Contents

ABSTRACT 3

ACRONYMS AND ABBREVIATIONS 4

1. INTRODUCTION 5

1.1 Background of the study 5

1.2 Statement of the problem 7

1.3 Objective of the study 8

1.3.1 General Objective 8
1.3.2 Specific Objectives 8

1.4 Research Questions 8

1.5 Significance of the Study 8

1.6 Scope of the Study 9

1.7 Organization of the paper 9

[Link] REVIEW 10

2.1 Theoretical literature review 10

2.1.1 Definition of Concepts 10
2.1.2 Theories 10

2.1 Empirical literature review 12

2.3 Research gap analysis 13

2.4 Conceptual framework 13

3. METHODOLOGY 15

3.1 Research design 15

3.2 Data Sources and Collection 15

3.3 Method of Data Analysis 15

3.4 Model Specification 15

3.5 Some Econometrics test 16

1
4. ANALYSIS AND INTERPRETATION 17

4.1 Introduction 17

4.2 Descriptive analysis 17

4.2.1 Trends of the variables 17
4.2.2 Descriptive Statistics 19

4.3 Econometric Analysis 20

4.3.1 Unit Root test 20
4.3.2 The Optimum Lag Length 21
4.3.3 VAR Estimation (Short-run dynamics) 22
4.3.4. Diagnostic Tests 23
4.3.4 VECM Estimation (Long-run dynamics) 26

5. CONCLUSION AND POLICY IMPLICATIONS 28

5.1 Conclusion 28

5.2 Recommendations 29

REFERNECES 31

2
 ABSTRACT
Ethiopia's persistent unemployment rate stands as a significant hurdle to achieving
sustainable socioeconomic development. Te main purpose this study is to the analyze the
relationship between unemployment and economic growth inorder to check for the
applicability of Okun's Law in ethiopia context,. This paper employ Vector Error Correction
Model (VECM) analysis on data spanning 1992 to 2014 EC, sourced from the National Bank
of Ethiopia. This study provides a more comprehensive story than a simple cause-and-effect
relationship. While economic growth plays a crucial role, its impact on unemployment is
more contingent than traditional theories propose. The VECM analysis suggests that a 1%
increase in real GDP growth leads to a modest 0.04% decrease in the unemployment rate, all
other factors being equal (ceteris paribus). This indicates a positive but modest influence of
growth on job creation. Further exploration reveals that additional factors, such as spending
patterns and structural rigidities within the labor market, significantly influence the
dynamics between growth and unemployment. Additionally, the study finds a counterintuitive
positive correlation between inflation and unemployment, a topic that warrants further
investigation in the Ethiopian context. The findings of this study suggest that by promoting
labor-intensive industries, investing in skills development, boosting SMEs, modernizing
agriculture, and implementing active labor market policies, Ethiopia can generate large-
scale employment opportunities, bridge the skills gap, and better utilize the country's human
capital.

3
 Acronyms And Abbreviations
ADF Augmented Dickey Fuller

AIC Akaike Information Criteria

ARDL Autoregressive Distributed Lag

BIC Bayesian information Criteria

CSA Central Statistical Authority

ECM Error Correction Model

GDP Gross Domestic Product

IMF International Monetary Fund

MDG Millennium Development Goal

MoFED Ministry of Finance and Economic Development

MoLSA Ministry of Labor and Social Affairs

NBE National Bank of Ethiopia

RGDP Real domestic product

UR Unemployment Rate

WB: WDI World Bank: World Development Indicator

4
 1. Introduction
1.1 Background of the study

The relationship between unemployment and economic growth is a complex and multifaceted
phenomenon that has been extensively studied by economists and policymakers alike.
Unemployment refers to individuals who are actively seeking employment but are unable to
find suitable job opportunities (Deribe et al. 2015). On the other hand, economic growth can be
seen as an increase in the capacity of an economy to produce goods and services, compared
from one period of time to another (Manuela Raisová, Júlia Ďurčová et al. 2014). Understanding
the interplay between these two variables is crucial for formulating effective policies that aim
to promote sustainable economic development.

Unemployment rates have fluctuated significantly over the past few decades, highlighting the
volatile nature of labour markets around the world. According to data from the International
Labour Organization (ILO), global unemployment steadily declined from 6.3% in 1992 to
5.4% in 2007 before experiencing a sharp increase during the 2008 financial crisis, reaching
6.0% in 2009. Since then, the global unemployment rate has remained relatively stable,
hovering around 5.5%. As of 2020, the world witnessed an unprecedented rise in
unemployment due to the COVID-19 pandemic. By the end of the year, the ILO reported that
global employment had declined by 8.8% compared to 2019, resulting in approximately 255
million job losses. These figures highlight the severe impact the pandemic has had on the
labour market, leading to widespread unemployment and economic instability worldwide
(ILO, 2021). These statistics indicate significant variations in regional unemployment
dynamics, Analysis of regional disparities reveals stark contrasts in unemployment rates
across different parts of the world. Western Europe has long experienced relatively low
unemployment rates, such as Germany's 4.2% or the Netherlands' 3.8% as of 2020.
Conversely, regions like Sub-Saharan Africa face higher levels of unemployment, with
countries like South Africa witnessing rates reaching a staggering 32.6% in the first quarter of
2021.

Unemployment remains to be one of the significant challenges for the economy of Ethiopia,
according to recent data from the Ethiopian Central Statistical Agency, the country's
unemployment rate has exhibited a gradual increase over the past decade. In 2010, the rate
stood at 17.5%, but by 2019, it had risen to 19.1%. However, it is essential to note that these
figures do not provide a complete picture of the situation as they only represent the formal
sector, excluding the substantial informal workforce. Urban areas witness higher
unemployment rates, primarily due to the lack of job opportunities and limited access to
formal employment. Additionally, youth unemployment remains a pressing concern, with
over 29% of the youth population currently unemployed. Several socio-economic and
structural factors contribute to the unemployment trend in Ethiopia. Firstly, a discrepancy
between the education system output and labour market demands exists. The Ethiopian
education system often fails to equip individuals with the necessary skills and knowledge to
meet the demands of the job market, leading to a surplus of unskilled laborers and a shortage

5
of skilled workers leading to a mismatch between qualifications and job requirements. The
persistent high unemployment rate in Ethiopia poses significant challenges to both
individuals and the economy at large. From an individual perspective, unemployment can
lead to diminished living standards, reduced dignity, and increased vulnerability to poverty.
On the macroeconomic level, a high unemployment rate implies a wasted labour force,
hindering the country's potential to achieve sustainable economic growth. Lower productivity,
decreased purchasing power, and reduced tax revenues exacerbate income inequality and
inflationary pressures.

