JINKA UNIVERSITY COLLEGE OF BUSINESS AND ECONOMICS

DEPARTEMENT OF ECONOMICS

The linkage between economic growth and income inequality in Ethiopian

Economy

By: Tadele Iyasu

Advisor: Desta. B (MSc)

ID No 1793

February, 2023
JINKA, ETHIOPIA

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 Acknowledgment

Above all, I would like to thank the Omniscient, Omnipotent and almighty God he gave me
courage, strength and impatience to finish the job of this study. Next to God, my special thanks to
my advisor Desta Birru (MSc) for his advising and invaluable support and smooth
communication throughout the preparation of this study. I would like to thank my families for
their ideas, and financial support. Finally I would like to tanks everyone who supported us at the
preparation of this study.

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Abstract

The main objective of this study is to investigate the relationship or linkage between economic
growth and income inequality in Ethiopian economy during the period 1990-2021. The vector
autoregressive (VAR) model is applied in order to investigate the long-run and short run
relationship between the dependent variable (GDP) and included explanatory variable. The
finding shows that there is a stable long run relationship between GDP and included variables.
And the empirical results reveal that income inequality measured by Gini coefficient is found to
have negative impact on economic growth. And also, government expenditure inflation are found
to have negative impact on economic growth in the long run. However, the studies found out that
investment, human capital and trade openness and have positive impact on economic growth in
the long run. This study has also an important policy implication. The findings of this study imply
that economic growth can be improved significantly when the income inequality among people
reduced through different redistributive mechanisms.

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 Acronym

ADF- Augmented Dickey fuller

CPI - consumer price index

CSA - central statistical Agency

VECM- Variable Error correction model

GDP - Gross domestic product

IMF- International monetary fund

MoFED - ministry of finance and Economic development

PPP- Purchasing power parity

NBE- National Bank of Ethiopia

WDI- World Development Indicator

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Contents

Acknowledgment...............................................................................................................................i
Abstract.............................................................................................................................................ii
Acronym..........................................................................................................................................iii
CHAPTER ONE...............................................................................................................................1
INTRODUCTION............................................................................................................................1
1.1 Background of the Study.........................................................................................................1
1.2. Statement of the problem.......................................................................................................2
1.3 Research question...................................................................................................................3
1.4 Objectives of the study............................................................................................................4
1.4.1 General objectives............................................................................................................4
1.4.2 Objectives Specific...........................................................................................................4
1.5 Significance of the study.........................................................................................................4
1.6 Scope of the study...................................................................................................................4
. 1.7 The the review of theoretical and empirical literatures.........................................................4
CHAPTER TWO..........................................................................................................................5
2. Literature review...........................................................................................................................5
2.1 The theoretical Review of Literature......................................................................................5
2.1.1 Economic growth and its measurement............................................................................5
2.1.2 Income Inequality and its measurements.........................................................................7
2.1.3. Factors influencing economic growth...........................................................................11
2.1.4. Factors influencing income inequality..........................................................................13
2.1.5 The relationship between economic growth and income inequality..............................14
2.1.6. Income Inequality as a cause of Economic growth.......................................................16
2.2. Empirical reviews................................................................................................................17
2.3 Conceptual Framework of the Study....................................................................................20
CHAPTER THREE........................................................................................................................21
3 Methodology of the Study........................................................................................................21
3.1. Source of Data..................................................................................................................21
3.2. Method of Data Analysis.....................................................................................................21
3.3 Model specification.............................................................................................................21
3.4. Description of variables and expected sign on Economic growth.......................................22
3.4.1. Dependent variables......................................................................................................22
3.4.2. Independent variable.....................................................................................................22
3.5. Estimation Procedure...........................................................................................................23

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 3.5.1 Vector Autoregressive Model (VAR Model).................................................................24
3.5.2 Vector Error Correction Models (VECM).....................................................................24
3.5.3 Testing for Stationary or unit roots................................................................................25
3.6 Co integration........................................................................................................................25
3.7 Hypothesis.............................................................................................................................26
CHAPTER FOUR..........................................................................................................................26
4. Descriptive and econometric analysis........................................................................................26
4.1 Descriptive analysis..............................................................................................................27
4.2.1 Trend in Economic Growth............................................................................................28
4.1.2 Trends in Inequality........................................................................................................29
4.3 Income Inequality Measured by Gini Coefficients...............................................................30
4.2 Econometric analysis............................................................................................................31
4.2.1 Stationary and unit root test............................................................................................31
4.2.2 Unit root test...................................................................................................................31
4.2.3 The vector auto regression estimates..............................................................................32
4.2.6 Diagnostic and Stability Tests........................................................................................34
4.2.4 Vector Error Correction Model (VECM).......................................................................35
4.2.5. Long Run Model Estimation.........................................................................................37
4.2.6. The Short Run Model (Dynamics)................................................................................39
4.2.6 Diagnostic and Stability Tests........................................................................................40
CHAPTER FIVE............................................................................................................................40
5. Conclusion and recommendations..............................................................................................40
5.1 Conclusion............................................................................................................................41
5.2 Policy implication.................................................................................................................41
Based on the analysis made and conclusion arrived the following policy implication are
forwarded....................................................................................................................................41
REFERENCES...............................................................................................................................43
Appendix.........................................................................................................................................44

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 CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

Economic growth is the increase in output of a country. It is the process by which a nation's wealth
increases over time. It occurs when the productive capacity of a country increases. Economic
development takes place when there is accelerate Economic growth accompanied by major changes
in social structures, popular attitudes and national institutions, reduction of inequality and eradication
of poverty (Todaro, 1994). An increase in GDP (gross domestic product) per capita is an indicator of
economic growth. For economic development to take place the economic growth rate has to be raised
and inequality reduced.
One of the most important factors believed to be related to the rate of economic growth is the issue of
income inequality in the process of national income distribution. Understanding the relationship
between these two economic variables is important because higher income inequality is often found
in lower developed countries. If there is a clearer understanding about the relationship between
income inequality and the rate of economic growth, particular economic policies could be employed
in the less developed countries in the appropriate manner to deal with income inequality and
encourage economic growth (Heyse, 1995).
Inequality in income is an economic problem first and it becomes also a political and social problem
in modern society. Disparities in income and wealth have tended to dominate the discussion on
inequality, not only because they contribute directly to the well-being of individuals and families, but
also because they shape the opportunities people have in life as well as their children’s future; access
to goods and considerable degree of good educational outcomes and good health. Therefore,
emphasizing on addressing income inequality is not only a moral issue but it is also necessary to
inspire human and productive potentials of each country’s population to bring development towards
socially sustained path (United Nations, 2015). So, because of bi-directional causality linkage,
estimating the relationship between economic growth and income inequality will become the
fundamental concern of developmental economists the focus on the economic growth and income
inequality relationship began in the 1950’s when Simon Kuznets presented his idea of an inverted U
relationship between per capita GNP and inequality in the distribution of income. Kuznets had
proved the hypothesis of a curve inverted U-shaped by linking the Gross Domestic Product per capita
(GDP per capita) to the level of inequality in income distribution. This hypothesis predicts that, the
unequal distribution of income seems endogenous to development process. In fact, in the first time,
the development process tends to increase inequality, but beyond a certain threshold, the trend is
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reversed, inequality stabilizes, then decrease until it reaches the lowest level as a country achieve its
higher level of per capita income. The inverted U-shaped hypothesis of Kuznets shows that the
process of economic development reflects a transition from an agrarian economy with low
productivity to an industrial economy with high productivity. So, Kuznets state that, inequality
increases at the early stages of Development due to the process of industrialization which leads to a
shift of labor force from agricultural sector to industrial sector and latter inequality tends to decline as
labor force in industrial sector diversified and that of agricultural sector declines (Kuznets, 1955).
Even though the earliest attempt to correlate income inequality with economic growth was
investigated by Simon Kuznets (1955), there are several studies that suggests growth does not have
an impact on inequality (Easterly, 1999) and more recently (Dollar and Kraay, 2002), and others have
found that there is positive linkage between income inequality and economic growth (D. Tsiddon,
1995), (U. Panizza, 2002), (J. Thornton, 2010). Still other researchers have found either negative or
no relationship at all (K. Jhe, 1996), (M. Cue, 1988), (M.R .Sezeles, 2011) and (O. Melikhova, 2010).
When we came to Ethiopia, its economy has experienced impressive growth performance over last
decades with average Gross Domestic Product (GDP) growth rate of 11%, which is about the double
of the average growth for Sub Saharan Africa World Bank (2015). According to World Bank report
on world development indicators (WDI) 2012, the top 10 percent of the population receives 28
percent out of country’s total income and in contrast to the bottom 20 percent of the population
receives only 8 percent of a country’s total income. So, even though this paper will not provide the
definitive answer on the relationship between economic growth and income inequality, it attempts to
contribute additional relevant evidence to show the linkage between economic growth and income
inequality in Ethiopia.

1.2. Statement of the problem

Abdurrahman Bedewi (2011) also tried to investigate the possible impact of inequality on economic
growth focusing on 12 African countries including Ethiopia for the period between 1970 and 2000.
The result of the study shows that there exists a link between income inequality and economic growth
in all countries with different degree of association. However, this paper also focused only on the
direct impact of income inequality on economic growth without considering other explanatory
variables like, urbanization and financial development, which affect the system. This study has also a
problem that there is no appropriate test of stationary and co-integration that have to be taken to
avoid statistical problems.

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Gideon Bulla (2012) also tried to examine the relationship between economic growth and income
inequality in Ethiopia for the period of 1996-2011. The result of the studies indicated that economic
growth has a negative influence on income inequality. However, the work of Gideon has the problem
of omission of relevant variable like government expenditure and inflation were not included as
explanatory variables in the model. And also, it used data of short time period, which makes the
reliability of the results so week.

Abdurrahman Hassen (2014) tried to assess economic growth-income inequality nexus in Ethiopian
economy. This study was conducted based on both the econometric and descriptive analysis by
taking income inequality as an independent variable and economic growth as a determinant variable.
The final conclusion of the study shows that, economic growth measured by GDP per capita has
negative and significant effect on income inequality. But, 5 this study was conducted by using short
time span of data (only 15 years) i.e. for the period only 1996-2011, which makes the final
conclusion questionable. Generally, there are many studies on the issue of relationship between
economic growth and income inequality at international level, and there are also studies that were
made to examine the linkage between economic growth and income inequality in case of Ethiopia.

More recently, Yirgalem Getahun (2019) tried to linkage between economic growth and income
inequality in Ethiopian economy. This study was conducted based on taking with dependent variable
of economic growth and independent variable of income inequality, inflation, investment, trade
openness, government expenditure and human capital in period (1982-2016). However, as shown
above, these studies have their own knowledge gaps. So, this paper try to fill these gaps by using
available data and tries to further investigate the relationship between economic growth and income
inequality by taking economic growth as a function of income inequality and by further expanding
the time period for 31 years from 1990-2021 in addition to including the above listed variables.

1.3 Research question

These studies tried to answer the following question.

1. What is the effect of income inequality on economic growth?

2. What is the factor that explains economic growth?

3. How income inequality can affect economic growth?

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 1.4 Objectives of the study

1.4.1 General objectives

The general objectives of this study provide a comprehensive study and critical overviews of the
linkage between economic growth and income inequality in Ethiopian economy based on available
data for time period between” 1990 to 2021”.

