The Effect of Exchange Rate Changes on Trade Balance of Ethiopia: 1970/71 - 2005/06."

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The purpose of this paper is to analyze the effects of change in exchange rate of Birr on the trade balance of Ethiopia. The study employs the standard Augmented Dickey-Fuller test in order to test the stationarity of all variables at levels and first differences and the Johansen and juselius' approach to estimation of multivariate co integration systems on the quarterly data in the period 1970/ 71QI - 2005/06QI. In order to establish the existence or absence of a j-curve phenomenon in Ethiopia, we employ impulse response function to trace the effect of real effective exchange rate on the trade balance of Ethiopia. The main findings of the study show that: first, there is a negative relationship between the trade balance and the real effective exchange rate appreciation indicating that a real depreciation will improve the trade balance in the long run; second, the results indicate that there seem to be no clear evidence of the J-curve phenomenon. The policy implication of the finding is that to improve its international competitiveness and its trade balance deficit, Ethiopia can use depreciation/devaluation based adjustment policy. Competitiveness, however, goes beyond currency depreciation. I.e. currency depreciation alone is unlikely to be able to increase competitiveness. Therefore, Ethiopia has to use also export diversification strategy i.e. the government has to pursue to diversify export commodities from agriculture to other products both vertically and horizontally in order to be competitive and reduce its trade deficit since most of export items relied on few primary commodities. The negative sign of domestic real income indicated that a rise in domestic income of Ethiopia encourages its consumers to demand more foreign goods, leading to a deterioration of trade balance in favor of its major trading partners. In this regard, the government has to promote import substitution strategy In order to shift the demand of domestic consumers towards domestic goods.



Exchange rate, trade balance, J-curve