Economic growth and unemployment rate have always been major drivers to explain
economic facts because of their interaction with other microeconomic and macroeconomic
factors, yet their relationship are prevalent inquiries that a great number of researchers has
embarked upon in their studies. Traditionally, there exists a commonly held assumption that a
rise in economic growth leads to a decline in unemployment rates, as expanding economic
activities create more job opportunities. Conversely, during economic downturns or
recessions, unemployment tends to rise due to decreased demand for goods and services,
leading to layoffs and downsizing by businesses aiming to cut costs. Nonetheless, the nature
and direction of the relationship between unemployment and economic growth have been
subject to various theories, empirical studies, and differing perspectives. Some economists
argue for a structural relationship where changes in one variable affect the other in a
sustained manner, while others emphasize cyclical fluctuations, suggesting that
unemployment and economic growth might move in tandem during specific phases of
economic cycles. Moreover, factors such as technological advancements, globalization,
demographic shifts, government policies, and labour market dynamics significantly influence
the correlation between unemployment and economic growth, making the relationship
intricate and context-dependent. The relationship between economic growth and
unemployment has been studied experimentally in the economic literature based on what is
known as the Okun law, which shows that there is an inversely proportional relationship
between the change in the growth rate (GDP) and the change in the unemployment rate. Okun
has succeeded to show that there is a reciprocal correlation between unemployment and
economic growth. He found that if unemployment decreased by (1%), then this would be due
to an increase in real gross domestic product (RGDP) by (3%) and vice versa, and when an
increase in the RGDP occurs, an increase in employment is achieved (Hjazeen, H., Seraj, M., &
Ozdeser, H. (2021).

Ethiopia has a predominantly agricultural economy, being the second-most populous country
in sub-Saharan Africa, with a population approaching 123 million people (UNDP,
Citation2022b) and over 63.66% of the population employed in farming (World Bank,
Citation2021a). However, the country is experiencing rapid population growth, which is
outpacing the ability to create sufficient jobs (Getahun & Fetene,2020).

The main purpose of this paper is to analyses the relationship between unemployment and
economic growth in Ethiopia and tests the validity of Okun's Law. It considers the country's
unique socio-economic landscape, policy frameworks, and challenges. The research aims to

6
provide policymakers, stakeholders, and economists in Ethiopia with actionable insights and
policy interventions to foster sustainable economic growth while addressing unemployment.

1.2 Statement of the problem

Unemployment usually comes as a result of disequilibrium between demand and supply in
the labour market. It is regarded as a serious problem faced most developed and developing
countries and resulting socio-economic problems. The governments have given great
attention to create job opportunities and reoperation the idle units to eliminate this
phenomenon. There are several reasons behind this phenomenon, especially in the developing
countries, it is attributed to the shortage of the economic growth accompanying with
incremental population, inability to mobilize domestic savings in financing desired
investments, decline in economic activity due to recession, changes in technology, changes in
consumer demand, on-qualifying employment, which are not commensurate with the changes
in labour market (Dr. Ibrahim khrais, Prof. Dr. Mahmoud Al-Wadi (2016).

Unemployment in Ethiopia is the prominent feature of the labour market. It has undesirable
social, economic and psychological influences. The least developed countries like Ethiopia in
which physical capital is in short, the labour resource plays significant role for economic
growth. However, a significant portion of the labour force is under the unemployment
category which poses a huge burden on the current economic growth of the country.
Unemployment has prevailed in Ethiopia for many decades which is mainly caused by
political instability, operational problems in industries, volatile investment and inefficient
growing flow of new graduates to labour market. Several strategies of macroeconomy in
Ethiopia was not able to realize the anticipated target of a sustainable economic growth and
low UR. Total labour force in Ethiopia was reported at 53,746,763 in 2019 (WB: WDI,2020;
ILO, 2020). Set the UR 19.5%, the total unemployed people in Ethiopia are 10,480,619.
According to the Ethiopian Prime Minister’s report to the House of People Representative
(Ahmed, 2020), 2.4 million new hires are expected in the fiscal year 2019/2020. Oppositely,
in the same year, 2.0 million new entrants join the labour market. That means, making other
factors constant, 25 more years3 are required to substantially lower the unemployment
problems of the country. Overall, the 19.4% tall UR in Ethiopia remain high as compared to
other countries. The degree of progress in employment status achieved due to economic
growth remains unclear and controversial. Studies that have focused on empirical validity and
policy implication of Okun’s law and efforts to address the unemployment-economic growth
puzzles are hardly available in Ethiopia. (Adam Feto. Ethiopian Economics Association (EEA), 282,
(2022).

Therefore, the objectives of the study are to: assess the linkage between unemployment and
economic growth in Ethiopia and examine the existence of Okun’s law in Ethiopia in the
period 1992 to 2014 EC.

7
1.3 Objective of the study
1.3.1 General Objective
This study seeks to understand the dynamic between economic growth and unemployment in
Ethiopia with a focus on the validity of Okun's Law. The findings aim to inform policy
decisions regarding economic growth strategies that minimize unemployment in the
Ethiopian context.

1.3.2 Specific Objectives

Those goals are the offshoots of the main goal, and the following issues are covered in this
research paper:

 To overview the trend of unemployment and economic growth in Ethiopia for the
period (1992–2014 EC)
 To determine the impact of economic growth on unemployment and vice versa.
 To provide insights into policy implications for managing unemployment and
fostering sustainable economic growth.

1.4 Research Questions

This study answers the following questions

 What are the trends and patterns observed in the unemployment rates and economic
growth in Ethiopia from 1992 to 2014 EC?
 How does the observed economic growth in Ethiopia during the specified period
influence the unemployment rates, and conversely, how does unemployment impact
economic growth?
 What policy interventions or measures could be recommended based on the
relationship identified between economic growth and unemployment in Ethiopia to
effectively manage unemployment while fostering sustainable economic growth?

