Abstract
This study investigated the relationship between real effective exchange rate and balance of payment in Ethiopia using annual data spanning the period of 1976 to 2015. The analysis was based on a cointegrated vector autoregressive approach. The methodology of the study begins with Augmented Dickey-Fuller stationarity tests of the data and the Johansen cointegration rank test that revealed current account, real gross domestic product, real effective exchange rate, budget deficit, interest rate and inflation rate to be cointegrated with one cointegrated relationship and thus share long-run equilibrium relationships. Empirical results suggest that real effective exchange rates do play a role in determining the short and long-run behavior of the Ethiopian current account. Thus, there is strong indication for the Marshall-Lerner condition to hold in Ethiopia, as the current account improved in the long run in response to depreciation in the real effective exchange rate. The result of the long run relationship from the vector error correction model, together with the outcome of impulse response function signify that, following devaluation in the real effective exchange rate, current account first deteriorates before it later improves, that is exhibiting the J-curve pattern. Accordingly, the major policy implication of this study is the depreciation of the real effective exchange rate by taking the macroeconomic realities of the country into account while advocating export promotion and import substitution strategies. Key words: Current account, real effective exchange rate, cointegration, vector autoregression, vector error correction model.
Highlights
Background of the studyA macroeconomic policy set up is primarily aimed to achieve sustainable economic growth, full employment, price stability and balanced balance of payment position
Coming to the major objective of this study, that is, investigating the impact of change in exchange rate on balance of payment of Ethiopia, the coefficient of the real effective exchange rate index, is positive and statistically significant at a 5% level of significance confirming the hypothesis that real depreciation succeeds in improving current account balance of Ethiopia in the long run
It can be observed that one generalized standard deviation innovation on REER in the short run does not improve current account balance in the 10-year forecast horizon
Summary
A macroeconomic policy set up is primarily aimed to achieve sustainable economic growth, full employment, price stability and balanced balance of payment position. Because countries can achieve satisfactory growth and employment under an environment of moderate inflation and balance of payments disequilibria, price stability and balance of payments equilibrium are regarded as secondary objectives to satisfactory economic growth and full employment. Continuous balance of payments disequilibria will eventually affect economic. This, justifies the case for considering the balance of payments equilibrium an important objective of economic policy (Bank of Uganda, 2003). The balance of payments is a macro variable and a statistical statement that systematically summarizes the economic transaction of an economy with the rest of the world for a specific period. It records transactions that give rise to sets of accounts that indicates all the flows of value between residents of one country and the residents of other countries of the world that they enter into economic dealings (IMF, 1996)
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