of best rain season at the time which is also an indication of heavy dependence of the economy on agricultural sector. The average annual growth rate of GDP and per capita GDP growth rate from 1988-90 was 1% and -2.3 % respectively. This was because of intensive internal war that takes place in Ethiopia in order to overthrow the government and to retain power by the ruling government.

After a long period of internal conflict in May 1991 EPDRF toppled socialist regime. During this period the government undertakes a series of economic reform programs of IMF and WB by focusing on private sector development through monetary policy and fiscal policy, restricting the role of the government and reducing poverty through stable macroeconomic environment (Zerayehu, 2013). Ethiopia saw one of the best economic performances since the early 1990s. The growth of the economy was impressive with an average annual growth rate of 9 percent per annum since 2000. The average annual growth rate escalates to 11 percent per annum if the abnormal first three years removed. In addition to fast growth the macroeconomic performance was also very good except for the last five years where inflation because of lack of prudent monetary and fiscal policy was a major problem (Alemayehu & Addis, 2014). The government also drew the growth and transformation plan (GTP) in 2010 which is aimed as stepping stone to reach middle income countries in 2025. Their main policy instrument was ADLI to achieve 11 % annual growth rate of GDP allowing the per capita income to reach 698 USD though it was believed to be ambitious (Zerayehu, 2013).

Generally Ethiopian economic history is characterized by ups and downs of economic performance owing to different regimes of ruling governments and their associated policies and objectives for what the government set policies. This can be the reason for the low level of living standards that the present Ethiopia is encountering. So the study of economic growth and their determinants is interesting and hot phenomena that is to be addressed to have high level of potential growth that lifts out the society from poverty.

1.2 Statement of the problem

The process of economic growth and the source of differences in economic performance across nations are some of the most interesting, important and challenging areas in modern social science. And it is important to focus on the study of economic growth rather than welfare, consumption or happiness indicators because it mainly determines the material wellbeing of billions of peoples. A number of economists argue that growth is the best way to achieve massive reduction in poverty.

The Ethiopian economic growth is characterized by mixed, erratic and averagely poor performance exhibiting positive and negative real GDP growth rates. For example it shows a negative growth rates seven times between 1981 and 2010 (Zerayehu, 2013). This shows it has been moving back and forth owing to different factors. In addition to poor and erratic growth the economy is characterized by lowest and stagnant share of manufacturing sector which is expected to enhance productivity and sustain economic performance.

On the other hand official report on growth poverty and inequality show that Ethiopia has registered a two digit rate of economic growth in the last decade and has made immense progress in poverty reduction (Alemayehu & Addis, 2014). However many suspect that the current unprecedented high growth rate is attributed to a combination of pro poor growth policy (since 2003 onwards) and state led development program (since 2005 onwards) (Zerayehu, 2013).

Despite being one of the fastest growing economies in the last decade Ethiopia is one of the poorest countries in the world. Ethiopia is more than thirteen times poorer than USA in 2000 GDP (income per capita) (Acemoglu, 2007) accompanied by full of conflict, drastic policy changes and reversals. However in the last ten years Ethiopia is amongst fastest growing non-oil economy as well as land locked country. With population of 98.9 million (world population review 2015), Ethiopia’s economy have grown with annual growth rate of 9.7 % in 2012/13 fiscal year.

Added to the lowest living standard this stochastic growth is the main problem in Ethiopia. Otherwise solved, Ethiopia have no any guarantee not to encounter the problems that she have faced in the last three regimes as far as the growth of the economy is concerned. This premise is evidenced by the growth patterns that she comes across in the last four decades. So research is mandatory on what affects the Ethiopian economic performance over the past periods and what is injected to the economy to make her register a relatively good economic growth rate over the past decade. It promising that, the Ethiopian economy is performing well in the last decade as compared to the past. However some argue that even this growth rate is not enough for small country like Ethiopia to achieve the intended objectives of joining middle income countries and above all lifting the society out of poverty

There is no consensus among scholars’ academicians and policy makers (politicians) on the causes of this mixed, erratic volatile and low performance of the economy for long periods and the fast growth rates registered in the last decade. Many researches have been conducted on what is the main driving force behind this growth and what are the causes for past lower growth rates in Ethiopia that makes the country the poorest in the world. (Alemayehu &, 2007), conducted a research entitled Growth, Poverty and Inequality in Ethiopia: Which way for Pro- Poor Growth: and found that capital has no significant economic impact and even it is not statistically different from zero. This is different from the conventional economic theory in which capital is the determining factor in economic growth and the premise that it is source of variation in growth for countries. However labor has significant impact on the growth as per their finding.

