The effect of currency devaluation on output: the case of Ethiopian economy

Abstract

The objective of this paper is to analyze the short and long run effect of currency devaluation on output growth in Ethiopia. The study is conducted by using quarterly time series data over the period ranging from 1997/98 to 2009/10 and employing a Vector Auto regression model. By controlling for monetary and fiscal policy, the study found that currency devaluations are contractionary in the long run and neutral in the shortrun. Other results are that monetary policy has the expected positive effect on output growth, while an increase in total government expenditure has negative effect. Moreover, this study clarify that devaluation explains a considerable part of real gross domestic product change in Ethiopia. Since the Ethiopian output is dominated by primary agricultural products and it is insensitive for the change in exchange rate, it is not possible the government allowing market forces to determine the value of Ethiopian birr. Policy intervention is needed to balance the adverse impact of exchange rate movements until the economy well transformed from agricultural sector to industrial sector and becomes less dependent on imported raw materials. Thus, monetary policy suggested a bigger role since it affects the total output positively and significantly. Key words: Currency Devaluation, Output, VAR