1.5 Significance of the Study

The study on the relation between economic growth and unemployment in Ethiopia holds
significant importance for several reasons. Firstly, Ethiopia is one of the fastest-growing
economies in Africa, making it crucial to understand the dynamics between economic growth
and unemployment in order to sustain and optimize the country's development trajectory.
Secondly, unemployment is a pressing issue in Ethiopia, with a large portion of the
population facing joblessness and underemployment. This study contributes to the existing
literature on unemployment in Ethiopia by specifically examining its relationship with
economic growth, providing valuable insights for policymakers and stakeholders to develop
effective strategies to address unemployment and promote inclusive growth. Additionally,
understanding the relationship between economic growth and unemployment in Ethiopia can
help identify potential barriers or bottlenecks that hinder job creation and economic
development. Furthermore, the findings from this study can inform policy interventions and
8
measures to promote employment generation, skill development, and entrepreneurship,
ultimately contributing to poverty reduction and improving the overall well-being of the
Ethiopian population.

1.6 Scope of the Study

This study is delimited to analyse the relation between unemployment on economic growth in
Ethiopia, by using a 22-year annual time series data from 1992-2014 EC based on the
availability of recorded data for the variables under study.

1.7 Organization of the paper

This research is structured across five chapters. Following the introduction, Chapter 2 dives
into the existing knowledge base, examining both theoretical frameworks and real-world
research (literature review). Chapter 3 then outlines the research methods used, including
data sources and collection. Chapter 4 presents and analyzes the study's findings,
incorporating both descriptive statistics and econometric [Link], Chapter 5 wraps up

the research with conclusions and recommendations

9
 [Link] review
2.1 Theoretical literature review
2.1.1 Definition of Concepts
Unemployment

The international standard definition of unemployment relies on three criteria that

have to be considered simultaneously. According to the definition, the unemployed
comprise all persons above the age specified for measuring the economically active
population whom, during the reference period, were: (a) "without work", i.e. those who
were not in a paid or self-employment, as defined by the international definition of
employment. (b) "currently available for work", i.e. those who were available for paid
employment or self-employment during the reference period; and (c) "seeking for work",
i.e. those who had taken specific steps in a specified recent period to seek paid employment
or self-employment (Surveys of economically active population, employment ... – ILO (1990)
Unemployment can therefore be, described as a number of active populations, willing and
able to work, but unable to find job (Deribe et al. 2015)

Economic growth
Economic growth is the increase in the capacity of an economy to produce goods and
services over time. It can be measured in nominal terms, which include inflation, or more
conventionally measured by adjusting inflation in real terms (real GDP) and economic
growth typically refers to this growth of potential output. As stated by ECA (2010), Economic
growth is important for not only increasing a country’s level of income, but also for laying the
foundation of sustainable poverty reduction, improving human welfare and enhancing overall
development. Growth enables countries to increase the availability and distribution of basic
life sustaining goods and services such as food, shelter, health, and protection. It also enables
countries to generate more jobs and better education, thereby expanding the range of
economic and social choices available to their citizens (Abdulkadir Hamza 2015)

2.1.2 Theories
The okun’s law

Arthur Okun (1962) investigated the relation between unemployment and economic growth
of [Link] findings postulated the Okun’s Law that predicts that 1% increase in the growth
rate above its trend rate will lead to only 0.3% reduction in the unemployment rate. More
specifically, recently accepted versions of Okun's law states that, a 1 % decline in
unemployment, in the course of a year, is related to approximately a 2% faster growth in
real GDP over that period (Abel, 2008). Okun estimated two models of his law,
the difference and the gap model, which are considered as original ones.
Both, assumed that to produce more products and services within the
economy, more labour is required.
Later, many economists argued that the labour may be increased not only

10
through hiring new
workers, but also through increasing the number of hours worked, the
level of productivity, etc. Also, the current level of unemployment may be
determined by the unemployment rates in the past. According to these
arguments, the existing models were upgraded with additional
independent variables. Later, two more models of Okun’s Law were
designed: the dynamic and the production function model. The dynamic
model includes lags of economic growth and unemployment rate, since it
predicts that the past values of the variables, growth and
unemployment, may affect the current unemployment rate. The
production-function model is
even wider and includes variables that combine the labour, capital and
technology (Despina Tumanoska (2020)

The classical view

The classical economists often define unemployment as the “excess supply” of labor over the
demand for labor that caused by adjustment in real wage. The Classical or real-wage
unemployment occurs when real wages for a job are set above the market-clearing level,
causing number of job seekers to exceed the number of vacancies. In this theory,
unemployment regarded as situation where the smoothly functioning labor market obstructed
in some way. In a smoothly functioning market, market forces would set the equilibrium
wage and quantity of labor. The Classical approach assumes that markets behave as described
by the idealized supply and demand model. The labor market characterized by perfect
competition, in which, it is assumed that, every unit of labor services is the same, and every
worker in this market will get exactly the same wage. Because such a Classical (idealized)
market for labor is free to adjust, there is ‘no involuntary’ unemployment and everyone who
wants a job at the going wage gets [Link], the only thing that can cause true
unemployment is something that interferes with the adjustments of the free market, such as a
legal minimum wage and other regulations. (Abdulkadir Hamza 2015)

The keynesian view

For Keynesian economists, unemployment is a situation in which the number of people

who are able and willing to work at prevailing wage exceeds the number of available jobs.
When the number of unemployed is significant, the demand in the product market will
negatively be affected , and as a result, firms become unable to sell all their goods.
Businesses respond to a declining demand for goods and services by cutting employment
in order to control costs and restore some of their lost profitability. Consequently, the higher
unemployment will tend to delay the growth of gross output, implying a vicious circle.
In the Keynesian model, aggregate employment depends on the level of aggregate demand
in the economy as a whole. If total spending is low and businesses unable to sell their
goods, they will tend to cut back on their investments and on the number of workers they
employ. Prices as well as wages may fall (as was observed during the Great Depression),

11
keeping real wages constant and thus giving employers no incentive to hire more workers.
Low aggregate demand for goods and services could lead to a vicious cycle of
unemployment, low incomes, and low spending in the economy as a whole. (Abdulkadir Hamza
2015)

2.1 Empirical literature review

A number of empirical studies, conducted to investigate the relation, and impact, between
unemployment and economic growth,presented as follows

The negative correlation between economic growth and unemployment was first stressed by
Okun (1962). Following studies have mostly proposed evidence that is parallel to Okun’s
study. It is possible to group these studies in the literature into two. First group of studies
establishes a symmetrical tie between economic growth and unemployment and the second
group which also includes the recent studies discusses asymmetrical relationship between
unemployment and economic growth. In most of the studies that support asymmetrical
relationship between economic growth and unemployment, the main idea is that economic
growth and unemployment relationship is more intense in the economic downturn periods
compared to economic expansion periods. And he proposed that an negative relationship
existed between real output level and unemployment level in his study in which he used data
obtained from U.S. economy.

