The Macroeconomic Effects of Fiscal Policy Shock Under Debt Feedback Rule in Ethiopia: Evidence from A Bayesian VAR Approach

Abstract

This paper investigated the macroeconomic effects of fiscal policy shocks in Ethiopia using a Bayesian Vector Auto Regression model. We examined the dynamic responses of output, inflation, interest rate and exchange rate to fiscal policy shocks employing quarterly data from 2000/01Q1 to 2015/16Q4. The empirical evidence suggests that government spending shock had a positive impact on output and inflation but the effect was too small. Initially the interest rate responded negatively to government spending shocks and was positive with small effect and the nominal exchange rate showed deterioration. In addition, government revenue shocks had positive effect on real GDP and exchange rate and then they responded negatively. The inflation response to the net tax was medium and negative whereas its effect on interest rate was positive, and persistent. The results support the idea of a ‘crowding-in’ effect and when we take into account the feedback from government debt, the results suggest that the effects of fiscal shocks on the majority of macro variables is too small except for the real GDP for government revenue shock. Therefore, empirical evidence shows that it is important to consider government debt dynamics in the model.

Keywords: Ethiopia, Fiscal policy shock, public debt, Bayesian VAR