Abstract
This study examined the effect of Birr devaluation on trade balance of Ethiopia for the period 1970-2014 using the Vector Error Correction Model. The key results of the present study revealed that Birr devaluation deteriorates the trade balance of Ethiopia in the short run and improves it in the long run. Moreover, the result from the long and short run models showed that real effective exchange rate, money supply, domestic real income and term of trade are the major determinants of the trade balance of Ethiopia both in the short and long run. Besides the short and the long run model, the impulse response function and the descriptive analysis revealed that a J-curve phenomenon exists for the trade balance of Ethiopia. That means, the finding of this study showed that the Marshall-Lerner Condition holds only in the long run. So, the present study revealed that the elasticity, monetary and absorption theories are significant in explaining the trade balance of Ethiopia. The policy implication is that policies that encourage productivity improvements, diversification of the export sectors and expansion of import computing industries are alternative policies for devaluation. Moreover, government may need to be conservative in using devaluation (exchange rate policy) to improve trade balance as it may worsen the situation in the short run. Thus, the country on the process of industrialization, first needs to promote import computing industries and then, once the production gets its way, devaluation would be clear. Key words: Marshal Lerner condition, currency devaluation, J curve phenomenon, co-integration analysis.
Highlights
Exchange rate is one of the key barometers of economic performance, indicating output growth, demand conditions, levels and trends in monetary and fiscal policy stance
The overall objective of this study is to test the effect of currency devaluation on the trade balance of Ethiopia for the period 1970-2014 using Vector Error Correction Model (VECM) which was developed by Johansen (1987) and Johansen and Juselius (1990)
Except for some essential consumer items, imports were free from licensing or other quantitative restrictions and exporters were required to give their foreign exchange to commercial banks at the prevailing official exchange rate and this led to the existence of macroeconomic stability and a relatively liberal trade regime
Summary
Exchange rate is one of the key barometers of economic performance, indicating output growth, demand conditions, levels and trends in monetary and fiscal policy stance. Exchange rate policy emerged as one of the controversial policy instruments in developing countries in the 1980s, with strong opposition to devaluation for fear of its inflationary impact, among other effects. Due to their vulnerability to external shocks, less developed countries have considered the exchange rate as the central policy issue over the years. The legal currency of Ethiopia was issued on 23 July, 1945 by defining the monetary unit as the Ethiopian. The currency Proclamation of 1945, defined the monetary unit of the country as the Ethiopian dollar with a value of 0.355745 g of fine gold. The linkage with fine gold was in accord with the monetary system established by the Bretton Woods Agreement of 1944 and automatically established the exchange rate between the national currency and other currencies with the same arrangement
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