Cuaresma (2003) proposed an asymmetrical relationship between unemployment and

economic growth in his study in which he used US economic data. The author found
significant relationship between economic growth and unemployment during economic
shrinkage periods.

Silvapulle et al. (2004) stressed that the effect of economic growth over unemployment was
more significant during the time of economic shrinkage in his study in which he used US
economic databetween 1947 and 1999.

Lee (2000) discussed existence of a strong relationship between economic growth and
unemployment in his study which supported Okun’s law and was conducted for 16 OECD
countries.

Malley and Molana (2008) used quarterly data for G7 countries between the years of 1960
to 2001 and they stated that the relationship between economic growth and unemployment
was more significant in the case of Germany.

Noor, Nor and Judhiana (2007) examined whether there exist an Okun – type relationship
between output and unemployment in the Malaysian economy. The empirical results show
that there was an inverse relationship between output and unemployment

Emeka, Emmanuel and Michael (2016) probed the connection among unemployment rate,
private consumption expenditure and economic growth for Nigerian economy by the use of
annual data from 1980 to [Link] cointegration test outcome indicated a cointegration

12
relation among the variables and empirical findings pointed out a negative relationship.
Besides, Granger causality test results supported a causal impact of economic growth on the
unemployment rate. The issue of unemployment has become a severe challenge for all
African countries, regardless of their different socio-economic development. People often do
not have a choice with regards to their employment due to the lack of available opportunities
and are therefore underemployed, i.e. their job is not their profession or is irrelevant to their
field of study. Ethiopia is the second most populous nation in Africa after Nigeria, and the
fastest growing economy in the region. The economy experienced strong, broad-based
growth averaging 9.9% a year from 1999 to 2009 EC, compared to a regional average of
5.4%. However, it is also one of the poorest, with a per capita income of $790. Despite
reducing the extreme poverty rate from about 46% in 1995 to 23.5% in 2016, Ethiopia still
has more than 25 million people living in poverty. The relationship between economic growth
and unemployment in Ethiopia is multifaceted. While sustained economic growth is crucial
for job creation, the link between GDP expansion and employment generation in the country
is not always direct As evident, the Ethiopian economy has been growing at a remarkable rate
for the last few years. However, it is important to examine how that growth has translated
into more jobs that are of a better quality and are inclusive. The statistical figures show that
more than 70% of Ethiopians are under 30 years of age, with urban youth unemployment
standing at 22% compared to an overall unemployment rate of 17% Challenges such as the
predominance of the agricultural sector, limited diversification into the industrial and service
sectors, and vulnerability to external shocks have influenced the capacity of the economy to
absorb the growing labor force ( Betgilu Oshora1, Tiblets Nguse Maria Fekete-Farkas, Zoltan
Zeman,,2020). Unemployment and Economic growth are intertwined concepts because; the
level of unemployment in an economy may affect the rate of economic growth, and is an
indicator of the state of the economic growth of an economy. In order to sustain economic
growth, high level of unemployment must be minimized (Bean, 1998). Furthermore, this
association between economic growth and unemployment also seen in terms of the required
output of services delivered by employees needed to withstand an economy and to encourage
economic growth. When there is a high level of unemployment, the level of output also drops
due to the reduction in the number of workers contributing to the output. (Abdulkadir Hamza
2015). Hence, taking the above works of literature as a hint and baseline, this study
empirically investigates the relation between unemployment on economic growth in Ethiopia.

2.3 Research gap analysis

Ethiopia's economic landscape has undergone notable changes over the past decades, marked
by varying levels of economic growth and shifts in unemployment rates. Despite numerous
studies on the country's economy, there remains a discernible gap in comprehensively
examining the relationship between economic growth and unemployment rates, specifically
in the context of Okun's [Link] study attempts to fill the gap of previous studies that have
predominantly focused on unemployment rates as a response to economic growth,
overlooking the reciprocal relationship, hindering a nuanced understanding of Okun's Law.

13
2.4 Conceptual framework
Economic growth often leads to increased demand for goods and services, which, in turn,
stimulates demand for labor. Expansion in industries such as manufacturing, services, and
technology creates job opportunities and reduces unemployment. During periods of robust
economic growth, businesses tend to hire more workers to meet rising demand, leading to a
decline in the unemployment rate. In the short term, there is an inverse relationship between
economic growth and unemployment, often depicted by the Phillips Curve. As economic
growth accelerates, unemployment tends to decrease due to increased hiring and business
expansion. Conversely, economic downturns or recessions result in reduced economic
activity, leading to layoffs, increased unemployment, and a contraction in job
[Link]-term economic growth can significantly impact the composition of
industries and the nature of employment. Technological advancements and shifts in consumer
preferences may render certain jobs obsolete while creating demand for new skills. Structural
changes in industries can lead to frictional or structural unemployment as workers need to
adapt their skills to match the evolving demands of the job market. In summary, the
independent variable i.e Economic growth in the research is expected to have postive or
negative impact based up on the reviewed literature.

14
 3. Methodology
3.1 Research design
This study uses a quantitative research design, utilizing econometric techniques to analyse
time series data on economic growth and unemployment rates in Ethiopia. This paper
investigates the potential causal relationship between unemployment and economic growth,
along with examining the validity of Okun's Law. It also employs descriptive statistics to
overview the trend of unemployment and economic growth.

3.2 Data Sources and Collection

The study is done based on statstical data obtained from reputable sources such as the
National bank of Ethiopia (NBE), World Bank databases, and other reliable national and
international economic databases. The time series data for GDP growth rate and
unemployment rate over a the period starting from 1992 EC upto 2014 EC is collected.

