Financial Exclusion and Monetary Policy Effectiveness in Ethiopia: A DSGE Model Estimation

This paper develops a medium scale New Keynesian dynamic stochastic general equilibrium (NK-DSGE) model for the Ethiopian economy to examine how financial exclusion affects monetary policy effectiveness. The model features heterogeneous households financially included and financially excluded and distinguishes between monopolistically competitive intermediate-good firms and perfectly competitive final-good firms. Using Bayesian estimation with quarterly data from 2000Q1 to 2022Q4, the model evaluates the transmission of monetary policy, preference, and productivity shocks to consumption and labor supply decisions. The results indicate that the effects of an expansionary monetary policy shock unfold gradually, requiring approximately ten quarters for full transmission following a one-standard-deviation reduction in the policy interest rate. Importantly, monetary policy effectiveness declines as the share of financially excluded households increases. Financial exclusion weakens the interest rate transmission channel and reduces welfare gains from stabilization policy. These findings highlight structural constraints that limit policy effectiveness in economies with underdeveloped financialsystems and underscore the importance of financial inclusion for improving macroeconomic stability and social welfare.