1.4.2 Objectives Specific

The specific objective of the study includes

1. To investigate the effect of income inequality on economic growth and test whether the
relation between them follow Kuznets inverted U-hypothesis in Ethiopian case.

2. To examine the factors that explains economic growth.

3. To assess macro performance of Ethiopia.

1.5 Significance of the study

The study tries to show the link between economic growth and income inequality. By examining this,
it will add to the existing knowledge on the impact of income inequality on economic growth. The
final outcomes and policy recommendations of the study will help concerned body to develop
appropriate economic policies.

1.6 Scope of the study

The link between economic growth and income inequality is bi-directional i.e. economic growth
affect income inequality and vice versa. It may lead to causality problem, which means the model
estimated will be biased. However, the study limited to the impact of income inequality on economic
growth and only on the case of Ethiopian for the period covering from 1990-2021

. 1.7 The the review of theoretical and empirical literatures

In chapter three methodologies and model specification would presented. In fourth chapter,
descriptive analysis and analysis of results of econometric model is made. Finally, chapter five
presents the conclusions and policy recommendations study is organized into five chapters.
Following the introductory chapter, chapter two presents of the study Organization of the study

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 CHAPTER TWO

2. Literature review

In economics the link between Economic growth and income inequality became the main concern for
more than half a century. Many works have been developed to explore the complex relationship
between income inequality and economic growth, which come-up with different conclusion or
results. This chapter summarizes previous work done on this area. The pioneer for this work was
Simon Kuznets (1955), who suggested that the relationship between economic growth and income
inequality can be shown by inverted U-shape, in which at the early stage of development income
inequality increases, reaches a maximum point at an intermediate level of income and then eventually
declines. This Research proposal is also an attempt to examine the linkage between economic growth
and income inequality in Ethiopia case. However, before analyzing the link between them let’s look
at some theoretical and empirical literatures.

2.1 The theoretical Review of Literature

2.1.1 Economic growth and its measurement

Economic growth is the increase in output of a country. It is the process by which a nation's wealth
increases over time. It occurs when the productive capacity of a country increases. Economic
development takes place when there is accelerated economic growth accompanied by major changes
in social structures, popular attitudes and national institutions, reduction of inequality and eradication
of poverty. An increase in GDP (gross domestic product) per capita is an indicator of economic
growth. For economic development to take place the economic growth rate has to be raised and
inequality reduced (M.P. Todaro, 2009). Economic growth is the increase in per capita domestic
product (GDP) or other measures of aggregate income. It is often measured as the rate of change in
real gross domestic product (GDP). Economic growth refers to only the quantity of goods and
services produced. Economic growth can be either positive or negative. Negative economic growth
can be referred by saying the economy is shrinking and it is associated with economic recession and
economic depression (A. Schulz, 2010). And it occurs when the production possibility frontier (PPF)
shifts upward and outward to the right, so that combinations of goods and services that were
unattainable can now be produced. Economists draw a distinction between short term economic
stabilization and long-term economic growth. M.L. Jhingan (2004) defines economic growth as a
gradual and steady change in the long run, which comes about by a gradual increase in rate of saving
and population. As G. Mankiw (1990) pointed out, the topic of economic growth is primarily conduct
with long run. The short run variation is termed as the business cycle. Despite some problems of

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measurements, an increase in gross domestic product (GDP) of a country is generally taken as an
increase in the standard of living of its inhabitants over a long period of time (A. Schulz, 2010). The
most common measures of economic growth are gross domestic product (GDP), which is defined as
the market value of all the final goods and services produced within in a country in a given time
period. A final good or services is an item that is bought by its final user during a specified time
period. The circular flow of income and expenditure shows real and monetary flows in the economy.
The circular flow involves; four economic sectors (households, firms, governments, and the rest of
the world), and three major markets (factor markets, goods markets, and financial markets). In these
markets people make their economic decisions by choosing the amounts of key economic variables;
consumption expenditures(C) - total house-hold spending on consumption goods and services,
investment (I)-firms’ purchase of new plants, equipment, buildings, and additions to inventories,
government purchases (G)-government spending on goods and services, net exports (NX)-exports
(X- sale of goods and services abroad) minus imports (M, purchases of foreign goods and services).
Aggregate expenditure, C+I+G+NX, equals aggregate production, GDP, and also equals aggregate
income, Y. This equality is the basis for measuring GDP (H. Hagos B, 2002). Specifically, GDP per
capita is the most common measures of overall level of economic activities. It is measured by gross
domestic product (GDP) of a country, which is the total value for final use of output produced in the
economy both by residents and non-residents divided by the total numbers of the country’s
population (M.P. Todaro,2009).

To facilitate the comparison of economic growth, a rise in per capita income among countries, there
are two ways; these are the prevailing exchange rate and purchasing power parity (PPP). Each
country income (in local currency) is converted in to common currency (typically in US dollars) and
divided by the country’s total population to arrive at a measure of per capita income. This conversion
scheme is called exchange rate method because it used the rate of exchange between local and the
common currencies to express income in common unit (D. Ray, 1998). However, this measure gives
biased estimates for different countries. As M.L. Jhingan (2004) argues, the use of exchange rate is
biased because it does not reflect the purchasing power of different country’s currencies and the use
of single currency unit for computing total output of goods and services underestimates the per capita
incomes (PCI) of underdeveloped countries due to tax evasion (avoidance) and the fact that the
proportion of income that is actually generated for self-consumption is relatively high in
underdeveloped countries. Moreover, the rates of exchange are primarily based on the prices of
internationally traded goods. But there are many goods and services in under developed countries that
are never traded internationally and are also low price.

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In an attempt to rectify this problem, researchers have tried to compare relative GNIs and GDPs by
using purchasing power parity (PPP), which is the calculation of gross national income (GNI) using a
common set of international prices for all goods and services to provide more accurate comparisons
of living standards, instead of exchange rates as conversion factors. In a simple version, purchasing
power parity is defined as the number of units of a foreign country’s currency required to purchase
the identical quantity of goods and services in the local country market. Clearly, if domestic prices
are lower, PPP measures of GNI per capita will be higher than estimates using foreign-exchange rates
as the conversion factor (M.P. Todaro, 2009).

This study used the annual increment in real gross domestic product (GDP) as the measure of
economic growth, to investigate the relationship between economic growth and income inequality
with the other macroeconomic factors as control variables.

2.1.2 Income Inequality and its measurements

Inequality is the degree to which distribution of economic welfare generated in an economy differs
from that of equal shares among its inhabitants (SID, 2004). It may also entail comparison of certain
attributes or well-being between two persons or a group of people and the differences in share of
these attributes. Inequality is observed not only in incomes but also in terms of social exclusion and
the inability to access social services and socio-political rights by different population groups,
genders and even races. Inequality can be classified into various types:

(a) Income inequality: refers to the gap between the rich and the poor or people with similar
background, status, qualifications but with different incomes.

(b) Gender inequality: Manifested in wages, discrimination, domination of positions of power and
responsibility. It limits extent to which women or men can make it to the top.

(c) Opportunity inequality: It is caused by ease of access to education, work, and housing, markets
on the basis of race, ethnicity or gender, even across countries.

(d) Asset/wealth inequality: It results from disparity not just in quantity but also in quality of natural
resources, infrastructure, raw materials, amount of human capital and assets.

Income inequality will be the main focus in this paper. Income inequality is the unequal distribution
of household or individual income across the various participants in an economy. Income inequality
is often presented as the percentage of income to a percentage of population. It is often associated
with the idea of income "fairness". It is generally considered "unfair" if the rich have a
disproportionally larger portion of a country's income compared to their population.

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Income inequality means that one segment of the population has a disproportionately large share of
income compared to other segments of that population. It depends on how income is distributed. The
income distribution arises from people’s decisions about work, savings and investment as they
interact through markets and are affected by the tax system. Inequalities result from education,
experience, family structure, qualification, skills, abilities and regressive tax system. Distortion in
factor prices may also result in income inequality. Inequality is an important issue in economic
development as it can hinder economic growth, and it can result in social instability (Maina, 2006) 13

Income inequality can also be defined as the existence of disproportionate distribution of total
national income among households, whereby the share going to rich persons in a country is far
greater than that of going to poorer persons. In other words, it is the higher the gap between incomes
accruing to the bottom (poor) and top (rich) population (M.P. Todaro, 2009). It is viewed as different
peoples having different degrees of income inequality is typically thought as a difference between
individuals within a population, normally a country, thought it can also be considered among
countries as the gap between per capita level in rich and poor countries (A.Mckay,2002).

Measuring income inequality is more complex. As a measure of income inequality, many different
indicators can be used. One of the most frequently used indicators of inequality is the Gini
coefficient, which is calculated as a ratio-the area between the Lorenz curve and the 45 degrees
equality line divided by the entire area below the 45 degrees line. The higher the Gini coefficient, the
more unevenly is income divided among the population. The biggest problem for a researcher is
unavailability of comparable data about different countries. Namely, the Gini coefficient can be
calculated either by using only earnings or using total income, either on the basis of only monetary
income or on the basis of all kinds of income. The basis of calculation may be both gross income and
income after taxes.

Income inequality generally summarized by an inequality measures which can be explained as a

degree of dispersion of distribution of income. Even though there are wide range of income
inequality measures, economists distinguished between two principal measures of income
distribution. These are personal or size distribution of income and functional /factor share/
distribution of income.

1. Personal (size) distribution of income

The personal or size distribution of income is the most commonly used measure of income
distribution. It simply deals with individual persons or households and the total incomes they receive.
The way in which that income was received is not considered. What matters is how much each earns
irrespective of whether the income was derived solely from employment or came also from other
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sources such as interest, profits, rents, gifts, or inheritance. Moreover, the locational (urban or rural)
and occupational sources of the income (e.g., agriculture, 14

Manufacturing, commerce, services) are ignored. Economists and statisticians therefore like to
arrange all individuals by ascending personal incomes and then divide the total population into
distinct groups, or sizes. A common method is to divide the population into successive quintiles
(fifths) or decals (tenths) according to ascending income levels and then determine what proportion
of the total national income is received by each income group (M.P. Todaro, 2009).

It includes the following;

2. Lorenz curve: A graph depicting the variance of the size distribution of income from
perfect equality. The Lorenz curve shows the actual quantitative relationship between the
percentage of income recipients and the percentage of the total income they did in fact
receive during, say, a given year. It is constructed by plotting income recipients in
horizontal axis and the share of total income received by each percentage of population
on the vertical axis

Figure 2.1 Lorenz curve

100

Percentage of income Line of equality A

0 100

Percentage of population
Source; Todaro, 2009

At every point on the diagonal, the percentage of income received is exactly equal to the percentage
of income recipients. In other words, the diagonal line in Figure 2.1 is representative of “perfect
equality” in size distribution of income.

The more the Lorenz line curves away from the diagonal (line of perfect equality), the greater the
degree of inequality represented. The extreme case of perfect inequality (i.e., a situation in which one
person receives all of the national income while everybody else receives nothing) would be
represented by the congruence of the Lorenz curve with the bottom horizontal and right-hand vertical
axes. Because no country exhibits either perfect equality or perfect inequality in its 15

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Distribution of income, the Lorenz curves for different countries will lie somewhere to the right of
the diagonal in Figure 2.1. The greater the degree of inequality, the greater the bend and the closer to
the bottom horizontal axis the Lorenz curve will be (M.P. Todaro, 2009).