3.3 Method of Data Analysis

The okun’s law model the relationship between unemployment and economic growth in two
ways the gap model and the diffrence [Link] research uses the VECM model a as a
method of analysis using the diffrence model of Okun to study the relation between the two
varibles GDP and unemployment rate. The selection of difference version is made because it
can provide more accurate results as compared to other versions of Okun’s law.

3.4 Model Specification

This study has employed the difference model of Okun's law, with unemployment as the
dependent variable and economic growth, net official aid received, foreign direct investment,
and inflation as the independent variables.

U NEM t =α + β1 R GDP+ β 2 TXP t + β 3 ¿ FLt + ε t

R GD Pt represents the GDP growth rate at time t.

U NEM t denotes the unemployment rate at time t.

INF Lt denotes the rate of inflation at time t.

TX P t denotes the total expenditure at time t

α is the intercept term.

Β1 is the coefficient representing the effect of changes in economic growth on

Unemployment.

15
Β2 is the coefficient representing the effect of changes in total investment on unemployment

Β3 is the coefficient representing the effect of changes in inflation on unemployment

ε trepresents the error term

3.5 Some Econometrics test

This study conducts a time series anyalsis to test the relationship between economic growth
and unemployment rates, specifically in the context of Okun's Law. Therefore the following
econometrics tests are crucial components in ensuring the validity, reliability, and robustness
of the analysis.

 Augmented Dickey-Fuller (ADF) Test: is used to test for stationarity in both the
dependent and independent variables (∆GDP and ∆Unemployment) to ensure they are
integrated of order one (I(1)) or stationary.
 Engle-Granger or Johansen Cointegration Test: help us to determine if there exists
a long-term relationship (cointegration) between ∆GDP and ∆Unemployment.
Cointegration indicates a stable long-term relationship between the variables, which is
essential for Okun's Law
 Jarque-Bera test: is an important statistical tool used to assess whether a given
sample of data follows a normal distribution
 Lagrange Multiplier (LM): test is a commonly used method for detecting the
presence of autocorrelation in regression models
 Lag Selection: To select appropriate lag lengths for the ARDL model this study uses
information criteria (e.g., Akaike Information Criterion - AIC, Schwarz Bayesian
Criterion - SBC).
 Stability test: used to ensure that the estimated coefficients and relationships among
the variables in the VAR model are consistent and valid over time

16
 4. Analysis and Interpretation

4.1 Introduction
This study uses a two-sided approach to examine the interaction between economic growth
and unemployment in the Ethiopian context. First, it uses descriptive analysis to provide a
comprehensive picture of the historical trends and relationships between these variables. This
is done by using graphs, charts, and tables to visually represent the data and identify
preliminary patterns. Second, the study examines economic analysis in depth to examine the
applicability of the Okun Law for the Ethiopian economy. Okun's Law establishes a negative
and complex relationship between a country's economic growth and the unemployment rate.
Using econometric methods, the study aims to quantify this relationship and to what extent
Okun’s law holds true for Ethiopia. This involves the development of mathematical models
and the use of appropriate economic tests to verify the validity of the hypothesized
relationship.

4.2 Descriptive analysis

4.2.1 Trends of the variables
An examination of Ethiopian unemployment data from 1992 to 2014 reveals a distinct two-
phase pattern. The earlier period (1992-2005) witnessed a sustained decrease in the
unemployment rate, reaching a nadir of 2.25% in 2005. This suggests a potentially favourable
economic climate during this timeframe. However, a reversal of this trend is evident from
2006 onwards. The unemployment rate embarked on an upward trajectory, culminating in a
peak of 3.93% in 2013. The final year included in the data (2014) shows a slight
improvement, with the unemployment rate dipping to 3.42%.

Trend of Unemployment (1992-2014)

Unemployment, total (%of total labor force) (modeledILOestimate)

4.00
3.50
3.00
2.50
2.00

1990 1995 2000 2005 2010 2015

Year

17
The trend of economic growth rate in Ethiopia throughout the study period reveals a pattern
of dynamic fluctuations. The initial phase witnessed a period of increasing growth, followed
by a decline to -2.1% in 1995. This negative growth suggests a period of economic
contraction. However, the trajectory subsequently reversed, with growth rebounding to 11.2%
by the year [Link] subsequent period (until 2007) is characterized by relative stability,
with growth oscillating between 11.4% and 8.7%. This period suggests a phase of moderate
economic expansion. However, a downward trend emerged after 2007, with growth dipping
to 8% in 2008. This could be indicative of a temporary economic slowdown. The following
years (2009-2011) exhibited a pattern of recovery and renewed volatility. Growth rebounded
to 10.1% in 2009, only to decline again to 7.7% in 2010. This highlights the dynamic nature
of economic performance during this timeframe. A subsequent increase to 9% in 2011
suggests a renewed period of expansion. The final years of the data (2012-2014) depict a
gradual downward trend, with growth reaching 6.1% by 2014.

Trend of RGDP (1992-2014)

15
10
Real GDP
5
0
-5

1990 1995 2000 2005 2010 2015

Year

4.2.2 Descriptive Statistics

This section presents a summary of the descriptive statistics for the variables employed in the
study, spanning the period from 1992E.C to 2014E.C. A total of 23 observations were
included in the analysis. The dependent variable for this investigation is unemployment. The
independent variables, factors potentially influencing unemployment, are Real GDP, Total
Expenditure and Inflation A descriptive statistics table accompanies this section, provides the
Mean Standard Deviation, Minimum and Maximum values for each variable. By examining
these descriptive statistics, we can gain a preliminary understanding of the central tendencies
and dispersion of the variables under investigation. This information serves as a foundation
for further analysis, allowing us to explore potential relationships between unemployment
and the chosen independent variables (Real GDP, Total Expenditure, and Inflation).

18
 Variable Obs Mean Std. Dev. Min Max

Unemploymen 23 2.73987 .530331 2.245 3.93

t

Real GDP 23 8.65 3.511173 -2.1 12.6

growth rate

General 23 13.45217 11.25841 -10.6 36.4

inflation

Total 23 189541.9 213014.3 15786.4 779099

Expenditure

Table 1: Descriptive statistic for dependent and independent variables

The above table shows us that the dependent variable unemployment rate averaged 2.74%
with minimal variation (SD = 0.53%), indicating a consistently low level of unemployment
(ranging from a minimum of 2.25% to a maximum of 3.93%). Whereas the independent
variables:

Real GDP growth exhibited moderate variability (SD = 3.51%) with an average growth rate
of 8.65%. However, the range (-2.10% to 12.60%) indicates periods of both economic
contraction and expansion.