On the other hand (Tewodros G. , 2014) in his research entitled determinates of economic growth in Ethiopia using ARDL model found a positive relationship between physical capital, labor and economic growth in. On his study he has tried to include some determinates of economic growths which are area of recent interest but he hasn’t included some important and main determining forces in Ethiopian economic growth.

(Zerayehu, 2013), found that sectoral total factor productivity is one of the principal sources of perpetual and permanent effect on economic growth as it has nature of an increasing returns to scale. TFP represents technological changes, technical efficiency, and allocative efficiency scale effects. And this TFP is gained through FDI, imported capital goods, foreign trade openness and trade liberalization as Ethiopia has no well-organized R& D that produces this efficiency.

This shows that there is mixed evidence on the driving forces of economic growth on one hand and lack of exhaustiveness in at least the main determinants on the other hand. So the researcher is going to analyze the main macro-economic determinants of economic growth by being exhaustive as much as possible and including the basic factors believed to affect growth and mixing the variables used in the past research.

In relation with the above premises the research will answer the following basic questions:

- What are the main driving forces in the growth of Ethiopian economy?
- What is the magnitude and direction of each variable on economic growth?
- How these variables interact to cause growth?

1.3 Objectives of the study

1.3.1 General objective

The general objective of the study is to provide comprehensive and critical exploration on the main macroeconomic determinants of economic growth in Ethiopia from 1974-2014.

1.3.2 Specific objectives

The specific objectives of the study are:-

- To examine the main macroeconomic determinants of growth in Ethiopia
- To analyze the interaction of these variables in growth process
- To assess the short run and long run relationship among these variables
- To give critical answers to the present debates over the driving forces as it is whether derived from external resource or domestic resource mobilization.

1.4 Justifications of the study

Several studies have been undertaken on economic growth in Ethiopia. These researches are done mostly on impact of one or two variables on economic growth in different time. However, much is not done on the determinants of growth in Ethiopia as compared to other world. But, it is difficult to generalize the findings of other world economies to Ethiopian economy since Ethiopia has different social, political, economic and institutional setup that distinguishes her from other world. Therefore, a research on this area is mandatory to identify the main determinants of economic growth to disprove theories related to the issue or to confirm it.

1.5 Significance of the study

The research is important for different stake holders as an input for the purpose they intended to use it. It will be used as a source of literature for scholars or academicians for further study on this area. The research is also used as policy recommendation for policy makers if believed to be important for their purpose. The research starts uses VECM method by starting from the simple Coub-Douglas production function to Lucas model of human capital. However it ends up including many more variables other than labor, Capital and human capital. So this paper is important to scholars by giving them insight about how to derive the other variables from the initial production function.

1.6 Scope of the study

The study explores the main macroeconomic determinants of economic growth in Ethiopia from 1974 to 2014 using time series data from different sources.

1.7 Limitations of the study

In conducting this research, some problems were encountered that have adverse effect on the output and quality of the research. The first problem was data shortage on some variables on one hand and the inconsistency of the data collected from different sources. The second problem was shortage of time in order to undertake the research. However, the researcher tried to fix the problems as much as possible and completed the research on time.

1.8 Organization of the paper

The paper consists of five chapters with different sections and sub-sections. The first chapter presents the introduction for the paper and the second chapter states the theoretical and as well as the empirical literature reviews. The third chapter presents the research design that is employed in the paper. The forth chapter presents the result and interpretation and finally the last chapter presents the conclusions and policy implications of the finding.


2.1 Theoretical Literature Review

The classical literatures on economic growth and development have been explained by four major strands of thoughts. The linear stages of growth, the pattern of structural change, the international dependence revolution and free market counter revolution (Todaro & Smith, 2011).

During 1950s and 60s theorists viewed economic development as a series of successive developmental stages through which all countries have passed which was developed by W. Rostow. According to him the transformation from underdevelopment to development can be described in terms of series of steps through which a country must proceed. These stages are; the traditional society, the precondition to take off, the take off stage, the drive to maturity and the age of high mass consumption (Mallick, 2005). Rostow argue that all developed countries had passed these five steps and it is inevitable for least developed counties to pass through these steps too. One of the principal policies of development important for takeoff is the mobilization of internal and external saving in order to generate enough capital formation to accelerate economic growth (Todaro & Smith, 2011).

