The Devaluation of Ethiopian Currency: What have We Learned? Vector Error Correction Model (VECM)
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Date
2019-06
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Addis Ababa University
Abstract
Ethiopia is a small open economy and has been applying exchange rate devaluation as policy instrument
repeatedly. The focus of this study was to look into the theoretical and empirical relationship between
Ethiopian currency devaluation, trade balance, Inflation, External debt servicing, and Economic growth
so as to draw constructive lessons. The study employed trend analysis along with Econometric analysis
such as Johnson co-integration, Vector Error correction model (VECM), Granger causality tests, impulse
response function, and forecast error variance decomposition to analysis long run and short-run
relationship between variables. These model was estimated using quarterly data for the period ranging
from 1992Q2 to 2017Q4. Depending on trend analysis and the results from econometric tools, this thesis
confirmed the hypothesis that currency devaluation will lead to inflationary and high external debt
servicing. However, it rejected the hypothesis that currency devaluation will boost economic performance
and allow a stable trade balance. It is crystal clear that huge inflation and huge external debt servicing
are the burdens for the Economy. Similarly, low economic performance and unstable trade balance are
bad news too. Ultimately, the thesis argued that the Devaluation of Birr is inappropriate policy
instrument for the Ethiopian economy yet.
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Keywords
Co-integration, Devaluation, Macroeconomic Variables