The main objective of the study is to examine the causal relation ship between the budgetrndeficit, money supply and inflation in Ethiopia using the Aghevli and Khan (1978) model usingrnEthiopian data obtained from Ministry of Finance, Ministry of Economic Development andrnCo-operation and National Bank of Ethiopia.rnrnThe main findings of the study are:rnThe existence of lag structure in the government budgetary mechanism caused a twornway causation between money supply and inflation.rnThe monetarist paradigm of sustained inflation resulting from budgetary deficitrnfinancing by money creation has been empirically confirmed. In the long-run supplyrnfactors have been found to have a significant influence in the determination of inflation.rnDue to the effect of government borrowing and external influence, the Central Bank isrnunable to conduct an independent monetary policyrnrnThe policy implication of the result of the study is that without implementing effective fiscalrnpolicy, it is difficult to realize macroeconomic stability and economic development. Thisrnincludes, among others, eliminating budget deficit, reducing time lags in tax collection,rnstrengthening fiscal discipline and accountability in the use of public fund. Fiscal prudence andrneffectiveness are also indicated in improved tax performance and efficiency in taxrnadministration. It is also necessary to reform the National Bank of Ethiopia and its operationsrnso that it is empowered to exercise independent monetary policy.