Modeling and Forecasting Inflation in Ethiopia Using Multivariate Time Series Analysis

Inflation is one of the basic indicators of macroeconomic stability, influences numerous other macroeconomic factors and it debilitates the economy of the country. Thus, in this study, the major objective was based on modelling and forecast inflation in Ethiopia and its components using a VAR model. all five series exhibited an increasing pattern, indicating non-stationarity in each of the series. The analysis was based on annually data from 1992 to 2021, encompassing 30 years. The results indicated that all five series were non-stationary at the level but stationary after their first differencing at a 5% level of significance. Johansen's cointegration tests were conducted. The results indicated the presence of at least one co-integration relationship between the variables. The Vector Error Correction Model (VECM) was then applied to estimate the cointegrated variables in the system, capturing short-run behavior and the speed of adjustment to reach equilibrium following a shock. The result indicated that the coefficient of error correction term is negative (-0.279), which suggests a 27.9 percent annual adjustment towards long run equilibrium when any shocks happen based on the variables under consideration. Granger causality tests were employed to explore potential causal relationships. Impulse response analysis and variance decomposition were used to determine the short-run interactions among the variables. The forecasting accuracy of the model was assessed using metrics such as RMSE, MAE, MAPE, and Theil-U statistics. Finally, using the fitted model, out-of-sample forecasts were produced, yielding forecasted plots and values for the endogenous variables. According to the forecasted inflation rates for the next five years, prices are projected to decrease by approximately 18.0% in 2022, 6.8% in 2023, and then increase by approximately 8.3% in 2024. Subsequently, prices are expected to decrease by approximately 2% in 2025 and 5% in 2026 over the specified time periods.