The other classical economists were Harrod and Domar. They argued that every economy must save or put aside some portion of its income if only to replace depreciated capital goods. For a country to grow new investments and net additions to the capital stock is necessary. At all these two economists give emphasis to the role of saving and investment in growth process.

In the mid-1950s Noble laureate W.Arthur Lewis developed one of the best theoretical models of development that gives due attention on the structural change of primary subsistence economy. According to his model the less developed economy consists of two sectors: the traditional rural subsistence sector characterized by zero marginal productivity of labor and a high productivity modern urban industrial sector with positive marginal productivity of labor. So the model focuses on the process of labor transfer and output and employment growth in the modern sector.

Other classical economists come to existence after Lewis model. These are the structural change and pattern of development model. Patterns of development model analysis of structural change focuses on the sequential change through which the economic manufacturing and structure of institutions of least developed economy is transformed through time to allow new industries to replace agriculture as the fuel of economic growth. However contrary to Lewis model they perceived saving and investment as a necessary but not sufficient conditions

During 1970s international dependence model gained the largest support among least developed country’s intellectuals because of growing disenchantment between both stages and structural change models. These theorists argue that least developed countries lack institutions and caught up in dependence and unbalanced relationship with industrialized countries.

They reject the single emphasis on traditional neoclassical economic theories set to increase the growth of GDP as the main source of development. They also put in to question the verifiability of Lewis two sector models and transformation. Rather they give attention to international power imbalances and on the importance of basic economic, political and institutional reforms both internally and externally

One of the most influential neo classical growth models and one that has shaped much modern thinking about the process of economic growth has been that of Noble prize winner American economist Robert Solow (1956). Although in some aspects Solow growth model describes industrialized economies better than developing (Todoaro & Smith, 2011), it remains basic reference on theories of growth and development. According to him economies will conditionally converge to the same level of income if they have the same saving rate, depreciation rate , labor force growth rate and productivity growth (Ray & Mookherjee, 1999).

Just as in classical models with which it shares strong similarities; the Solow growth model exhibits diminishing returns to labor and capital and constant returns to scale from capital inputs by the same percentage over long term. It is exogenous technology which leads to higher level of income per capita over time. Exogenous technological progress affects production function’s position but not its general shape. With technology and rate of growth of labor constant and fully employed labor force, Solow model predicts that for any given rate of saving and investment there is a constant steady state level of real per capita that can be attained (Cypherand & Ditez, 2008)

Another theoretical model is models of endogenous growth model which beers some resemblances to their neoclassical counterparts, but they differ in their underlying assumption and conclusion drawn. The most significant theoretical differences stem from discarding the neoclassical assumption of diminishing marginal returns to capital permitting increasing returns to scale in aggregate production and frequently focusing on the role of externalities in determining the rate of return on capital investments. Public and private investments in human capital generate external economies and productivity improvement that offset the natural tendency for diminishing returns (Todaro & Smith, 2011).

Endogenous growth theory seeks to explain the existence of increasing returns to scale and the divergence of long term growth patterns among countries. Technology still plays an important role in this model but it is not exogenous. The main contribution of this theory is that it emphasis on the link between technical innovation, human capital and institution including government whereas the previous neoclassical models emphasized on the close relationship between technical innovation and physical capital.

Another theory of growth is set by Keynes who gives emphasis to demand unlike Smith’s conception of saving as an influential prerequisite for growth. According to the Keynesian theory of growth demand from households and government were the prerequisite for economic growth. This implies that the change in income, especially income after tax or disposable income is the major influence on expenditures. If economic agents have more income because of the economy is growing, then they raise their consumption expenditures. On the other hand if economic have less income because of the economy is contracting and a large group of workers is unemployed, then they decrease consumption expenditures and this will in turn hurt economic growth (Tewodros G. , 2014).

2.2 Empirical Literature Review

In connection with the theoretical literature numerous researches have been conducted to examine sources of economic growth and cross country differences in growth using panel data and time series data approach both in developing and developed countries using a wide variety of explanatory variables.

According to the empirical studies Country’s economic growth is influenced by several macroeconomic variables like physical capital formation (formally gross investment) , labor force (human capital) , export level, Aid, money supply, government expenditure, external aid, saving and foreign direct investment etc.

(Tewodros G. , 2014), used ARDL model to explore the relationship between the variables and economic growth. His finding indicates that physical capital, human capital, foreign aid and export have significant positive impact on economic growth. However foreign debt and general inflation rate have negative and significant impact on economic growth.