General inflation presented a concerning picture, averaging a high of 13.45% with significant
variation (SD = 11.26%). The inflation rate even dipped into deflation (-10.60%) at times,
while reaching highs of 36.40%.

Total expenditure displayed a high degree of variability (SD = 213,014.30) with an average of
189,541.90, highlighting the substantial spread in expenditure levels across the observations
(ranging from a minimum of 15,786.40 to a maximum of 779,099.00).

4.3 Econometric Analysis

This section presents the findings of the VECM regression analysis and the results of various
econometric tests conducted to ensure the robustness and credibility of our model.

4.3.1 Unit Root test

When conducting regression analysis with time series data, checking for stationarity is
crucial. Stationarity means the data's average level and variability remain constant over time.
Non-stationary data, often exhibiting trends or seasonality, can lead to misleading
relationships (spurious regression) in regression analysis. Therefore, an Augmented Dickey-
Fuller (ADF) test, a unit root test, will be employed to identify non-stationary behaviour in
the variables. Additionally, log transformation is applied to the variables. This technique can
not only improve stationarity by reducing trends but also allows interpretation of regression

19
results in terms of elasticities and helps mitigate the influence of outliers and data
fluctuations.

Test Critical Values Order of

Variable statistic P-Value Integration
1% 5% 10%

LUNEM -3.181 -3.750 -3.000 -2.630 0.0211 I (1)

LRGDP -4.779 -3.750 -3.000 -2.630 0.0001 I (1)

LINF -3.456 -3.750 -3.000 -2.630 0.0092 I (1)

TotExpln -5.321 -3.750 -3.000 -2.630 0.0000 I (1)

The results of the Augmented Dickey-Fuller (ADF) test, with all p-values falling below the
0.05 significance level, provide robust evidence for rejecting the null hypothesis of a unit root
in each variable. This signifies the presence of non-stationarity in the level data. However, the
observed stationarity at first difference (order one integration) suggests that differencing the
data once effectively eliminates any trends or persistent effects, rendering the variables
suitable for further statistical analysis.

4.3.2 The Optimum Lag Length

The Optimum Lag Test is a method used in the context of Vector Autoregressive (VAR)
models to determine the appropriate number of lagged terms to include in the model. The
number of lags, or the lag length, is a crucial parameter in VAR models as it helps capture the
dynamic relationships between the variables in the system. The purpose of the Optimum Lag
Test is to select the lag length that provides the best fit for the VAR model, based on certain
statistical criteria. The test evaluates different lag orders and selects the one that minimizes a
chosen information criterion, such as the Akaike Information Criterion (AIC), Bayesian
Information Criterion (BIC), or Hannan-Quinn Information Criterion (HQIC). These
information criteria balance the goodness of fit with the complexity of the model, and the lag
order that minimizes the selected criterion is considered the optimal lag length. The Optimum
Lag Test typically involves specifying a maximum lag length, estimating the VAR model for
each lag order, calculating the selected information criterion for each lag order, and then
identifying the lag order that minimizes the chosen criterion. This optimal lag length is
important for capturing the dynamic relationships between the variables, making accurate
forecasts, and ensuring the reliability of the model's statistical inferences, such as Granger
causality tests, impulse response functions, and forecast error variance decompositions. The
table below shows the optimum for each variable under consideration;

20
 Variable Lag FPE AIC HQIC SBIC

LUNEM 2 0.001654 -3.56946 -3.54422 -3.42034

LRGDP 0 0.12827 0.78416 0.792572 0.833867

LINFL 0 0.09291 0.461592 0.464065 0.509879

LTotEx 1 0.002911 -3.00218 -2.98535 -2.90276

Table 3: Optimum Lag test

4.3.3 VAR Estimation (Short-run dynamics)

The study employed a VAR model to obtain the short-run relationship among the variables.
VAR models are commonly used for analysing the short-run dynamics among multiple time
series variables. In a VAR model, each variable is regressed on its own lagged values as well
as the lagged values of all other variables in the system. This approach allows for capturing
the contemporaneous relationships and feedback effects among the variables.

Mathematically, a VAR model of order p can be represented as:

Y t =c + A1 K−1 + A 2 Y t−2 +⋯ A p Y t− P+ e t

Where:

• Y t is a vector of endogenous variables at time t

• c is a constant term

• A1 , A2 , ... A p are coefficient matrices capturing the lagged effects

• e t is a vector of error terms

The short-run dynamics in a VAR model refer to the immediate responses of the variables to
changes in their own lagged values and the lagged values of other variables. By estimating
the coefficients of the VAR model, researchers can quantify the short-run impact of shocks or
changes in one variable on the other variables in the system.

This analysis of short-run dynamics is particularly useful for understanding the immediate
responses of economic and financial variables to various shocks or policy changes. It
provides insights into the underlying mechanisms and feedback effects that drive the
relationships among the variables in the short run.

21
 LUNEM Coefficient Standard error p-value

LUEMP (-1) 0.7263013 0.2086793 0.001

LUEMP (-2) -0.3557025 0.2158083 0.099

LRGDP (-1) 0.0501856 0.0194191 0.010

LRGDP (-2) 0.0645137 0.0196115 0.001

LINF (-1) -0.0467831 0.0242455 0.054

LINF (-2) 0.0358662 0.0223888 0.109

LTotEx(-1) -0.2696127 0.1302123 0.038

LTotEx(-2) 0.3407633 0.1344652 0.011

Constant -0.2959154 0.1017115 0.004

Table 4: VAR Estimation Result

Here’s the interpretation of the result above;

 If one-year lagged unemployment rate increases by 1%, then unemployment rate

increases by approximately 0.73%, Ceteris Paribus.
 If two-year lagged unemployment rate increases by 1%, then unemployment rate
decreases by approximately 0.35%, Ceteris Paribus.
 If one-year lagged real GDP growth rate increases by 1%, then unemployment rate
increases by approximately 0.05%, Ceteris Paribus.
 If two-year lagged real GDP growth rate increases by 1%, then unemployment rate
increases by approximately 0.064%, Ceteris Paribus.
 If one-year lagged inflation increases by 1%, then unemployment rate decreases by
approximately 0.04%, Ceteris Paribus.
 If two-year lagged inflation increases by 1%, then unemployment rate increases by
approximately 0.035%, Ceteris Paribus.
 If one-year lagged total expenditure increases by 1%, then unemployment rate
decreases by approximately 0.27%, Ceteris Paribus.
 If two-year lagged inflation increases by 1%, then unemployment rate increases by
approximately 0.34%, Ceteris Paribus.

