This study investigated the relationship between real effective exchange rate and balance of payment in Ethiopia using annual data spanning the period of 1976 to 2015. The analysis was based on a cointegrated vector autoregressive approach. The methodology of the study begins with Augmented Dickey-Fuller stationarity tests of the data and the Johansen cointegration rank test that revealed current account, real gross domestic product, real effective exchange rate, budget deficit, interest rate and inflation rate to be cointegrated with one cointegrated relationship and thus share long-run equilibrium relationships. Empirical results suggest that real effective exchange rates do play a role in determining the short and long-run behavior of the Ethiopian current account. Thus, there is strong indication for the Marshall-Lerner condition to hold in Ethiopia, as the current account improved in the long run in response to depreciation in the real effective exchange rate. The result of the long run relationship from the vector error correction model, together with the outcome of impulse response function signify that, following devaluation in the real effective exchange rate, current account first deteriorates before it later improves, that is exhibiting the J-curve pattern. Accordingly, the major policy implication of this study is the depreciation of the real effective exchange rate by taking the macroeconomic realities of the country into account while advocating export promotion and import substitution strategies.
Key words: Current account, real effective exchange rate, cointegration, vector autoregression, vector error correction model.
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