(Lendyaeva & Linden, 2008) have empirically examined determinants of economic growth in Russia during the period of 1996-2004 using dynamic panel data. Their finding suggests that initial conditions, domestic investments and export are the most important ones for stimulating economic growth in Russia and natural resource availability not contributed significantly to short run economic growth.

(Ndambiri &, 2012), investigated determinants of economic growth in sub Saharan Africa using a panel data approach. The study confirms the positive impact of human capital development, physical capital accumulation and export on economic growth. But the study reveals that government expenditure and foreign aid have negative impact on economic growth in this region. This indicates that there are contradictions in the findings of some researchers in determinants of economic growth in this area since Ethiopia is part of sub Saharan African countries.

(Bassanini & Scarpeta, 2001) , analyzed the driving forces of economic growth using panel data evidence from 21 OECD (Organization for Economic Cooperation and Development). They identified accumulation of physical capital, human capital, research and development, macroeconomic policy setting financial development and international trade as the main driving forces behind economic growth. The study once again confirms the positive impact of human capital and physical capital accumulation on economic growth. Their finding also supports the notion that “the overall size of government in the economy may reach levels that hinder growth”. In addition the finding reveals that expenditure on health, education and research & development sustains living standards. On the other hand higher direct taxes government consumption and government investment hinders development. Above all the study suggests that differences in GDP across OECD countries are largely explained by differences in policy and institutional settings.

(Tricidio, 2006), introduced somehow different approach to investigate determinants of economic growth in emerging economies. In his study the usual determinants of economic growth like human capital and physical capital accumulation are included. However he also includes human development index and institutions as explanatory variables for growth. These two variables are in different approaches from other scholars view. Governance indicators are used as a proxy for institutions which focuses on political and informal institutions which are published by World Bank since 1996. Export and human capital development increases their explanatory power when associated with none income dimensions of development which are also policy indicators. These are human development index and good governance expressed by government effectiveness and political stability.

The initial neoclassical model starts with a labor force as the main input for growth. Labor force is a key determinant of economic growth in Ethiopia being a major factor of production. The absolute size of the national labor force was estimated at 12.9 million people in 1984. Over the subsequent decade the size of the labor force increased, reaching an estimated 28.3 million people in 2005, with an annual average increase of 1.26 per cent. During the period under consideration, the population growth effect on labor force growth is more significant than the participation rate. The effect of changes in the population growth has exceeded those of the participation rate, contributing to 1.12 and 0.14 percentage point per year respectively (Tegenu, 2008) agriculture is always the starting point for economic growth whether for western economies on the eve of industrial revolution or for developing economies at their independence in the mid-20th century. Lewis described the transition of the economy from agriculture to none agriculture as a precondition for economic transformation and economic growth. Cheap and unlimited supply of labor is available in most economies before onset of rapid economic growth. These argument leads to recognition early growth as resulted from the reallocation of labor from the low productive agricultural sector to highly productive nonagricultural sector mainly industry.

Geda as cited by (Rahel, 2003),explore the determinants of long run growth by an augmented Solow model that uses coefficients derived from cross country regression based on data from 85 developing countries. Their finding is that Ethiopia’s growth has been below predicted in all periods. However it is mostly explained by initial income level, investment rate initial education attainment and the growth rate of population.

(Alemayehu, Shimeles, & John, 2007), applied augmented Solow model to and its conditional variant to the Ethiopian data and found that the source of GDP growth was intensive use of resources especially labor. Productivity growth played a little role and when it did its impact was negative. And this is because of backwardness of the available technology combined with hostile policy plus some natural shocks and shocks originating from external markets.

A research conducted by (Shahid, 2014), in Pakistan using time series data and Johansen’s cointegration approach shows a significance positive relationship between labor force and economic growth.

Foreign direct investment is another crucial for developing countries that are in acute shortage of capital and technology. According to UNCTADSTAT (2011), as cited by (Yesuf & Tsehay, 2011), foreign direct investment (FDI) is defined as “an investment involving a long-term relationship and reflecting a lasting interest in and control by a resident entity in one economy (foreign investor or parent enterprise) of an enterprise resident in a different economy (FDI enterprise or affiliate enterprise or foreign affiliate). Such investment involves both the initial transaction between the two entities and all subsequent transactions between them and among foreign affiliates”.

