Investigating the Macroeconomic Effects of Climate Change on the Ethiopian Economy: A Dynamic Factor Model Approach

Abstract

ABSTRACT This study examines the macroeconomic effects of climate change on the Ethiopian economy using quarterly data from 1970Q1 to 2023Q4. The study combines a Dynamic Factor Model (DFM) to extract a latent common economic factor with a set of observed climate variables (methane, greenhouse gases, temperature, precipitation, carbon intensity) and a Structural Vector Auto‐regression (SVAR) to trace within‐economy transmission. The DFM identifies climate and demographic variables that significantly influence inflation, agricultural output, exports, and GDP; the SVAR shows how shocks to inflation and agriculture propagate to lowering economic growth and exports. Climate‐related agricultural shocks and inflationary pressures can reduce GDP and exports, underscoring the need for integrated monetary and adaptation policy; strengthening export‐oriented, climate‐resilient agriculture can stabilize export performance and national income which reduces macroeconomic vulnerability; and investments in early warning systems, irrigation and educational programs that disseminate adaptive farming knowledge are essential to support sustainable development goals (SDG‐13 and SDG‐8).