Gini coefficient: An aggregate numerical measure of income inequality ranging from 0 (perfect
equality) to 1 (perfect inequality). Deaton defines the Gini coefficient as: “the average difference in
income between all pairs of people divided by the average income” (Deaton, 2013). It is measured
graphically by dividing the area between the perfect equality line and the Lorenz curve by the total
area lying to the right of the equality line in a Lorenz diagram. The higher the value of the
coefficient, the higher the inequality of income distribution; the lower it is, the more equal the
distribution of income. This is also known as the Gini concentration ratio.

As M.P. Todaro (2009) pointed out Gini coefficient is among a class of measures that satisfy four
highly desirable properties. These are:

(A) Anonymity principle: simply means that our measure of inequality should not depend on who
has the higher income.

(B) Scale independence principle: means that our measure of inequality should not depend on the
size of the economy or the way we measure its income.

(C) Population independence principle: it states that the measure of inequality should not be based
on the number of income recipients. And

(D) Transfer sensitivity principle: (sometimes called the Pigou-Dalton principle after its creators);
it states that, holding all other incomes constant, if we transfer some income from a richer person to a
poorer person (but not so much that the poorer person is now richer than the originally rich person),
the resulting new income distribution is more equal.

Arjon, Ladaique and Pearson (2003) highlight that: “the Gini coefficient is particularly sensitive to
changes in the middle of the income distribution” so it is an inadequate inequality measure in order to
study the relationship between inequality and economic development. When the impact of income
distribution on the investment decisions is analyzed, the top quintile is the most relevant. However,
Knowles claims that: “the Gini coefficient is chosen as the measure of inequality, because the data
are more readily available than for other possible measures and for comparability with the existing
literature” (Knowles 2001). 16

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Coefficient of variation: a measure of dispersion common in statistics, which is simply the sample
standard deviation divided by the sample mean, is another measure of inequality that also satisfies the
four criteria (M.P. Todaro,2009).

2. Functional distribution of income

The second common measure of income distribution used by economists, the functional or factor
share distribution of income, attempts to explain the share of total national income that each of the
factors of production (land, labor, and capital) receives. Instead of looking at individuals as separate
entities, the theory of functional income distribution inquiries into the percentage that labor receives
as a whole and compares this with the percentages of total income distributed in the form of rent,
interest, and profit (i.e., the returns to land and financial and physical capital). Although specific
individuals may receive income from all these sources, that is not a matter of concern for the
functional approach. It attempts to explain the income of a factor of production by the contribution
that this factor makes to production. Supply and demand curves are assumed to determine the unit
prices of each productive factor. When these unit prices are multiplied by quantities employed on the
assumption of efficient (minimum-cost) factor utilization, we get a measure of the total payment to
each factor. The supply of and demand for labor are assumed to determine its market wage. When
this wage is then multiplied by the total level of employment, we get a measure of total wage
payments, also sometimes called the total wage bill.

In a competitive market economy with constant-returns-to-scale production functions (a doubling of

all inputs doubles output), factor prices are determined by factor supply and demand curves, and
factor shares always combine to exhaust the total national product. Income is distributed by function-
laborers are paid wages, owners of land receive rents, and capitalists obtain profits. This model of
income distribution is at the core of the Lewis theory of modern-sector growth based on the
reinvestment of rising capitalist profits. Unfortunately, the relevance of the functional theory is
greatly diminished by its failure to take into account the important role and influence of nonmarket
forces such as power in determining these factor prices (M.P. Todaro, 2009).

2.1.3. Factors influencing economic growth

The economic growth of a country may get hampered due to a number of factors, such as trade deficit
and alternations in expenditures by governmental bodies. The economic growth of a country is also
adversely affected when there is a sharp rise in the general prices of goods and services. As Nitisha
(2013), pointed out the following are some of the important factors that affect the economic growth
of a country.

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A, Human Resource: refers to one of the most important determinants of economic growth of a
country. The quality and quantity of available human resource can directly affect the growth of an
economy. The quality of human resource is dependent on its skills, creative abilities, training, and
education. If human resource of a country is well-skilled and trained then, the output would also be of
high quality. On the other hand, a shortage of skilled labor hampers the growth of an economy,
whereas surplus of labor is of lesser significance to economic growth. Therefore, the human resource
of a county should be adequate in number with required skills and abilities, so that economic growth
can be achieved.

B, Natural Resource: affect the economic growth of a county to a large extent. A natural
resource involves resources that are produced by nature either on the land or beneath the land. The
resources on the land include plants, water resources and landscape. And the resources beneath the
land or underground resources include oil, natural gas, metals, non-metals, and minerals. The natural
resource of a country depends on the climatic and environmental conditions. Countries having plenty
of natural resources enjoy good growth than countries with small amount of natural resources. The
efficient utilization or exploitation of natural resources depends on the skills and abilities of human
resources, technology used and availability of funds.

C, Capital Formation: involves land, building, machinery, power, transportation, and medium of
communication. Producing and acquiring of all these manmade products is termed as capital
formation. Capital formation increases the availability of capital per worker, which further increase
capital/labor ratio. Consequently, the productivity of labor increases, which ultimately results in the
increases in output and growth of the economy.

D, Technological Development: it is also one of the important factors affecting growth of the
economy. Technology involves the application of scientific methods of production techniques.
Technological development helps in increasing productivity with the limited amount of resources.
The selection of right technology also plays an essential role for growth of an economy. On the
contrary, an inappropriate technology results in high cost of production.

E, social and Political factors: these factors also play a crucial role in economic growth of a
country. Social factors involve customs, traditions, values and beliefs, which contribute to the growth
of an economy to a considerable extent. For example, a society with conventional beliefs and
superstitions resists the adoption of modern ways of living. In such a case, achieving becomes
difficult. Apart from this, political factors, such as participation of government in formulating and
implementing various policies, have a major part in economic growth.

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2.1.4. Factors influencing income inequality
Different studies on both the developing and developed countries propose many factors that influence
income inequality to a smaller or larger degree. The direction of these influences, however, is often
unclear: whether a higher value of a certain factor causes higher or lower inequality depends on the
characteristics of the economic system and the overall level of development of the country is in
question. Likewise, there are often problems with causality. For instance, there is no consensus about
the direction of the relationship between income inequality and economic growth. Some empirical
studies support the hypothesis about growth influencing inequality, while others report that inequality
influences growth. It is possible that this is so because causal links between economic growth and
income inequality work through many other factors. A. Kaasa (2003) classified different factors
affecting inequality into five groups as follows.

Economic growth and the overall development level of a country-this group includes growth in the
GDP, technological progress and the structure of the economy, meaning the shares of the agricultural,
industrial and service sectors. There are studies that report the inverted U-shaped relationship
between the average income and income inequality first introduced by Kuznets (Ferreira, 1999):
growth from the low development level leads first to an increase in inequality,

but then, at a higher development level, to a decrease in inequality. However, the evidence from 19
the transition process and many studies has caused skepticism about Kuznets’ hypothesis. According
to this, it may be reasonable to look for a connection between growth in the GDP and inequality
through other indicators, which describe a particular country’s level of development. One of these
indicators may be the share of the population employed by different sectors. There is evidence that if
a large part of the population moves to a higher sector, inequality will increase, but if the movement
stops, income distribution will become more even again (Gustafson and Johansson, 1997).
Technological change can also cause dispersion of wages because of an increased need for skilled
workers and rising productivity of skilled workers only. However, these changes can be avoided with
appropriate adjustments in education policy (Cornia and Kiiski, 2001).

Macroeconomic factors- are inflation and unemployment, the size of government’s expenditure,
external debt and foreign reserves, changes in the exchange rate, and other factors. High inflation
mainly causes deepening inequality, because it redistributes resources from persons with fixed
nominal income usually from the socially less insured and poorer part of the population (Gustafson
and Johansson, 1997). Unemployment has inequality increasing effects, because high unemployment
worsens the situation of those at the bottom of income distribution.

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The influence of the government’s expenditure depends on its composition, mainly on the share of
social transfers in public expenditure (Cornia and Kiiski, 2001).

Demographic factors-include processes of demographic development, including the age structure of

population (share of economically active population), the growth and density of population;
urbanization, level of human capital, including the level of education and health condition of
population. For example, inequality tends to be lower in countries with high population density than
in those with low population density. Research has indicated that the relationship between
educational expansion and inequality is inverted U-shaped (Cornia and Kiiski, 2001).

Political factors-include privatization and the share of the private sector, level of taxes and the share
of the public sector, openness of a country, especially trade openness and freedom of labor
movement; social policy and other decisions of economic policy. Privatization in the transition
countries causes wealth concentration to a greater or smaller extent, leading to a more uneven 20

Income distribution Earnings inequality in the public sector is typically lower than in the private
sector; thus, the bigger the share of the public sectors in economy, the lower the overall inequality
(Gustafson and Johansson, 1997).

Historical, cultural and natural factors- which among others include distribution of land ownership,
people’s attitude to inequality, extent of shadow economy, which are all formed in the course of long
history. In addition to these, there is one more factor; availability of natural resources. Countries
well-endowed with natural resources tend to have greater inequality because of capital based
technology and a lower need for unskilled labor. Inequality is certainly higher in those countries,
during whose history land, natural resources and wealth have concentrated into the hands of a small
group of the population (Cornia and Kiiski, 2001).

2.1.5 The relationship between economic growth and income inequality

Theory shows that income inequality is a condition that prevails along with economic growth.
According to the utilitarian view, income inequality must exist along with the economic growth in
order to maximize social welfare. This is in sharp contrast to the egalitarian view according to which,
all members of the society should have equal access to all economic resources in terms of economic
power, wealth and contribution. Kuznets (1955) introduced the inverted U-shaped Kuznets curve that
showed that in an economic system, at the initial level of low economic growth, income inequality is
low and as growth occurs, income inequality increases till a threshold, after which, income inequality
decreases with increased economic growth. In the United States, income inequality remained stable
till the 1970s but then began to increase as earnings increased.

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There is also both theoretical and empirical literature that divided with some studies concluding that
inequality leads to faster growth, and some others suggesting that inequality is likely to lower growth.

In the theoretical literature, there are three main arguments for the detrimental impact of inequality on
growth. The first is the political economy argument (Alesina and Rodrick, 1994), which is based on
the following three premises: (i) redistributive government expenditure and taxation are negatively
related to growth because of their negative effect on capital accumulation; (ii) taxes are proportional
to income but the benefits of public expenditure accrue equally to all individuals, which in turn
implies that an individual's preferred levels of taxation and expenditure are inversely related to his
income; and (iii) the tax rate selected by the government is the one preferred by the median voter.
Taken together, those premises would imply that growth increases as inequality falls.

A second argument for an inequality-to-growth direction of causality relies on the so-called

sociopolitical instability approach (Alesina and Perotti, 1996) which can be summarized as follows:

(i) Highly unequal societies create incentives for individuals to engage in activities outside normal
markets, such as crime, etc.; and

(ii) Socio political instability discourages accumulation because of current disruptions and future
uncertainty. This approach would also imply that growth increases as inequality falls.