The effect of FDI on economic growth is one of the debatable and interesting areas in recent economics. There are mixed evidences on its impact on economic growth particularly in underdeveloped countries. These are the negative or neutral effect and the positive effects. The advocators of positive impacts believe that FDI enhances economic growth by increasing capital stock (composition effect) and or facilitating the international technology transfer (knowledge effect). The technology transfer possibly occurs through imitation, competition, linkage or training in order to have better production efficiency or to survive in market. In addition to that multinational companies (MNCs) transact with domestic firms creating linkages that lead to different forms of assistance and trainings which in turn improves domestic human capital. On the other hand FDI may not be beneficial because of profit repatriation from FDI recipient country to FDI sending country (Yesuf & Tsehay, 2011).

According (UNCTAD 2000), cited by (Michie, 2001), the largest share of FDI goes not to developing country. In 1999, 77 percent of total FDI inflows were to OECD (Organization for Economic Cooperation and Development). The nature of these flows altered though with more going in to mergers and acquisitions rather than on Greenfield investment. Because of these reasons and others the effects of FDI on developing economies is mixed. The potentially positive effects of FDI are inducing incumbent firms to upgrade their technology and spillover benefits whereas the negatives are the possibility of MNCs deliberately raising their concentration levels, forcing competitors out of business by predatory pricing, taking away skilled labor and R&D staffs from local firms or engaging in restrictive business practices which deter technological development.

Despite the debatable results of FDI on economic growth especially in developing country, global FDI inflows in 2007 after four years of consecutive growth by 30% and reach $1,833 billion well above the previous all-time high set in 2000. There are two driving forces for the fast growth of FDI by enterprises. The first one is to reduce production cost and through this to become efficient compared to competitors by exploiting the abundant resources in host country (vertical FDI) and the second is the motive to have new markets (horizontal FDI) (Wesseleder, 2009).

The increase in foreign direct investment is also shown by a rise in the number of jobs in the foreign investors of MNEs. An estimated 73 million labors, 3% of the world labor force, were working in foreign affiliates of multinational companies in 2006, almost three times than in 1990. Some portions of these workers are working in the foreign affiliates of MNEs in least developed countries and transition economies, reflecting the higher dependence on labour intensive production system in foreign affiliates in those countries. The distribution of works in firms owned by foreigners also resembles towards industrial sector proving that activities conducted in these firms are relatively labor intensive manufacturing sector. The extent to which employment by foreign firms shows the causes of FDI on job creation is highly conditional up on whether FDI is attracted through Greenfield investment or mergers and acquisition (M&A). Generally, FDI invested on Greenfield investment is more likely to have a high and positive impact on employment. However, OECD (2008) suggests that cross-border M&A also may have substantial positive effects on employment in some countries. Although the share of the labour force employed in foreign-owned firms appears to be relatively small, the impact of FDI may not be limited to direct effects within foreign-owned firms, but may also spillover to affect productivity, employment and working conditions in domestically-owned firms (OECD-ILO, 2008)

Africa is a continent with high endowments of natural resources especially fertile agricultural lands on one hand and weak in capital on the other hand. These basic facts increase the willing ness of the continent to receive capital through selling and leasing land. Being part of Africa Ethiopia is also engaged in these activities.

FDI flows in the agribusiness sector have increased highly in Ethiopia in the last years (since 2006). As Ethiopia is among the most populous countries in the African continent, more than 45 % of the population suffer from undernourishment (WFP, 2009) and about 40 % of the population live from less than one 1 $ a day one needs to understand which consequences large amounts of FDIs in the agricultural sector will have for the rural population (Wesseleder, 2009)

Empirical evidence on the relationship between FDI and economic growth is still inconclusive. Recent studies have examined factors that could influence this relationship but have not extensively addressed the role of the characteristics of foreign direct investment (FDI).

(Yesuf & Tsehaye, 2011) investigated the casual relationship between FDI and economic growth in Ethiopia using annual data from 1974 to 2010. Their result indicates that there is no causal relationship between FDI and economic growth or vice versa. But they found the existence of cointegration between the two variables indicating that there is long run relationship between them (negative or positive). According to them economic growth is necessary but not sufficient condition to attract FDI. In addition to that the impact of FDI on economic growth is conditional on the type of economic sector, power of technology transfer, managerial skill, organizational process and skill acquisition.

(Fortanier, 2007), has found positive interaction between economic growth and FDI for developed countries but negative interaction between the two variables for developing countries. He argued that problems like trade openness, weak institutional setups, organizational structure and sectoral specialization are the basic reasons for differences in the impact of FDI on the two economies.

