Devaluation, Balance of Payment and Output Dynamics in Developing Countries: (The Case of Ethiopia)

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Addis Ababa University


The objective of the study is to investigate the theoretical and empirical relationship between currency devaluation, balance of payment and output in Ethiopia. The study employed Johnson co-integration analysis, and Granger causality tests. The analysis was made using impulse response function and variance decomposition by adopting Structural Vector autoregressive (SVAR) and Vector Error correction model (VECM). The models were estimated using quarterly data for the period ranging between 2000/2001Q1 to 2016/17Q4. The study found that devaluation has negative impact on the balance of payment. A great variation in real GDP emanates from the balance of payment variation and the variation in exchange rate comes from real GDP. This designates, in the long run, the balance of payment affects exchange rate through real output. Therefore, there is a linkage between exchange rate, the balance of payment and output. The contractionary effect of devaluation on output comes in different ways. First, devaluation increases money supply, a rise in the money supply has inflationary pressure on market prices and this intern forces output to decline. Second, devaluation increases interest rate, an increase in interest rate forces output to decline. Third, devaluation reduces foreign asset reserve, a reduction in foreign asset reserve leads to a fall in the balance of payment. A reduction in the balance of payment led to a decrease in output. Finally, devaluation increases external debt burden. The study recommends that before devaluating its currency the government should consider a policy that encourages productivity, diversification of the export sectors and expansion of import substituting industries which are alternative policies for devaluation.



Balance of Payment, Devaluation, Developing Countries