The significance of a result can be determined by its p-value. If the p-value is less than 5%,
the result is significance and if it is above 5%, it is insignificant. Thus, from the above table,
it is clear that all the variables are significant except for LUNEM (-2), LINF (-1) and
LINF (-2)

22
4.3.4. Diagnostic Tests
Diagnostic tests are used to check for the validity and efficiency of the coefficients as well as
determining whether they could be used for prediction or not.

Stability Test

The stability of the VAR (Vector Autoregression) model is crucial for ensuring reliable and
meaningful analysis. Stability is an important property that needs to be examined when using
VAR models. A stable VAR model ensures that the estimated coefficients and relationships
among the variables are consistent and valid over time. Instability in the VAR model would
imply that the parameter estimates and the inferences drawn from the model are not reliable,
as the underlying relationships may be changing over the sample period.

Eigenvalue stability condition

Eigenvalue Modulus

.9930101 .99301
.5149939 + .3940469i .648453
.5149939 - .3940469i .648453
-.1502253 + .6286591i .646359
-.1502253 - .6286591i .646359
-.1294388 + .3483986i .371667
-.1294388 - .3483986i .371667
.1724418 .172442

All the eigenvalues lie inside the unit circle.

VAR satisfies stability condition.

Autocorrelation Test

Autocorrelation refers to the correlation between error terms or residuals in a regression

model at different time points. This is a violation of one of the key assumptions of classical
linear regression, which states that the errors should be uncorrelated. When autocorrelation is
present, it indicates that there is some systematic pattern or dependence among the error
terms over time. The Lagrange Multiplier (LM) test is a commonly used method for detecting
the presence of autocorrelation in regression models, and it can be particularly useful in the
VAR framework. The LM test is a powerful tool for detecting the presence of autocorrelation
in VAR models. It tests the null hypothesis of no autocorrelation against the alternative
hypothesis of the presence of autocorrelation. If the p-value of the LM test is greater than the
significance level of 5%, it indicates that there is no evidence of autocorrelation, and the VAR
model satisfies the assumption of uncorrelated errors. For this study, the LM test results show
that there is no autocorrelation in the VAR model, as the p-value is greater than 5%. This is an
important finding, as it suggests that the parameter estimates and inferences drawn from the
VAR model are reliable and not affected by the presence of autocorrelated errors.

23
 Lagrange-multiplier test

lag chi2 df Prob > chi2

1 21.5404 16 0.15866
2 12.8678 16 0.68240

H0: no autocorrelation at lag order

Normality Test

The Jarque-Bera test is used in this study to check for the normality of the distribution. The
Jarque-Bera test is an important statistical tool used to assess whether a given sample of data
follows a normal distribution. This test is particularly relevant in the context of econometric
model, where the assumption of normality is often crucial for the validity of the analysis. The
Jarque-Bera test is based on the skewness and kurtosis of the data, which are measures of the
symmetry and peakedness of the distribution, respectively. Skewness measures the degree of
asymmetry of the distribution, with a value of zero indicating a perfectly symmetric
distribution. Kurtosis, on the other hand, measures the degree of "peakedness" or "flatness" of
the distribution, with a value of 3 indicating a normal distribution.

If the p-value of the Jarque-Bera test is greater than the chosen significance level (e.g., 5%), it
indicates that there is no evidence to reject the null hypothesis, and the data can be considered
to follow a normal distribution. Conversely, if the p-value is less than the significance level, it
suggests that the data does not follow a normal distribution, and the null hypothesis can be
rejected. In this study, the result shows that the error term is normally distributed within the
model, which is an important assumption for the validity of the statistical inferences drawn
from the VAR analysis.

Jarque-Bera test

Equation chi2 df Prob > chi2

LUNEM 3.461 2 0.17722

LRGDP 3.083 2 0.21403
LINF 0.529 2 0.76749
TotExpln 0.535 2 0.76516
ALL 7.609 8 0.47260

24
Johansen Test

The Johansen cointegration test is a statistical tool used to determine the presence and rank of
cointegration among multiple time series variables. Cointegration is a crucial concept in
economic analysis, as it refers to a long-term relationship between non-stationary variables,
indicating that they move together in the long run despite having individual trends.

The Johansen cointegration test is particularly valuable in situations where the variables
under investigation may be cointegrated, meaning that they share a common long-term trend.
This is often the case when analysing economic variables that are expected to have a long-run
relationship.

Johansen tests for cointegration

Trend: constant Number of obs = 23

Sample: 1992 - 2014 Lags = 2

-------------------------------------------------------------------------------

maximum
rank parms LL Eigenvalue Trace Statistic 5% critical value
0 20 59.58312 - 69.1328 47.21
1 27 79.762905 0.89378 28.7733* 29.68
2 32 90.868878 0.70887 6.5613 15.41
3 35 94.11934 0.30313 0.0604 3.76
4 36 94.149543 0.00335 - -

-------------------------------------------------------------------------------

maximum rank parms LL Eigenvalue max Statistic 5% critical value

0 20 59.58312 - 40.3596 27.07
1 27 79.762905 0.89378 22.2119 20.97
2 32 90.868878 0.70887 6.5009 14.07
3 35 94.11934 0.30313 0.0604 3.76
4 36 94.149543 0.00335 - -

In the context of the current study, the results of the Johansen test show that there is co-
integration among the variables. Thus, there exists a long-run relationship among the
variables in the study.

25
4.3.4 VECM Estimation (Long-run dynamics)
To obtain the long-run relationship among the variables, the study employed a Vector Error
Correction Model (VECM). The VECM is an extension of the Vector Autoregressive (VAR)
model that incorporates the concept of cointegration, which is crucial for capturing the long-
run equilibrium relationships among non-stationary variables.