A third argument for the proposition that increases in inequality lead to lower growth is the presence
of credit constraints. Galor and Zeira (1993), note that if (i) the process of development is
characterized by complementarities between physical and Human capital so that growth increases as
investment in human capital increases; and (ii) credit constraints prevent poorer individuals from
investing in education, then inequality will adversely affect growth prospects by reducing the number
of individuals who are able to invest in human capital. Similarly, Aghion (1999), show that :-

(i) There are decreasing returns with respect to individual capital investments; and

(ii) Credit imperfections mean that individual investments are an increased function of initial
endowments, then inequality would be detrimental to growth by concentrating investment in fewer
richer people (with a lower marginal return to investment).

It is worth noting here that even if the three arguments above predict that inequality hampers growth,
their predictions on the impact of redistribution on growth are different. For example, the political
economy argument is based on the premise that progressive distributional change has a negative
impact on growth. On this argument, redistribution would negatively affect growth through two
different channels. First, it would provide a disincentive to work effort from those on the receiving

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side. Second, if would discourage investment from those who transfer the bulk of resources. On the
other hand, the sociopolitical and credit constraints arguments would predict that redistribution - by
increasing political stability and the associated investment in the first case and by creating investment
opportunities with a high marginal return in the second case - would have a positive impact on
growth.

Admittedly, there are also models that predict that inequality is likely to be growth enhancing. First,
one may consider Caldor’s hypothesis that the marginal propensity to save of rich people is higher
than that of poor people. Then if the investment rate is positively related to the saving rate, and
growth is positively related to investment, more unequal economies can be expected to grow faster.
Bourguignon (1981), builds a more elaborate model and shows that with a convex saving function,
aggregate output depends on the initial distribution and is higher the more unequal society. Second
reason why inequality may lead to faster growth is related to investment indivisibilities. If new
investment projects require large initial sums, in the absence of effective capital markets that allow
pooling of resources by small investors, wealth concentration would support new investment and
therefore lead to faster growth. A third reason supporting this argument can be based on the potential
tradeoffs between efficiency and equality. For example compressed wage structures that do not
reward merit will lead to more equal societies, but it also likely that they will reduce workers’
incentives to put in additional effort or aim at outstanding achievements (Mirrlees, 1971).

2.1.6. Income Inequality as a cause of Economic growth

The debate presented so far has been on the effect of economic growth on income inequality, to
which the bulk of the literature has been devoted. Let us now to turn our attention to the reverse of
relationship. According to Colman and Nixson (1988), the Lewis model gives support to the
argument that increasing inequality is not the only an inevitable effect of economic growth, but also a
necessary condition for growth. The basic argument is that savings are essential to increase
productive capacity which leads to higher rates of growth, the reason why income must be
redistributed towards the groups that save and invest- the rich- in order to ensure capital
accumulation and growth.

Therefore an economy with a high concentration of income by the upper groups is more likely to
grow faster than one with a more equitable distribution of income. This is the pro- inequality
argument. However, in line with Kuznets’ (1955) warnings, in a least developed countries (LDC)
context there are no guarantees that the higher income groups will save a significant proportion of
their incomes in their own country. According to Todaro (1994), unlike the historical experience of
the now developed countries, the rich in the developing countries are characterized by spending in
luxury consumption (usually imported) and saving abroad. He also challenges the pro-23 inequality
16 | P a g e
argument pointing out that highly unequal distribution of income is manifested in poor health,
nutrition, housing and education for the vast majority of the population, which in turn lead to the low
levels of productivity and thereby to a slower growing economy, while the redistribution of income to
the lower income groups would stimulate demand for home production, since the rich tend to spend
more of their additional incomes on imported goods. “Rising demand for local goods provides a
greater stimulus to local production, local employment, and local investment. Such demand thus
creates the conditions for rapid economic growth and a broader popular participation in that growth”
(Todaro, 1994). This is pro-equality argument.

2.2. Empirical reviews

A large number of empirical studies have attempted to explore the relationship between income
inequality and economic growth. Different researchers have used different types of data to study the
relationship. This section will summarize previous work done on this area. Empirical research on
economic growth-income inequality relationship started in 1955 when Simon Kuznets published his
study. The general conclusion suggested for developed countries using scanty data was that, the
relative distribution of income, as measured by annual income incidence in rather broad classes, has
been moving toward equality. The scanty empirical evidence suggested that the narrowing of income
inequality in the developed countries did not characterize the earlier stages of economic growth. The
reduction in the inequality of income in developed countries was accompanied by significant rises in
real income per capita. However, for underdeveloped countries, the income inequality increased. The
wider inequality in the secular income structure of underdeveloped countries is associated with a
much lower level of average income per capita (Maina, 2006). According to Kuznets, the level of
economic development is related to the degree of income inequality. Income inequality tends to
increase during the early stages of economic growth, then levels off, and finally decreases during
later stages. The Kuznets curve illustrates this relationship; the level of inequality first rises at the
early phases of economic growth and then starts declining at the later phases of economic growth.

Kuznets describes a positive relationship 24 between income inequality and economic growth at the
early phases of growth and a negative relationship in the later phases of economic growth. However,
there are many empirical findings that have done in different countries in different period of time.
Some empirical findings support Kuznets hypothesis, while the others would not argue that the
Kuznets sequence of increasing and then decreasing inequality is inevitable. Among these empirical
findings lets us to see the following;

Perotti (1996) studied the reduced form relationship between income distribution and growth. He
used cross sectional data for a number of countries. From the reduced form estimates and tests
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performed he found that: there is a positive association between equality and growth, although a good
deal of it is coming from intercontinental variation; this positive association is quantitatively much
weaker, and statistically insignificant, for poor countries; however, this can be explained both on
empirical and theoretical grounds; there is some indication that the association between equality and
growth is stronger in democracies; however, the democracy effect does not seem to be very robust;
because of the high concentration of democracies in rich countries, it is virtually impossible to
distinguish an income effect from a democracy effect in the relationship between income distribution
and growth.

Lee and Roemer (1998) studied the political economy of inequality and growth by combining the
political economy approach with an imperfect capital market assumption. They show that inequality
affects private investment not only through the political effect, which relates inequality to private
investment negatively, but also through the threshold effect, which associates inequality to private
investment positively. In general, private investment and inequality do not show a monotone negative
relationship. A high inequality induces a high redistributive tax rate with a median voter political
process; a high tax rate chokes off private investment due to the disincentive effect; and any factors
detrimental to private investment are harmful to growth. On the other hand, a high tax rate might
choke off private investment, but it also boosts public investment. Hence a high tax rate is not
necessarily detrimental to economic growth.

A study by Dahan and Tsiddon (1998), investigated the dynamic interactions among demographic
transition, income distribution, and economic growth. It showed that fertility and income distribution
follow an inverted U-shaped dynamic in the process of economic development. In the first stage
fertility increases and income inequality widens, whereas in the second stage fertility declines,
income becomes more equally distributed, human capital becomes more abundant, and growth of
income per capita takes off. The dynamic process is based on two main elements. The net return to
education of the child of an educated parent is higher than the net return to education of the child of
the uneducated parent, and the costs of raising children are measured in terms of parents' foregone
earnings. Hence, provided that children are viewed as a normal good, educated parents have fewer
children than uneducated parents have. As the premium to investment in human capital increases,
eventually some of the offspring of the uneducated poor choose to invest in human capital and
become educated. During this second phase, the population's overall level of education rises, fertility
declines, income becomes more equally distributed and output per capita takes off. Since the poor
have a growing weight in the economy in the first phase and a declining weight in second phase, the
economy wide average rate of fertility first increases and subsequently declines.

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A study by Barro (2000), using a broad panel of countries showed little overall relation between
income inequality and rates of growth and investment. However, for growth, higher inequality tended
to retard growth in poor countries and encourage growth in richer countries. The Kuznets curve -
whereby inequality first increases and later decreases during the process of economic development -
emerged as a clear empirical regularity.

Panizza (2002) used a cross-state panel for the United States to assess the relationship between
inequality and growth. His paper did not find evidence of a positive relationship between inequality
and growth but found some evidence in support of a negative relationship between inequality and
growth. However, the paper showed that the relationship between inequality and growth is not robust
and that small differences in the method used to measure inequality can result in large differences in
the estimated relationship between inequality and growth. 26 Voitchovsky (2005) investigated the
importance of the shape of the income distribution as a determinant of economic growth in a panel of
countries. Using comparable data on disposable income from the Luxembourg Income Study, results
suggested that inequality at the top end of the distribution is positively associated with growth, while
inequality lower down the distribution is negatively related to subsequent growth. The central
hypothesis of his paper was that the positive and negative influences of inequality on growth are
mostly associated with inequality in different parts of the income distribution. Many of the positive
mechanisms were linked to inequality at the upper end of the income distribution, while many of the
negative mechanisms were associated with inequality further down the distribution. The results of the
study suggested that growth was facilitated by an income distribution that is compressed in the lower
part of the distribution, but not so at the top end. In this view, redistributive policies - such as
progressive taxation and social welfare - are likely to facilitate growth through their impact on the
bottom of the distribution, and to inhibit growth through their impact on the top of the distribution.

Dollar and Kraay (2001), using data on trade liberalization as a share of GDP in constant prices for
101 countries including 73 developing countries between 1975-79 and 1995-97 found that trade
openness leads to declining inequality between countries, and declining poverty within countries. The
poor countries that have reduced trade barriers and participated more in international trade over the
past twenty years have seen their growth rates accelerate. In the 1990s they grew far more rapidly
than the rich countries, and hence reduced the gap between themselves and the developed world. At
the same time the developing countries that are not participating in globalization are falling further
and further behind. Within the globalizing developing countries there has been no general trend in
inequality.

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When we came to our country Ethiopia, there are few studies on the relationship between economic
growth and income inequality. Beza Girma (2009) assessed the link between economic growth and
income inequality in Ethiopian case. This paper employed a data from 1995/96-2007/08 and used
descriptive method of analysis. Generally, the conclusion of this study was that, as growth is attend;
inequality between the societies increase, leading to the few to hold the most important part of the
resources. The society would be in deep poverty and income will be distributed unevenly.

Abdurahman Bedewi (2011), tried to examine the possible relationship between inequality and
economic growth in 12 African countries including Ethiopia. This papers approach was essentially
descriptive by employing the data from 1970’s-2000’s. the result of the study showed that, there exist
the link between income inequality and economic growth in almost all the countries, with different
degree of association. Additionally, it indicated that initial income inequality influences subsequent
economic growth with different manner and degree according to the specific condition in the
countries. Gedion Bula (2012), tried to examine the relationship between economic growth and
income inequality in Ethiopia with the help of Kuznets inverted U-hypothesis for the period of 1996-
2011. It employed time series data and analyzed it using Augmented Dickey Fuller (ADF) test, unit
root test of stationary and Engel Granger (EG) test of co-integration. The result of the analysis
indicated that real GDP per capita has a negative influence on inequality, which is measured by Gini-
coefficient.

