This study examined the effect of Birr devaluation on trade balance of Ethiopia for the period 1970-2014 using the Vector Error Correction Model. The key results of the present study revealed that Birr devaluation deteriorates the trade balance of Ethiopia in the short run and improves it in the long run. Moreover, the result from the long and short run models showed that real effective exchange rate, money supply, domestic real income and term of trade are the major determinants of the trade balance of Ethiopia both in the short and long run. Besides the short and the long run model, the impulse response function and the descriptive analysis revealed that a J-curve phenomenon exists for the trade balance of Ethiopia. That means, the finding of this study showed that the Marshall-Lerner Condition holds only in the long run. So, the present study revealed that the elasticity, monetary and absorption theories are significant in explaining the trade balance of Ethiopia. The policy implication is that policies that encourage productivity improvements, diversification of the export sectors and expansion of import computing industries are alternative policies for devaluation. Moreover, government may need to be conservative in using devaluation (exchange rate policy) to improve trade balance as it may worsen the situation in the short run. Thus, the country on the process of industrialization, first needs to promote import computing industries and then, once the production gets its way, devaluation would be clear.
Key words: Marshal Lerner condition, currency devaluation, J curve phenomenon, co-integration analysis.
Copyright © 2018 Author(s) retain the copyright of this article.
This article is published under the terms of the Creative Commons Attribution License 4.0