This study analyses money growth – inflation nexus in Ethiopia using annual
datasets covering the period 1970-2009. This period was considered due to
data limitations. A significant aspect of the study is that it tries to identify the
optimal level of money growth using Two Regime Threshold Model. The
result from the two-regime threshold model reveals that there is indeed a
threshold effect in the relationship between money growth and inflation and
the optimal level of money growth is estimated to be 17% which has an
important policy implication. Here, money supply creates inflationary
pressures only when it exceeds 17%. A percentage increase in money supply
above this threshold value is expected to cause 1.47 percent increase in
annual inflation indicating that monetary factors are valid sources of
inflation in Ethiopia. The results imply keep the money growth below 17%.
Hence, a specific monetary policy measures that could be envisaged is
controlling broad money supply (M2).