2.3 Conceptual Framework of the Study

The conceptual framework of this study will confined several works of literature, practical
experiences, and findings of the reality have indicated that economic growth has a great role to affect
current account balance. The conceptual frameworks also show different factors that determine
economic growth includes; Income inequality, government expenditure, Inflation, human capital and
Investment.
.
Income inequality

Government
Economic Expenditure
Growth
Inflation Investment

Human Capital

Figure 3 Conceptual Frame Work for the Derivers of EG and Its Effect on
Income,
Source:Investment, Inflation,
Own description based GE and Human capital.
on literature

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 CHAPTER THREE

3 Methodology of the Study

3.1. Source of Data

Due to the study nature the only source of data used in this study is secondary source based on a
country level macroeconomic data. A yearly time series on GDP per capita, income inequality,
human capital, government expenditure, trade openness and private investment is gathered covering
the period from 1982-2016. The choice of the period is basically based on the availability of the data.
The relevant data will be collected from national bank Ethiopia (NBE), international monetary fund
(IMF), ministry of finance and economic development (MOFED) and other source which are
perceived to be relevant and reliable.

3.2. Method of Data Analysis

In this study both simple descriptive and econometric methods of data analysis are used. In an
attempt to meet the objectives, we use the tools of descriptive statistics such as trend graphs. The rest
of the research objective will be achieved using the standard econometric technique which will be
discussed in the next topic.

3.3 Model specification

This section presents a simple econometrics model that attempts to analyze the linkage between
income inequality and economic growth in Ethiopia. However many other variables are must be
analyzed (has identified), because various factors that influence the economic growth of a country
from the classical, neo classical and new growth theories. These factors on per capita income, income
inequality, human capital, government expenditure and private investment are in order to
understanding characteristics and determinant of economic growth requires an empirical framework
that can be applied to a relatively long time frame work. In order to examine the empirical evidence
of the macroeconomic determinants of economic growth in Ethiopia, the study considers most of
these factors listed above. Moreover, the variables are preferred based on their relevance and data
availabilities. Therefore the mathematically relationship between real GDP and its major
macroeconomic determinant are expressed as follows:
GDP= β0+ β1GINI+ β2GE+ β3HC+=β4INV+ β5INF+ µt …………. (3.1)
Then, the researcher transformed all the variables under study into; in to the following ways
GDPt =β1+β2GINIt +β3GEt +β4HCt +β5INFt+β6INt +µt…….. (3.2)

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Where: Gini=Income inequality as measured by Gini coefficient
GE= Government expenditure
INF= Inflation
HK: Human capital
INV=Investment:
µt =Error term All variables are at time t.

3.4. Description of variables and expected sign on Economic growth

3.4.1. Dependent variables

Economic growth
In this study the dependent variable is economic growth which is defined as the long-run expansion
of the economy's ability to produce output by increasing the quantity or quality of the economy's
resources (labor, capital, land, and entrepreneurship). It is measured by real GDP growth rate.
Economic growth related to an increase in real GDP. Real GDP is the total market value, measured in
constant prices, of all goods and services produced within the political boundaries of an economy
during a given period of time, usually one year. The key is that real gross domestic product is
measured in constant prices, the prices for a specific base year. Real gross domestic product, also
termed constant gross domestic product, adjusts gross domestic product for inflation. So, the increase
in real GDP means there is an increase in the value of national output / national expenditure.

3.4.2. Independent variable

This paper tries to include some other explanatory factors in addition to income inequality based on
the availability of data. The selected factors as clearly seen in the model are described as follows;

1. Income inequality
One of the major factors that affect economic growth within this specified model is income
inequality. Income inequality means that one segment of the population has a disproportionately large
share of income compared to other segments of that population. It depends on how income is
distributed. Income distribution is a manner in which income is divided among the members of the
economy. A certain amount of inequality in the income distribution is to be expected because
resources are never equally distributed. Gini index is used as a measure of income inequality, which
shows extent to which the distribution of income among individuals or households within an
economy deviates from a perfectly equal distribution. Gini index of 0 (zero) represents the
distribution is perfectly equal, that is, everyone has exactly the same amount of income or 31 Wealth,
while an index of 100 implies the distribution is perfectly unequal. There for Gini coefficient used as
a proxy and the sign of the coefficient would expected to be negative.

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2. Inflation
Inflation: is a persistent increase in the average price level in the economy. Inflation occurs when the
average price level (that is, prices in general) increases over time. This does not mean that all prices
increase the same, or that all prices necessarily increase. Some prices might increase a lot, others a
little, and still other prices decrease or remain unchanged. Inflation results when the average of these
assorted prices follows an upward trend. The most common price indices used to measure the
inflation is the Consumer Price Index (CPI). The coefficient of this variable would expect to be a
negative.

3. Government Expenditure
Government expenditures refer to the expenses that the government incurs for its own maintenance,
for the society and the economy as a whole. According to Keynesian view, government could reverse
economic downturns by borrowing money from the private sector and then returning the money to
the private sector through various spending programs. High levels of government consumption are
likely to increase employment, profitability and investment via multiplier effects on aggregate
demand. Thus, government expenditure, even a recurrent nature, can contribute positively to
economic growth. On the other hand, endogenous growth models such as Barro (1990), predict that
only those productive government expenditures will positively affect the long run growth rate

4. Human Capital
Human capital can be developed by investing in education, training and health care. Human capital is
a means of production, into which additional investment yields additional output. Human capital is
substitutable, but not transferable like land, labor, or fixed capital. Modern growth theory sees human
capital as an important determinant of economic growth
5. Investment
Investment (proxy by gross capital formation) is a net addition to the existing capital stock by
sacrificing current for future consumption. It is the purchase of new capital such as equipment and
others. For Keynes, investment refers to real addition to capital equipment. It leads to increase in
level of income and production by increasing the production and purchase of capital goods. It needs
purchase of new capital; hence it affects import positively. Similarly, it affects export positively
because it increases domestic production of exportable goods and service

3.5. Estimation Procedure

To test the long run relationship between dependent variable (GDP) and independent variable
(income inequality, government expenditure, human capital, private investment, Inflation) the study
applies vector autoregressive (VAR) model or vector error correction (VEC) model, because if there

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is co-integration between the explanatory variables VCEM is applicable but if there is no co-
integration problem VAR model is applicable for time series econometric analysis. The study will
first investigate the time series properties of our data by using Augmented Dickey-Fuller (ADF) test.
The unit root tests will be used to check the stationary of the variables and to check none of the
variables are order two (i.e. I (2)), which is the precondition to apply VCEM or VARM.
3.5.1 Vector Autoregressive Model (VAR Model)
A large number of past studies have used the Johansen co integration and Engle-Granger causality
technique to determine the long-term relationships between variables of interest.
Vector auto regression (VAR) was introduced by Sims (1980) as a technique that could be used by
macroeconomists to characterize the joint dynamic behavior of a collection of variables without
requiring strong restrictions of the kind needed to identify underlying structural parameters. It has
become a prevalent method of time-series modeling. Although estimating the equations of a VAR
does not require strong identification as-assumptions, some of the most useful applications of the
estimates, such as calculating variance decompositions do require identifying restrictions. A typical
restriction takes the form of an assumption about the dynamic relationship between a pair of
variables, for example, that x affects y only with that x does not affect y in the long run. A VAR
system contains a set of m variables, each of which is expressed as a linear function of p lags of itself
and of all of the other m – 1 variable, plus an error term. (It is possible to include exogenous variables
such as seasonal dummies or time trends in a VAR, but we shall focus on the simple case.) With two
variables, x and y, an order-p VAR would be the two equations

3.5.2 Vector Error Correction Models (VECM)

If the time series are not stationary then the VAR framework needs to be modified to allow consistent
estimation of the relationships among the series. In this study VECM offers a possibility to apply
Vector Autoregressive Model (VAR) to integrated multivariate time series. The first step is one estimate
a VAR model with appropriate number of lags (using the usual goodness of fit criteria) and then
checks if the residuals correspond to the model assumptions, namely the absence of serial correlation
and heteroscedasticity. So, one check if the VAR model appropriately describes the multivariate time
series and one proceeds to further steps only if it does. The vector error correction (VEC) model is
just a special case of the VAR for variables that are stationary in their differences (i.e., I (1)). The
VEC model can also take into account any co integrating relationships among the variables. Consider
two time-series variables, yt and xt.

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Generalizing the discussion about dynamic relationships to these two interrelated variables yields a
system of equations;

Yt=β1+β2yt-1+β3xt-1+µt (3.3)

Xt=α1+α2yt-1+α3xt-1+µ (3.4)

The equations describe a system in which each variable is a function of its own lag, and the lag of
the other variable in the system. In this case, the system contains two variables y and x. Together the
equations constitute a system known as a vector auto regression (VAR). In this example, since the
maximum lag is of order one; we have a VAR (1).
If y and x are stationary, the system can be estimated using least squares applied to each equation. If y
and x are not stationary at levels, but stationary in differences (i.e., I (1)), then take the differences
and estimate:
 Yt=β1+β2yt-1+β3xt-1+µt (3.5)
Xt=α1+α2yt-1+α3xt-1+vt (3.6)
If y and x are I(1) and co integrated, then the system of equations is modified to allow for the co
integrating relationship between the I(1) variables. Introducing the co integrating relationship leads to
a model known as the vector error correction (VEC) model.

3.5.3 Testing for Stationary or unit roots

As Mahadeva and Robinson (2004) define stationary series as those with a constant mean, constant
variance and constant auto-covariance for each given lag. Hence, Stationary is tested using the
Augmented Dickey Fuller (ADF). The Dickey Fuller test estimated in three forms that is:-

t= t-1+ut--------------------------------------------------- when Y t is random walk and no trend and

intercept

t = o+ t-1 +ut--------------------------------------------------------------------- when Yt is random walk with drift (intercept only).

Yt= 0+ t-1+ 1t+ ut-------------------------------------------------------------- when Yt is random walk with drift around stochastic
trend/trend and intercept.
In each test the null hypothesis is that the variable is non-stationary against the alternative stationary.
The null hypothesis is rejected only when there is strong evidence against it at the conventional levels
of significant evidence against it at the conventional levels of significant.

3.6 Co integration

The study use EG test to test whether the variables are co integrated or not. Co integration theory is
definitely the innovation in theoretical econometrics that has created the most interest among

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economists in the last decade. The definition in the simple case of 2 time series xt and yt, that are
both integrated of order one I(1), and means that the process contains a unit root), is the following:
Yt=αXt+ut (3.7)
Xt and YT are said to be co integrated if there exists a parameter α such that:
ut= yt– αxt (3.8)
It’s a stationary process. This turns out to be a path breaking way of looking at time series. Because,
it is seems that lots of economic series behaves that way and because this is often predicted by
theory. The first thing to notice is of course that economic series behave like I (1) processes, i.e. they
seem to “drift all over the place"; but the second thing to notice is that they seem to drift in such a
way that they do not drift away from each other. If you formulate this statistically you come up with
the co integration model. The reason unit roots and co integration is so important is the following.
Consider the regression
Yt = αo + α1xt+ ut (3.9)
Assume that Xtis a random walk and that yt is an independent random walk (so that
Xt is independent of ys for all s). Then the true value of α1 is of course 0, but the limiting
Distribution of α hat1 is such that α hat 1 converges to a function of Brownian motions; this is called
a spurious regression.

3.7 Hypothesis

The study will be hypothesizes that the factors income inequality and inflation affect economic
growth negatively and significantly, that means the sign of the coefficient of these variables expected
to be negative. But the coefficient sign of human capital (measured by primary education enrollment
rate), investment and government expenditure expected to be positive.

