While a large body of literature explores the fiscal deficit—money growth—inflation nexus, the empirical evidence remains mixed and contingent on country context. Several factors may influence the timing and strength of this nexus (Agénor and Montiel 2015). If the deficit is financed by bonds rather than money creation, the short-run relationship may be weak. Moreover, if the government resorts significantly to external borrowing, the relationship between the consolidated government deficit and inflation may be weak. Other factors would have to be considered in explaining high inflation in such contexts. Finally, the impact of deficit monetization on inflation may be weakened or delayed in the presence of unstable money demand and slow inflation adjustment due to inertial forces such as sticky wages and price controls.

Evidence from African countries is generally supportive of a positive relationship between fiscal deficits and inflation (Ahmad and Aworinde, 2019). In the case of Ethiopia, a study by Alemu, Mulugeta, and Wassie (2016) finds evidence of a positive impact of the fiscal deficit on inflation in both the short run and long run.

This study contributes to the literature by providing both a theoretical and institutional motivation for the impact of the fiscal sector—including the deficit and public sector borrowing— on inflation. The analysis distinguishes between long-run effects (through adjustment to equilibrium in the fiscal sector) and short-run effects (through the impact of increased borrowing by the central government and state-owned enterprises).

# **External factors of inflation**

External factors play an important role in fueling domestic inflation, notably through imported food and energy products as well as exchange rate movements, although the relative impacts of these factors need to be further explored in future research. For Ethiopia, empirical evidence has shown that rising world food prices exert upward pressure on local food prices (Durevall et al. 2013). However, the transmission of global food prices to domestic prices remains unclear. According to UNCTAD trade statistics, Ethiopia is a net exporter of basic foods, while it is a net importer of cereals and cereal preparations. This issue deserves further empirical investigation.

Another channel of external pressure on domestic prices is imports of petroleum and related products. Petroleum and related products represent 10-20 percent of Ethiopia’s total imports. The country is therefore exposed to the vagaries of international energy prices which filter through the domestic cost of production of goods and services, ultimately fueling inflation.

The exchange rate also plays an important role in any economy that is import-dependent, as is the case for Ethiopia. In the event of a devaluation, the weakening of the domestic currency raises the cost of imports, which in turn increases the domestic price level. In an economy facing foreign exchange constraints, a devaluation can set off an inflationary spiral whereby devaluation causes domestic prices to rise, causing an appreciation of the real exchange rate which discourages exports. Further devaluation aimed at preventing the deepening of the trade deficit can ignite other rounds of domestic price increases while raising expectations of further exchange rate devaluation. Under tight foreign exchange reserve constraints and dependence on imports, inflation can indeed offset some of the intended benefits of devaluation. The World 5