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Abstract
Entrusted with the responsibilities of maintaining exchange rate stability, the central bank
Ethiopia, namely, the National Bank of Ethiopia (NBE) has paid more attention to the
maintenance of exchange rate stability in the formulation and implementation of monetary
policy during the past years. These considerations often prompted the NBE to intervene
in the foreign exchange market so as to influence exchange rate developments.
A recent study that estimated an index of the Exchange Market Pressure(EMP) for
Ethiopia over the period November, 2001 to December, 2005, on the other hand,
reveals that in majority of the cases (in 42 months out of 49 months considered) the
Ethiopian foreign exchange market was characterized by depreciation pressures
(Abebe, 2006). According to a monetary model of exchange market pressure, an
increase in domestic credit (expansionary monetary policy) will increase the EMP by
decreasing foreign reserves, or by causing a depreciation of the exchange rate, or
some combination of the two (Kim, 1985).
The objective of this study is, therefore, to examine empirically the existence of such
link between EMP and monetary policy in Ethiopia using the Girton-Roper monetary
model of exchange market pressure and VAR technique. The result of the single
equation model reveals that measure of the stance of monetary policy, i.e domestic
credit growth, has a significant and positive impact on EMP. The VAR test provides
further evidence supporting the claim that domestic credit has a positive impact on
exchange market pressure. The estimated impulse response function (IRF) as well
indicates a positive response of EMP due to a shock in domestic credit, implying that
an expansionary monetary policy increases EMP in line with the traditional theory.