This paper examines the determinants of personal consumption expenditure in Ethiopia by incorporating other variables, in the consumption expenditure function based on both the traditional Keynesian absolute income and permanent income hypotheses. The analysis begins with the determination of the non-stationarity and stationarity of the variables to be included in the two alternative specifications of the personal consumption expenditure function. Using augmented Dickey-Fuller and Phillips-Perron tests, all the variables were found to be integrated of order one. In order to make them stationary, the variables were differenced once, and an advanced time series econometric technique was applied to avoid spurious regression associated with the time series data. The Engle-Granger two-step procedure was used to test cointegration among the variables. According to this test, all the variables in both Keynesian absolute income hypothesis and permanent income hypothesis specifications were found to be cointegrated. The error correction models were estimated to take into account the short-run dynamics in the relationships among the variables in the two specifications. In Ethiopia, real disposal income and inflation were found to explain personal consumption expenditure pertaining to the Keynesian absolute income hypothesis, whereas permanent income, inflation and real tax revenue were found to be economically and statistically significant in the permanent income hypothesis specification.
Personal consumption expenditure is one of the components of aggregate demand for goods and services in an economy, and consumption spending by the households is the largest component of the aggregate demand for goods and services in most of the countries. In Ethiopia, personal consumption expenditure accounts for about three-fourth of the total spending. Besides the sheer size of consumption spending, another reason to study it was that the individual's or household's decision regarding how much to consume is closely related to another important economic decision, the decision on how much to save. Indeed, for a given level of disposable income, the decision about how much to consume and how much to save is actually the same (Abel and Bernanke, 2001).
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