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 CHAPTER FOUR

4. Descriptive and econometric analysis

4.1 Descriptive analysis

During the period between 2008/09-2015/16 the country planned and implemented two development
plan and strategy. The sustainable development and poverty reduction program (SDPRP) which
covered the years 2007/08-2009/10 and a plan for accelerated and sustained development to end
poverty (PASDEP) that ran from 2010/11 to 2012/13. Under this plan periods the government took
different political, social and economic measures. Conducive government policies such as
infrastructure development, commercialization of agricultural products and improvement in access in
the basic services as well as on private sector of development, heavy investment on roads,
telecommunication and energy. This measures increase the participation of the private sector by
decreasing cost of doing business. As a result, different sectors of the economy showed a tremendous
growth.

The service sector showed a remarkable growth and surpassed the agriculture sector. The impressive
growth in the service sector was driven by the rapid expansion in financial intermediation (private
banking), public administration, retail business activities, and hotel and transport service delivery.
Private investors invest their fund in the service sector such as transport and transport than investing
on industry. This is due to the capacity of the sector to generate a higher rate of return within a
shorter period to the investor. On the other hand, the share of GDP has remained relatively static
between 13 and 14%. This implies that the economy is transforming from the agriculture sector to the
service sector. The low share of the industrial sector, a crucial sector in transforming an economy, is
a concern for the Ethiopian government. The agricultural sector has the highest share to the GDP
means that the economy is vulnerable to economic and natural shocks since agricultural productions
are depend on nature and primary products are subject to price fluctuations. The service sector is not
much productive compared to the industrial sector. Therefore the structural transformation of the
economy from the agricultural sector to the service sector (less productive) sector is a problem.

Table 4.1different sectors

Sector 2007 2008 2009 2010 2011 2012 2013 2014 Average

/04 /05 /06 07 /08 /09 /10 /11

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 Real GDP growth rates

Agriculture 16.9 13.5 10.9 9.4 7.5 6.4 7.6 10 10.2

Industry 11.6 9.4 10.2 9.5 10.0 9.9 10.8 15 10.8

Service 6.3 12.8 13.3 15.3 16.0 14.0 13.2 12.5 12.9

Sectorial Shares to GDP (%)

Agriculture 47.0 47.4 47.1 46.1 44.6 43.2 42.0 41.1 44.8

Industry 14.0 13.6 13.4 13.2 13.0 13.0 13.0 13.4 13.3

Service 18.0 22.9 23.6 30.6 44.4 35.1 14.2 33.5 27.8

4.2.1 Trend in Economic Growth

Table 1 below presents the trend in economic growth by using average real per capita growth and
growth rates for different periods. The raw data is extracted from World Bank world development
indicators, WDI (2019). The available evidence indicates that the rate of GDP per capita growth rates
shows fluctuations over the last 30 years (figure 1). During the year 1990 and 2013, GDP showed ups
and downs. For instance, it was -6.08%, -0.76 and -4.6 in the year 1990, 2002 and 2004 respectively.
The reasons behind the fluctuation were economic and political shocks. There was a border conflict
between Eritrea and Ethiopia, internal political instability, fluctuations in prices of coffee and chat i.e.
a major export item for the country and the resulting export earning instability. Between the years
2008-2015 GDP showed a continuous and significant progress. The introduction of market oriented
economic reforms to initiate private sector development and foreign investments. As a result private
investments increased significantly. Private owned banks, insurance companies and large scale
manufacturing industries, construction firms, hotels, and transportation service emerged. Price
deregulation helped farmers to sell their produce in the open market. This combined effects of rapid
transformation in the economic sphere led to increase incomes, between 2008 and 2015, GDP in
Ethiopia increased by 8.08%.

From the trend of economic growth during the last years, it is possible to conclude that the positive
growth can be achieved for the coming many years but it is depend on favorable economic and
natural conditions such as good weather conditions ( the main determinant of agricultural output),
external economic stability since Ethiopian economy is dependent on the external economy
especially the industrial sector which is dependent on imported input, political stability, good macro-
economic performance etc.

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Even if GDP showed annual fluctuations, the average real per capita growth has improved from
1.86% in the first five year period of 1982-2000 to 4.07 in the second five years period of 2002-2006
and to 7.42 in the third six years period of 2008-2012.

Table4.2: GDP Growth (2000 $ US)

Year Per Capita GDP (2000 Per Capita Growth Rate
$US) (%)
1990 124.24 9.73
1992 124.52 0.22
1994 116.94 -6.08
1996 119.92 2.54
1998 123.68 3.13
2000 130 5.6
2002 129 -0.76
2004 123 -4.6
2006 136 10.56
2008 149 9.55
2010 161 8.05
2012 176 9.31
2014 190 7.95
2016 203 6.84
2018 218 7.38
20020/21 229 5.04

Source: Own Computation Based on World Bank (2021), ADI

Even if, GDP per capita shows annual fluctuation over the last sixteen years there was an
improvement in GDP per capita from one period to another. For instance, average real per capita was
121.2 (dollar) in the first five year period of 1996-2000, 133.4 (dollar) in the second five year period
of 2002-2006 and finally 196.16 (dollar) in the last thirty two year period of 2008-2012.

Table4.3 Average GDP Per Capita (2000 $ US)

Description Year

1990-2000 2001-2010 2011-2021

Average GDP Per Capita for 121.2 133.4 196.16

Different Periods

Source: Own computation based on World Bank (2021), ADI

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4.1.2 Trends in Inequality
To analyze the trends in income inequality, Gini coefficient, Lorenz curve, and distribution of
expenditure across different groups in different periods are used. We are already discusses those
issues on chapter two. And we will examine them in Ethiopia case.

4.3 Income Inequality Measured by Gini Coefficients

Table4.4 Trends in urban, rural, and national Gini coefficient

Year Rural Urban National

2006/7 0.27 0.34 0.29
2010/01 0.26 0.38 0.28
2015/6 0.26 0.44 0.30
2019/21 0.27 0.37 0.30
Source: CSA, HICES 2021
As can see in table 4 above, the overall national Gini coefficient decreased from 0.29 in 2006/7 to
0.28 in 2010/01/. The Gini coefficient increased from 0.28 in 2010/01to 0.30 in 2015/06 and it
remains unchanged until 2019/21.The increment in national income inequality was driven by
increased urban income inequality. The decline in income inequality in urban areas has resulted in a
huge decline in poverty. Such positive developments in urban areas are because of the urban focused
development activities carried out in the country including urban infrastructure development (road,
private and condominium housing construction), promotion of labor intensive activities(use of
cobblestone to construct urban roads), promotion of labor intensive enterprises via the provision of
training, credit and business development support, and the distribution of subsidized basic food items
to urban poor in times of crisis over the past five years. As we can observe from the figure below,
urban Gini coefficient (income inequality) is higher relative to rural and national Gini coefficient.
From this we can conclude that there is high level of income inequality in urban areas compared to
rural areas and at national level. The possible reasons for higher urban income inequality were the
following. Rural to urban migration, poor and illiterate peoples migrate to urban areas in search of
job but it is difficult to find a good paid job. This increases the urban poor. Inflation which occurred
frequently affects the urban poor since their majority consumption goods is purchased from the
market. This widens urban income inequality. Differences in employment type ranging from the day
laborers to university professors causes inequality in monthly income earning and the main reasons
behind high income inequality in urban areas. Initial asset value such as house is another reason for
the problem. Now a day there is high rural unemployment, due to shortage of agricultural land and
this will results in a high degree of rural to urban migration. But the urban economy will have not the
capacity to employ the increasing urban population.
30 | P a g e
This will aggravate the problem unless appropriate measures are taken. The growing rural population
and the fixity of agricultural land result in high concentration of land which is the main source of
income in rural areas. This will increase the rural income inequality and the national income
inequality unless the industrial and service sector absorbs the surplus rural labor.

4.2 Econometric analysis

4.2.1 Stationary and unit root test

Before we going to estimation part the first step is testing whether the variable shares a common
trend in such a way they can be considered long run equilibrium relationship is to find whether each
series contain stochastic trend or not.

Estimation regression using non-stationary variable based on ordinary least square leads to spurious
and inconsistent (Gujarati, 1995). It is also different to conduct hypothesis testing in non-stationary
variable as classical assumption on the property of disturbance term is violated.

So to avoid such problems the popular test were used for detecting stationary of variables or not in
time series the econometric unit root test. One could achieve stationary by applying appropriate
differencing called order of integration and this can be tested by ADF test

4.2.2 Unit root test

In econometrics a time tests that has a unit root test is known as random walk which is an example of
non-stationary time series can be stationary by differencing the variable. If a given series contains a
unit root test then the series is said to be non-stationary other ways it's called stationary. In these
study the variable of the model tested by using Augmented Ducky fuller (ADF) test.

The null hypothesis for this testing is that the series contains unit roots and the results are reported in
table below. The variables involved in unit root tests are real values of GDP (ln GDP), income
inequality (lnGini), human capital (lnhc) government expenditure (lnge) and private
investment (lninv)) over the period of 1990 – 2026. From the table given below the test statistics
shows the failure to reject the null hypothesis that is the calculated value is less than the critical or
tabulated value at the level.

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Table 4.5 ADF test for stationarity

Variable With intercept With trend and None Order of

intercept integration
Lngdp -3.04465 -1.181654 I(1)
1.286404
Dlngdp -7.72953* -9.025034* -7.537166*
LnGinico -1.347548 -3.397069 0.69884 I(1)
DlnGinico -6.575929* -6.612879* -6.412059*
Lnhc -1.598707 -2.493815 -1.568925 I(1)
Dlnhc -6.36826* -6.348904* -6.398952*
Lninf -0.185156 -0.709152 1.027558 I(1)
Dlninf -9.442456* -9.620037* -9.374600*
Lntop -1.071737 -1.726695 -0.515880 I(1)
Dlntop -5.123476* -5.066272* -5.188266*
Lnge 2.438182 1.368125 -0.140553 I(1)
Dlnge 1.237344* 3.559872* 3.559872*
Lninv -4.221363 -3.795463 1.701544 I(1)
Dlninv -6.737761* -6.995758* -6.328590*

Source: statata software, 2021

NB: “*” shows significant at 1%, 5%and 10% significance level.

ADF test shows that all the variables which are non-stationary at level, but becomes stationary at first
difference at level and first difference of the variables. So the statistical test shows the rejection of the
null hypothesis for the test. Since differencing will remove the trend effect from the data the
inclusion of time trend in the test is not important.