Saving is the most important source of internal finance as it reduces dependence on external economies and self-financing of projects. According to (Aron, Nigus, & Getnet, 2013), saving is defined as the “portion of disposable income not spent on the consumption of consumer goods, but accumulated or invested–directly in capital equipment, by paying off a home mortgage or indirectly through the purchase of securities”. There are also other forms of saving beyond the above definition. These are putting money aside in banks or other financial institutions; investment in pension plan and so on. Empirical studies revealed that domestic saving and investment have highly and positively related. This is because saving enables the conversion the available resource to capital. Moderate amount of saving is also important for macroeconomic, financial and price stability.

Even though, there are fast growing countries, today, Sub-Saharan Africa (SSA) is the poorest and least-developed region in the world with about three-fourths of the countries in it is classified in the low income category. Furthermore, among developing regions in the world, the subcontinent is the most dependent on official development assistance. The primary reason for this is political and economic instability, which weakens several sectors that can play an important role in strategic development. It is also revealed that the SSA economy is underdeveloped because agriculture as the main economic activity of the region’s livelihood, is highly dependent on traditional practices and erratic rainfall. Moreover, the overall share of exports from SSA, including South-Africa and Nigeria, is yet less than 2 percent of the global trade and the continent has the lowest income level in the world, thereby, enhancement of domestic saving is difficult (Mebratu, 2013).

Despite its importance on mobilization of domestic resources saving rate is very low in Ethiopia for the past several years. The saving rate in Ethiopia is averaged to 9.5 percent which is very low as in comparison to china, Bangladesh and South Africa who are considered to have better saving rates in the world (Aron.H, 2013).

Ethiopia has registered low savings rate in the two consecutive regimes ( Derg & EPDRF) for the last few decades. From 1974/75 to 2010/11, the average saving to GDP ratio was 7.1%. During the Derg regime (1973/74 to 1990/91) percentage share falls down to 6.7% from that of 11.3% from 1960/61 to 1973/74. This is mainly because of political instability, successive internal and external war and conflict in the regime. However during the EPDRF regime, saving rate in the first decade (1992 to 2002) showed slight change and registered only 7.7% of the GDP. From 2003 to 2011, the rate declined to 6.5%. Even Though the country is following the free-market policy of economy for the last two decades and private sectors participation have flourished, saving rate did not show progress as expected. The main reasons accountable for this are; volatility of bank interest rate mostly downward, rate of inflation, low income of the society , underdevelopment of financial institutions sector, dependency burden of the population structure, and limited access to financial services (Gebeyehu, 2013)

The casual relationship between saving, investment and growth has received reasonable attention among researchers, academicians and policy makers. The importance of saving and investment in enhancing growth has been attracting researchers and is still remained debatable. Proponents of saving argue for enhancing domestic saving to increase productive potential where investment is an essential force to enhance productivity and generate knowledge transfer and new technologies. Saving is an important variable as capital importation can be erratic and lead to sudden road breaking, and may force to huge macroeconomic changes and gradually growth crises. From growth theories a country can grow faster by investing on its physical and human capital of production with international capital markets and investment obtained from international capital flows. Hence, saving is not an essential element of growth process. Many advocators of the domestic saving, gross investment and growth correlation support the effect of growth on saving not vice versa (Mebratu, 2013).

Another important variable in growth process is external debt mostly having negative effect. According to (Ayadi & O.Ayadi, 2008), on their journal of economic development in Africa, external debt is one of the sources of financing capital formation in any economy. Developing countries in Africa are characterized by inadequate internal capital formation due to the vicious circle of low productivity, low income, and low savings. Therefore, this situation calls for support from developed countries to close the resource gap. However external debt does not contribute significantly to finance development of the economy rather it risks the economy by imposing burdens. In most developing countries debt is accumulated because of the service repayment and principal itself. So external debt in underdeveloped economy is self-perpetuating method of poverty aggravation and resource exploitation and it is constraint to development. The finding also indicates that debt have nonlinear impact on growth in Nigeria. This means that it initially positively contributed to growth and starts to hurt the economy if it goes beyond certain points. They also found that debt is not a significant factor affecting growth in South Africa.


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Macroeconomic Determinants of Economic Growth in Ethiopia. A Vector Correction Model
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Economic growth, Determinants, VECM
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Asmamaw Kassahun Agdew (Author), 2016, Macroeconomic Determinants of Economic Growth in Ethiopia. A Vector Correction Model, Munich, GRIN Verlag,


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Title: Macroeconomic Determinants of Economic Growth in Ethiopia. A Vector Correction Model

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