EDRI Working Paper 008: Implications of Oil Price Shocks and Subsidizing Oil Prices to the Ethiopian Economy: A CGE Analysis

Abstract

Economic growth is largely dependent on the availability of reliable sources of energy. As an importer of oil and petroleum products, Ethiopia’s economy is potentially vulnerable to fluctuations in the world price of crude oil. The recent oil price shocks adversely affected oil-importing developing countries such as Ethiopia. The paper attempts to quantify the impact of an increase in international price of crude oil and oil subsidy scheme on the Ethiopian Economy by applying the IFPRI’s static CGE model using the EDRI’s 2005/06 SAM. The results show that the oil price shock causes a depreciation of the Ethiopian Birr (ETB) and brings about an increase in exports and a decline in imports. The depreciation of the ETB also brings a rise in agricultural tradable goods output and a decline in manufacturing and service sectors output. The shock also deteriorates income and consumption of all households. In general, rural households are more negatively affected by the oil price shock as compared to urban households. The oil subsidy scheme increases government expenditure and reduces government savings, hence total investment falls. Output of the construction sector goes down because of the fall in investment demand. On the other hand, the oil subsidy improves consumption of all households. In the short run, the oil price subsidy scheme improves household welfare. Nevertheless, in the long run, it is harmful since it absorbs a high share of limited public resources, leads to lower investments and reduces future growth. Financing the oil subsidy scheme by increasing taxes on other goods brings improvement in investments but it distorts the level of domestic production and household welfare. We conclude that this type of subsidy is an inefficient tool to reverse the high oil price increase in developing countries. Rather, finding ways to substitute oil by other energy sources could be a better solution in the medium to long-run.