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4.2.3 The vector auto regression estimates

Variable Coef. Std. Err. t P>|z|

LnGinic 3.8423 2.88617 1.33 0.195

o

Lnhc .44418 .82194 -0.54 0.594

Lntop -1.20763 .82755 -1.46 0.156

Lnge 1.4271 .6323 2.2 0.033

6

Lninv 2.8998 2.1498 1.3 0.189

5

Lninf -0.0061 -0.00866 -0.71 0.482

e_01 -.91901 2.12753 -0.64 0.000

-con -081864 .12753 -4.22 0.527

Source: statat software 2019

Table 4.6 The Vector Auto Regression results

D.lnrgdpch Coef. Std. Err. Z P>|z|

lnrgdpch .0148709 .1467979 0.10 0.919

lnHERFExpo .049496 .0097068 5.10 0.000

lnhumanc -.0030036 .0151791 -0.20 0.843

Lnlabour .9603355 .1999813 4.80 0.000

Lnreer -.0112521 .0358056 -0.31 0.753

lnfdi_mill .1229052 .0259585 4.73 0.000

-con -.0100892 .0062126 -1.62 0.104

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As depicted in the table above, the regression of the auto regression reveals that, the dependent
variable gross domestic product is the dependent variable and the explanatory variables taken are
income inequality, human capital, government expenditure, trade openness and private investments.
Therefore, based on the Dickey –Fuller statistic test of variables all the explanatory variables are
stationary at first difference. Based on the result, government expenditure, investment, trade
openness, human capital are statistically significant and economically meaning full results which
affect the gross domestic product of the country

Thus, the Herfindhal index is statistically significant and economically meaning full at even at 1%
(percent) probability level of significance. Therefore, other things remain constant the percentage
increase in Gini coefficient results in increases the gross domestic product of the country by 3.8423
%. This result is consistent with theoretical under suggestions which argue that increased Gini
coefficient also increases GDP. With the theory in which it stated that Gini coefficient is important
and indispensable for developing countries.

With regard to human capital, it is statistically significant also even at 1 percent level of significance
and it positively affects the gross domestic product. So holding other things remain constant a
percentage change in humane capital leads to increase in gross domestic product of the country by
0.44418%.

Thus, there is a positive relationship between human capital and GDP which is against the
theoretical underpinnings which suggest that increases human capital decreases GDP. However,
increases in human capital can start to affect GDP positively in the future when there is enough
human capital.

In addition, the variable trade openness affects the GDP negatively. Means that when other things
remain constant one percentage change in trade openness leads to decrease GDP by -1.20763%.
Further inflation affects GDP negatively and significantly the GDP of the country. Thus, a 1%
change in inflation, results in decrease in GDP by -0.0061%. The negative relationship between
inflation and GDP is in line with the theoretical underpinning since theory suggests that an increase
in inflation is associated with declining in economic growth.

Like many empirical findings, it is found that investment has a share to GDP has a positive and
statistically significant impact on the GDP. This shows a 1% percent increase in investment as a
share of GDP leads to about an average of 2.898% increase in economic growth.

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 4.2.6 Diagnostic and Stability Tests
1. Stability test
. vecstable, graph dlabel

Eigenvalue stability condition

Eigenvalue Modulus

1 1
1 1
1 1
1 1
1 1
1 1
-.09112713 .091127

The VECM specification imposes 6 unit moduli.

Roots of the companion matrix

1
.5
Imaginary
0

0.909 0.000
-.5
-1

-1 -.5 0 .5 1
Real
The VECM specification imposes 6 unit moduli
Points labeled with their distances from the unit circle

The fitness of the model was tested in three main ways. Firstly, serial correlation shall be tested using
the by the White test for heteroscedasticity and serial correlation finally the Jarque-Bera for normality
test.

The test of langrage multiplier test indicates that there is no serial correlation that can be seen from
appendix thus, 0.91 greater than the 0.05 at the 5 % significance level.

As the heteroscedasticity test conducted using Brush pagan test reveals that a p- value f 0.91 which is
greater than 0.05significance level. So, the result shows that there is no heteroscedasticity problem
and the null hypothesis is rejected which states there is heteroscedasticity. (See from appendix 3).

35 | P a g e
The jarque Bera test for normality also reflects there is normal distribution between the variables.

4.2.4 Vector Error Correction Model (VECM)

The VECM was used to analyses the long run and short run effects of the variables on the dependent
variable. The VECM is specified based on the results of the co integration tests.

Variables Coef. Std. Err. Z P>|z|

Lngdp 3.8058 .23885 1.59 0.111

LnGinico 2.48830 3.5746 -0.70 0.486

Lnhc 2.5700 1.0229 -2.51 0.12

Lninf -0.01584 0.0088 1.78 0.074

Lnge 0.53612 .69653 0.77 0.4410

Lninv 2.5700 2.3315 0.77 0.442

Lntop -0.3343 1.13571 0.29 0.768

_trend .01718 .01115 1.54 0.123

-con -.21494 0.0248 -1.06 0.288

Source: stata software 2020

Table 4.7 The long run and short run estimation of variables

The long run effect of economic growth and other factors that affect economic growth can be
illustrated as in equation below:

LnGDP =-2.1494+2.48830GINI+0.53612GE-0.3343TOP-2.5700HC+2.5700 INV+

0.01584IN………….(3.1)
From equation 4.1 it can be deduced that, human capital, investment and government expenditure
have positive long run relationship with GDP. The results suggest that a 1 % increases in Gini
coefficient lead to increase in GDP by approximately by 2.48830%.

There is a positive relationship between human capital and LnGDP which is against the theoretical
underpinnings which suggest that increases human capital increase in GDP.. On the same note, a 1%
increase in trade openness also causes decrease in GDP of about -0.3343%. According to theory trade

36 | P a g e
openness can either have a negative or a positive relationship with GDP depending on the whether
the trade has got relatively more exports to imports or vice-versa.

According to the long run of this study, a percentage increase in the value of inflation causes
approximately -0.0184% decrease in GDP. The results of investment, government expenditure, and
human capital and Gini coefficient show that there is a positive effect on the economic growth.

4.2.5. Long Run Model Estimation

From the table above (table 4.3) the residual is stationary at 1% significant level shows the presence
of long run relationship between the dependent and in dependent variables. Accordingly from the
estimation, the following results are obtained for the long run model of;

𝑙𝑛𝐺𝐷𝑃𝑡 =β0+ β1𝑙𝑛GINI+ β2𝑙𝑛GE =β4𝑙𝑛HC++ β5 𝑙𝑛INV+ β6𝑙𝑛IN+ µt ………….(3.1)

Table 4.7 long run estimation results
Dependent variable GDP (lnGDP)

Variable Coef. Std. Err. t P>t [95% Conf. Interval]

LnGinico -22.0385 3.19603 -6.68 0.000* -1.83652 11.62168

Lnhc .19699199 .560689 0.35 0.725*** -2.92357 -.3323

Lninf -0.386577 .008587 45 0.000* -.012114 .02826

Lntop .491743 -52007 0.94 0.346*** -1.9840 -.41422

Lnge -1.53506 -289129 -5.31 0.000* .78890 1.7034

Lninv 5.04632 1.83860 2.75 0.006* -.77027 8.1057

Tred .1142917 _ _ _ _
CONS -12.2841 _ _ _ _
Number of obs = 35 R-squared = 0.7027

F( 6, 28) = 28.44 Adj R-squared = 0.6390

Prob> F = 0.0000 Root MSE = .53433

NB: *significant at 1% ** significant at 5% ***significant at 10%

R2-value measures the percentage of variation in the values of the dependent variable (lnGDP)
that can be explained by the variation in the independent variable jointly included in the model.
R2-value varies from 0 to 1. The long run estimation model reveals that the coefficient of
determination which is denoted by R2 is 0.7027or 70.2 percent.
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Its meaning is that 70.2 percent of the variation in GDP is explained by the given explanatory
variable jointly included in the model. The remaining 27.8% of the variation in the dependent
variable (lnGDP) is presumed to be due to random variability.

The estimated long run model result shows that the entire explanatory variables are statistically
significant. Gini coefficient, investment and inflation are statistically insignificant. The value of
constant term, -12.28 which is also the intercept of GDP and significant at 10% significance
level, interpreted as the value that we would predict for GDP if all the explanatory variables
included in the model are zero. However, this is only a meaningful interpretation if it is
reasonable that the entire explanatory variable included in the model can be zero (0), and if the
dataset actually included values for predictor variable that were near 0. If neither of these
conditions is true, then the constant term really has no meaningful interpretation.

The above regression coefficients represent the mean change in the response variable for one unit of
change in the predictor variable while holding other predictors in the model constant. This statistical
control in the regression is important because it isolates the role of one variable from all of the others
in the model.

As shown in above table in the long run income inequality has a negative and significant impact on
GDP. The estimated result shows that holding other variable constant, a 1 unit increase in income
inequality measured by Gini coefficient will cause decrease in GDP by -22.03units.This result
negative relationship between income inequality and economic growth does not follow Kuznets
hypothesis since Ethiopia is a low income country and this would make economic growth and income
inequality to rise at the same time. Our case is different. This can be explained by the social problems
associated with inequality. These social problems include stealing, corruption, political instability.

Inflation is found to have negative and insignificant on economic growth. The coefficient of inflation
shows that on the average, a 1% increase in the consumer price index which is the measure of
inflation will decrease GDP by -0.38% holding other variable constant. This shows that there are no
high rates of inflation and hyperinflation which are caused by an excessive growth of the money
supply. The effects of absence high inflation or hyperinflation include a decrease in the opportunity
cost of holding money, uncertainty over future inflation which may discourage investment and
savings. This in return leads to the increase in the GDP of a country.

Investment also found to have positive and significant effect on country’s GDP As the
estimation result shows in table 4.5a 1% increase in investment will increases countries GDP by
5.04% holding the effect of other variable constant.

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This is because, investment creates capital formation and it further leads to technical innovation
and progress which helps with the economies of large-scale production and increases
specialization, which helps to accelerate the productivity of labor, it further resulting increased GDP.

Government expenditure has negative and insignificant impact on country’s GDP. This means,
an increase in government expenditure by 1% will decrees countries GDP by -1.53% citrus’
paribus. This is justified through that the government higher spending undermines economic
growth by transferring additional resources from the productive sector of the economy to
government, which uses them less efficiently.

4.2.6. The Short Run Model (Dynamics)

Even though there is a long run relationship between dependent and independent variable or co-
integration in the long run, there may be disequilibrium in the short run. ECM (Error correction
model) is use to estimate the short run relationship between the variables and to determine the
adjustment in the short run shock by differencing the long run model. The short run model can be
estimated (ECMT-1) to capture the adjustment towards the long run and the model can be
specifying as follows.

𝐷𝑙𝑛𝐺𝐷𝑃𝑡 = 𝛽𝑜 + 𝛽1𝐷𝑙𝑛𝐺𝐼𝑁𝐼𝑡 + 𝛽2𝐷𝐼𝑁𝐹𝐿𝑡 + 𝛽3𝐷𝐹𝐼𝑁𝐷𝐸𝑉𝑡 + 𝛽4𝐷𝑆𝐴𝑉𝑡 + 𝛽5𝐷𝐺𝑂𝑉𝐸𝑋𝑡

+ 𝛽6𝐷𝐸𝐷𝑈𝑡 + 𝛽7𝐷𝑈𝑅𝐵𝐴𝑡 + 𝛽8𝐷𝑇𝑅𝐴𝐷𝐸𝑡 + 𝛽9𝐷𝐿𝐹𝑡 + 𝐸𝑡

The error correction model is employed to correct for disequilibrium and determine the short run
relationship between variables. The analysis of short run dynamics is often done by first
eliminating trends in variables usually by differencing. In order to capture the adjustment towards
the long run mode, the ECM incorporates the equilibrating error term (ECMt-1).