The VECM achieves this by incorporating an error correction term, which represents the
deviation from the long-run equilibrium. This term captures the speed at which the system
adjusts back to the long-run relationship when it is temporarily out of equilibrium. The
inclusion of this error correction term is what distinguishes the VECM from the standard
VAR model, which does not explicitly account for cointegration.

LUNEM Coefficient Standard error p-value

LRGDP -0.0388351 0.028728 0.003

LINF -0.2039596 0.0345138 0.000

LTotEx -0.0923785 0.0184033 0.000

Table 5: VECM Estimation Result

Here’s the interpretation of the long run relationship between the dependent variable and the
independent variables based on the above result;

 If real GDP growth rate increases by 1%, then unemployment rate decreases by
approximately 0.04%, Ceteris Paribus.
 If inflation increases by 1%, then unemployment rate decreases by approximately
0.203%, Ceteris Paribus.
 If total expenditure increases by 1%, then the unemployment rate decreases by
approximately 0.09%, Ceteris Paribus. The result also shows that the coefficients of
all the variables are statistically significant at 95% confidence interval.

26
 5. Conclusion and Recommendations
5.1 Conclusion
Unemployment constitutes a paramount obstacle to sustainable socio-economic development
in Ethiopia. Its detrimental effects are further exacerbated by a complex interplay of many
other interrelated factors. The objective of this study was to explore the intricate relationship
between unemployment and economic growth, while also assessing the validity of Okun's
Law in Ethiopia, with economic growth serving as the explanatory variable. Utilizing data
spanning from 1992 to 2014 EC, this study employed Vector Error-Correction Model
(VECM) analysis as the primary analytical method. This approach allowed for the capture of
both the short-term dynamics and long-term equilibrium relationships between
unemployment, economic growth, and other macroeconomic variables. Through rigorous
empirical analysis, this study sought to unravel the complexities of Ethiopia's labour market
dynamics and their nexus with broader macroeconomic conditions.

The insights gleaned from the Vector Error-Correction Model (VECM) shed light on the
dynamics of unemployment and its determinants within the Ethiopian context. Consistent
with Okun's Law which assumes an inverse relationship between changes in the
unemployment rate and changes in real GDP. Specifically, Okun postulated that a 1%
increase in unemployment would correspond to a 2% to 3% decrease in real GDP. This
suggests that during periods of economic downturns or recessions, where unemployment
rises, there tends to be a proportional decline in the overall output of goods and services in
the economy., the negative coefficient associated with real GDP (LRGDP) in the VECM
analysis suggests that sustained economic growth holds promise in mitigating unemployment
over the long term. This is because as the economy grows, businesses experience an
expansion in demand for their products and services to meet this increased demand, firms
need to hire more workers, leading to a decline in unemployment levels and generation of
additional income and this additional income generated leads to increased consumer
spending, which in turn creates more jobs in industries catering to this demand. Specifically,
the numerical findings indicate that a 1% increase in real GDP growth corresponds to a
0.04% decrease in the unemployment rate, Ceteris Paribus. Therefore, this nuanced validation
of Okun's Law in Ethiopia suggests that while economic growth does serve as an effective
lever for reducing unemployment, the labor market dynamics are more complex and the
employment-output relationship is not as straightforward as the original theory proposes.
Factors such as structural rigidities, sectoral composition, and institutional characteristics
may be influencing the strength of this link.

Moreover, the significance of total expenditure (TotExpln) in bolstering employment

emphasizes the pivotal role of fiscal policy interventions in galvanizing aggregate demand
and fostering job creation, aligning closely with Okun's theoretical assertions. According to
the VECM results, a 1% increase in total expenditure corresponds to a 0.09% decrease in the
unemployment rate, Ceteris Paribus.

27
However, the findings about the relationship between inflation and unemployment differ from
Okun's theoretical postulates. While Okun's Law posits an inverse relationship between
inflation and unemployment, the empirical analysis reveals a contrasting trend within the
Ethiopian context. Specifically, the VECM numerical findings indicate that a 1% increase in
inflation corresponds to a 0.203% decrease in the unemployment rate, Ceteris Paribus. This
discrepancy can be the result of a high prevalence of informal employment, structural
rigidities in the labor market, the impact of rising prices on consumer demand and
production, or other underlying complexities of the Ethiopian labor market and
macroeconomic environment.

5.2 Recommendations
Ethiopia's remarkable economic growth has been a beacon of hope, yet it casts a long shadow
—the persistent challenge of unemployment. As the labor force expan202ds, so does the
urgency to create meaningful job opportunities. Based on the findings of this study, the
following potential remedies can be proposed to alleviate this pressing issue:

- Promote Labor-Intensive Industries: Strategically target the development of labor-

intensive sectors like textiles, apparel, and light manufacturing. These industries are
known for their ability to generate large-scale employment opportunities, especially
for the country's abundant low-skilled workforce. Provide targeted incentives,
infrastructure support, and access to finance to attract both domestic and foreign
investment in these key employment-generating sectors.
- Invest in Skills Development: Bridge the skills gap by providing targeted training
programs that equip the workforce with the skills demanded by the evolving labor
market. Collaborate with industry leaders to design vocational and technical education
curricula that are responsive to the needs of the private sector. Establish public-private
partnerships to fund and manage skills development initiatives, ensuring a steady
supply of work-ready talent to drive economic growth.
- Boost Small and Medium Enterprises (SMEs): Facilitate access to finance,
technology, and markets for SMEs, which are crucial engines of job creation in
Ethiopia. Establish dedicated SME finance facilities, including loan guarantees and
venture capital funds, to unlock the entrepreneurial potential of the nation. Provide
business development services, mentorship programs, and market linkage support to
help SMEs scale up and create more employment opportunities.
- Modernize Agriculture: Invest in improved agricultural inputs, irrigation systems,
mechanization, and extension services to enhance productivity in the sector. This will
not only boost overall economic growth but also create opportunities for employment
in agro-processing industries, which can add value to agricultural commodities and
generate additional jobs along the supply chain.
- Implement Active Labor Market Policies: Introduce programs like job search
assistance, wage subsidies, and skills training to enhance employability and facilitate
effective labor market matching. These active labor market policies can help bridge
the gap between job seekers and available opportunities, ensuring a better utilization

28
of the country's human capital and reducing the mismatch between labor supply and
demand.

29
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