Impact of Ethiopian Trade Balance: Bound Testing Approach to Cointegration

Abstract

This study is an attempt to examine the short and long-run relationship between the trade balance, income, money supply, and real exchange rate in the case of Ethiopian economy. The bounds testing approach to co integration and error correction models, developed within an autoregressive distributed lag (ARDL) framework is applied to annual data for the period 1979/80 to 2012/13. Additionally, variance decompositions (VDCs) are used to draw further inferences. The result of the bounds test indicates that there is a stable long-run relationship between the trade balance and income, money supply, and exchange rate variables. The estimated results show that the coefficient of the real exchange rate variable is positive and statistically significant at a 10 percent level confirming the hypothesis that real depreciation succeeds in improving trade balance of Ethiopia in the long run. Similarly, The coefficients of money supply and income positive and statistically significant at 1and 5 percent level it provides that money supply and income play a strong role in determining the behavior of the trade balance. The error correction model result indicates all of the coefficients of variables are statistically insignificance. This implies that all variables do not affect trade balance in the short run. Based on the coefficients of the variables statistically significant level exchange rate policy can help improve the trade balance but it will have a weaker influence than economic growth and monetary policy.