Table 4.8 Short run estimation results

Dependent variable real GDP (lnGDP)

Variable Coef. Std. Err. t P>t [95% Conf. Interval]

Lngdp .1158771 0.136661 0.85 0.396 -1.83652 11.62168

LnGinico .2002208 .0064911 3.08 0.022 -2.92357 -.3323

Lnhc -.068952 .02615 -0.65 0.518 -.012114 .02826

Lninf 7.35844 3.00295 2.45 0.014 -1.9840 -.41422

Lntop -07219 .028759 -2.53 0.011 .78890 1.7034

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 Lnge .860403 .034245 2.15 0.012 -.77027 8.1057

Lniv -0155363 .010725 -1.45 0.14 .56734 2.3470

ECMt-1(e- -.91901 2.12753 -0.64 0.000 -.0192144 .005702

01)

Cons .148846 .01267 11.75 0.000 .1226362 .1750558

Number of obs = 34 R-squared = 0.5701

F( 10, 23) = 5.92 Adj R-squared = 0.5984

Prob> F = 0.0002 Root MSE = .06686

As indicated in the about table 57.01% of the variation in the short run model is explained by the
variables included in the model. The lagged error correction (Ecmt-1) indicates that-0.919% of the
shock is adjusted in each year or the shock is eliminated in each year or, it shows -0.919% of
discrepancy between the actual and long run or equilibrium value of GDP corrected in each year.

The estimated short-run model reveals that investment is the main contributor to GDP change
followed by government expenditure (one period lagged value). When investment decreases by
one percent, GDP decreases by -0.0155363 percent, while the same percentage change in one
period lagged value of government expenditure resulted in about 0.860403% rise in real GDP.
But, unlike its long run insignificant impact, government expenditure has no insignificant short
run impact on the economy in without lag value. On the other hand, investment has a significant
positive contribution to economic growth; Its one period lagged value has a negative impact on
real GDP. The short run coefficient of human capital also has insignificant negative impact on
economic growth. Holding other things constant, a 1 percent increase in human capital leads to a
decrease the GDP of the counters by –0.001689%.

4.2.6 Diagnostic and Stability Tests

The fitness of the model was tested in three main ways. Firstly, serial correlation shall be tested using
the langrage multiplier (LM) test, followed by the White test for heteroscedasticity and finally the
Jarque-Bera for normality test. The test of langrage multiplier test indicates that there is no serial
correlation that can be seen from appendix thus, 0.90 greater than the 0.05 at the 5 % significance
level. As the heteroscedasticity test conducted using Brush pagan test reveals that a p- value f 0.91
which is greater than 0.05significance level. So, the result shows that there is no heteroscedasticity
problem and the null hypothesis is rejected which states there is heteroscedasticity.

The jarque Bera test for normality also reflects there is normal distribution between the variables
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 CHAPTER FIVE

5. Conclusion and recommendations

5.1 Conclusion

The general objective of this study is to provide a comprehensive study and critical overviews of
the linkage between economic growth and income inequality in Ethiopian economy.

To determine relationship among the variables, vector-autoregressive model was applied. Before
applying an econometric estimation by using vector error correction, all the variables are tested
for their time series properties (stationarity properties) using the ducky fuller (DF) tests. As a
result GDP, income inequality (Gini), human capital, inflation government expenditure, trade
openness and investment are integrated of order one I(1) or stationary at first difference. The
residual also stationary at level indicates that the variables are co integrated. This means that,
there is long run relationship among the variables, finally VECM estimation techniques is used
to estimate the short run and the long run coefficient of variables used to investigate the
relationship of variables in the model. Descriptive analysis also applied to show the trend of both
dependent variable (GDP) and included independent variable.

The empirical result showed that income inequality has a negative and insignificant impact in the
long run but positive and significant impact in the short run on country’s GDP. The estimated
result shows that holding other variable constant, a 1% increase in income inequality measured
by Gini coefficient will cause decrease in GDP by -22.03% in the long run and 0.22% in the
short run. This does not follow Kuznets hypothesis since Ethiopia is a low income country and
this would make economic growth and income inequality to rise at the same time. But this
finding found to contradict with Kuznets hypothesis.
The other included determinant of economic growth, as expected investment has positive and
significant impact on economic growth in the long run but negative and insignificant impact in
the short run. The finding also shows inflation has negative and significant impact on economic
growth in the long run which is inconsistence to prior expectation. Government expenditure to
GDP contributes negative e and insignificance impact on economic growth which found to be
inconsistence with the hypothesis. Trade openness, which is proxies by the ratio of total trade to
GDP, is positively and significantly related to economic growth in the long run which supports
the prior expectation.

5.2 Policy implication

Based on the analysis made and conclusion arrived the following policy

implication are forwarded.

 The negative relationship between economic growth and income inequality indicates that the
reduction in income disparities among peoples helps to sustain the economic growth of a
country. So, the government pursues redistribution of income. The adoption of pro-poor

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 growth policies that aims to boost economic development while paying attention to the
interests of the poor and reducing income gap is important to sustain economic growth.
 The moderate inflation is good because it can result in more productivity, because when inflation
rises companies tend to increase their production so as to earn more and at times of prolonged
deflation or very low inflation the economy stuck in a recession.
 Efforts have to be made to raise the savings in a sustainable manner and should take appropriate
strategy to divert savings in to productive investment through stabilizing inflation,
strengthening domestic financial institutions, and increasing the role of market signals in the
allocation of savings and investment.
 Avoid fiscal policies inflexibility meaning avoid considerable time-lag between spending and
the benefits that arise. Reduce crowding out of private sector through limiting expansionary
fiscal policy. To make human capital in a position to promote economic growth expands the
coverage of education through public and private investment in educational sectors.
 Trade liberalization policy (the removal or reduction of restrictions or barriers on the free
exchange of goods with other nations) encourage economic growth. This includes the removal
or reduction of both tariff (duties and surcharges) and non-tariff obstacles (like licensing rules
and quotas). And finally, the government improves labor productivity through proper training
of laborers to make it significant to economic growth.

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REFERENCES

Abdurrahman Bewedi (2011) Impacts of inequality on economic growth in some African countries a
descriptive analysis (1970-2000).

Gideon Bulla (2012) Relationship between Economic growth and Income inequality in Ethiopia for the period
of (1996-2011)

Alemayehu Geda, Abebe Shimeles, John Weeks, (2009), Growth, Poverty and Inequality in Ethiopia: Which
way for Pro-Poor Growth? Journal of International Development, J. Int. Dev. 21, 947 –970 (2009) Economic
Commission for Africa (ECA), Addis Ababa, Ethiopia

G,(2009) Economic growth and income inequality, AAU Economics department. Binatli, A.O, (2012).
Growth and income inequality: a comparative analysis. Econ. Res. Int. doi: 10.1155/ 2012/569890

Abdurohman Hassen (2014) tried to assess economic growth-income inequality nexus in Ethiopian economy.
For the period only 1996-2011

Yirgalem Getahun(2019) tried to linkage between economic growth and income inequality in Ethiopian
economy. In period (1982-2016)

Dollar D. and Kraay A. (2001) Growth is good for the poor, Policy Research Working paper2001:2199,
Development Research Group, The World Bank.

Fekadu Gelaw (2010) „The Relationship between Poverty, Inequality and Growth in Rural Ethiopia: micro
evidence: Journal of Development and Agricultural Economics 2(5), 197-208,
http://www.academicjournals.org/JDAE

Foreign Assistance and Economic Development, Hollis B. Chenery and Alan M. Stout, the American
Economic Review, 58(4), 912-916.

Fosu, A. K. (1996). The impact of external debt on economic growth in Sub-Saharan Africa Journal of
economic development, 21(1), 93-118

Friedman, M. 1937. The use of ranks to avoid the assumption of normality implicit in the analysis of variance
Journal of the American Statistical Association 32: 675–70.

Galor and Zeira J. (1993), Income Distribution and Macroeconomics, Review of Economic Studies, Vol: 60,
pages 35-52. Gashaw Getaye,(2016). The link between economic growth and income inequality in Ethiopia,
AAU Economics department

Gideon B. (2012). Economic growth and income inequality: a test of Kuznets inverted U hypothesis, AAU.

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 Appendix

Reg RESULIT
. gen year=1982+_n-1

. tsset year
time variable: year, 1982 to 2016
delta: 1 unit

. reg lngdp lnginico lnhc inf lntop lnge lninv

Source SS df MS Number of obs = 35

F( 6, 28) = 11.03
Model 18.8949977 6 3.14916628 Prob > F = 0.0000
Residual 7.99437786 28 .285513495 R-squared = 0.7027
Adj R-squared = 0.6390
Total 26.8893755 34 .790863987 Root MSE = .53433

lngdp Coef. Std. Err. t P>|t| [95% Conf. Interval]

lnginico 4.892576 3.285042 1.49 0.148 -1.836526 11.62168

lnhc -1.627985 .632485 -2.57 0.016 -2.923571 -.3323981
inf .0080752 .0098563 0.82 0.420 -.0121145 .028265
lntop -1.199137 .3831813 -3.13 0.004 -1.984048 -.4142257
lnge 1.246158 .2232249 5.58 0.000 .7889025 1.703413
lninv 3.667749 2.166571 1.69 0.102 -.7702709 8.105768
_cons -16.5059 9.005072 -1.83 0.077 -34.95195 1.940158

Johansen test for CO-integration

. vecrank lngdp lnginico lnhc inf lntop lnge lninv, trend(constant)

Johansen tests for cointegration

>
Trend: constant Number of obs = 3
> 3
Sample: 1984 - 2016 Lags =
> 2

>
5%
maximum trace critical
rank parms LL eigenvalue statistic value
0 56 77.824371 . 171.5204 124.24
1 69 110.04377 0.85811 107.0816 94.15
2 80 132.05935 0.73665 63.0504* 68.52
3 89 145.6083 0.56007 35.9525 47.21
4 96 154.40627 0.41328 18.3566 29.68
5 101 161.03176 0.33071 5.1056 15.41
6 104 162.93386 0.10888 1.3014 3.76
7 105 163.58456 0.03867

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Dicky-fuller test of unit root
. dfuller DlnGDP

Dickey-Fuller test for unit root Number of obs = 33

Interpolated Dickey-Fuller
Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value

Z(t) -6.766 -3.696 -2.978 -2.620

MacKinnon approximate p-value for Z(t) = 0.0000

. dfuller DlnGinico

Dickey-Fuller test for unit root Number of obs = 33

Interpolated Dickey-Fuller
Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value

Z(t) -10.248 -3.696 -2.978 -2.620

MacKinnon approximate p-value for Z(t) = 0.0000

. dfuller INF

Dickey-Fuller test for unit root Number of obs = 34

Interpolated Dickey-Fuller
Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value

Z(t) -4.589 -3.689 -2.975 -2.619

MacKinnon approximate p-value for Z(t) = 0.0001

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. dfuller DlnTOP

Dickey-Fuller test for unit root Number of obs = 33

Interpolated Dickey-Fuller
Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value

Z(t) -5.182 -3.696 -2.978 -2.620

MacKinnon approximate p-value for Z(t) = 0.0000

. dfuller DlnGE

Dickey-Fuller test for unit root Number of obs = 33

Interpolated Dickey-Fuller
Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value

Z(t) -3.260 -3.696 -2.978 -2.620

MacKinnon approximate p-value for Z(t) = 0.0168

. dfuller INF

Dickey-Fuller test for unit root Number of obs = 34

Interpolated Dickey-Fuller
Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value

Z(t) -4.589 -3.689 -2.975 -2.619

MacKinnon approximate p-value for Z(t) = 0.0001

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