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Theories Of Exchange Rate And Trade Balance Economics Essay

In the theory of exchange rate there are majorly two types of exchange rate; the nominal exchange rate and the effective exchange rate. The former refers to the official exchange rate set by countrys central banks officially while the latter refers to the actual exchange rate where foreign currency traders trade each other. One reason for the deviation of effective exchange rate from the official exchange rate can be high degree of governments’ intervention in foreign trade through tariffs, quotas, excise taxes or charges which make this discrepancy much wider. For instance, exporters face devaluated exchange rate in real terms when export tariffs are raised despite of the official exchange rate unchanged.

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In addition there is another type of exchange rate known as real exchange rate. Conceptually this type of exchange rate refers the nominal exchange rate divided by the partner country’s price index and multiplied by country’s price index (Krueger, 1990). Alternatively, Roderik, D., 2008, defined real exchange rate to be the relative price of tradables to non tradables. However, in the real economy, countries are have more than one trading partners. Hence, another vital type of exchange rate is the real effective exchange rate (REER) which is defined as the nominal effective exchange rate (NEER) multiplied by the home country’s price index and divided by the partner country’s price index. The nominal effective exchange rate is computed as the weighted nominal value of considered basket of currencies depending on the countries weighted trade share. Hence the REER is an important tool in analysis of an open macro economy debate of exchange rate and trade balance.

One approach regarding the impact of devaluation on trade balance is the Marshall-Lerner (M-L) condition depicting a “J curve” effect. This is referred as the elasticity approach of devaluation on trade balance. The M-L condition takes the trade balance equivalent to the current account. Implicitly, this approach leaves out capital inflows form unilateral transfers (e.g. Official Development Assistance (ODA) and remittances) and income receipts (return on assets or stock) as a component of current account. As a result both nation’s trade balance and current account balance are determined thoroughly by the movement of real exchange rate, and domestic real income, which also gave it a name of elasticity approach. Therefore, according to the M-L condition, “all else equal, a real currency depreciation improves the current account if export and import volumes are sufficiently elastic with respect to the real exchange rate” (Krugman, P., 2006, p.p. 444). This also implies that, an improvement in the current account due to real devaluation is subject to the sum of the elasticity of demand for export and import exceeding 1 (Krugman, 2006). The M-L analysis is a partial equilibrium analysis of the response of tradables to relative price changes. Further modified version of M-L incorporating elasticity of tradables, assumes infinite supply elasticity of exports and imports, i.e., exports and imports face constant costs (Albert O. Hirschman, 1949).

To elaborate more on aftermath devaluation of the M-L condition, two extreme cases are discussed below by assuming an initial domestic currency unit denominated trade balance. In the first extreme case of perfectly inelastic import demand [1] , the value of import denominated in domestic currency increases by the same percentage of real devaluation. In this situation, for the trade balance to improve, the value of export denominated in domestic currency has to increase by more than the percentage of real devaluation. In the second extreme case of perfectly inelastic export demand [2] , the value of export denominated in domestic currency is left unchanged. At such circumstance, a fall in the value of import is required for the trade balance to improve.

Due to time lag response of trade balance towards currency devaluation, M-L condition describes two effects of devaluation on trade balance: the value effect or price effect and the volume effect or quantity effect (Krugman, P., 2006, p.p. 444). The value effect refers to the immediate post devaluation deteriorating trade balance. This is because in spite of reduced import demand in real or quantity amount, the nominal value is exaggerated due devaluation. On the other hand; the volume effect refers to the long run improvement of trade balance as a result export in real quantity increases. Therefore, in the early stage of devaluation, the value effect outweighs the volume effect. This impact of devaluation is referred as “J curve” impact.

Krueger, 1990, further discussed theoretical impact of exchange rate devaluation on demand side of an economy. If there is idle resources in an economy, taking trade balance as net export from the Keynesian aggregate demand model devaluation can depict two impacts. First, as the domestic currency prices of imports increase devaluation increases the value of foreign currency measured in units of domestic currency, a switch in the expenditure behavior of domestic consumers from imports to import substituting domestically produced goods occur. Mean while as the relative price of tradables to non-tradables rises; producers are encouraged to shift resources from non-tradables sectors like service and domestically produced goods and to increase export supply. Further the international demand for exports will increase as foreigners find the trading much cheaper. Such impact of devaluation on both production and consumption through altering relative prices of tradables and non-tradables Commodities; is known as expenditure-switching.

Philip R. L. and Gian Maria M-F., 2002, also highlighted that the relative price of non-traded goods was the important channel that links trade balance and the real exchange rate in their investigation. A weak or devalued real exchange rate was at the center of the authors’ discussion, for a country to run a trade surplus. According to these researchers among many factors the three reasons were as follows. First due to devaluation the purchasing power of the domestic currency lowers that “…the negative wealth effect of maintaining absorption below production lowers demand for nontradables” Philip R. L. and Gian Maria M-F., 2002, p. 6. Second the declining demand for non-tradables resulting in a fall of relative price of non-tradables to tradables, signals for factors of production movement from domestic good and service production (non-tradables) to export production (tradables). Third the export sector faces, a lower cost of production, or at least a constant cost as labor supply increases since workers would be forced to provide their labor even at cheaper wages in order to compensate for their declining demand.

Mean while during “full employment” [3] of resources devaluation as a tool of improving trade balance deficit in addition requires an expenditure-reduction policies in order to free resources for additional export production. First Johnson, Harry G., (1968) and latter Robert W. Gillespie and Philip J. (1973), termed this analytical frame work as expenditure switching-expenditure reducing. From an open Keynesian macroeconomic model of output, with Y = C + I + G + X – M, for the trade balance of X – M, to improve either the available resources must increase or absorption pattern of the economy must change. In addition, domestic saving is the part of nations output that is not consumed both in private and government sectors, i.e., S = Y – C – G and domestic absorption is A = C + I + G. With the available resources limited, for the trade balance to improve, the second policy option is taken, i.e., changes in the proportion of resource usage or change in absorption pattern. Accordingly Harry G., (1968) and latter Robert W. Gillespie and Philip J. (1973) showed this policy tool as Where, domestic resource available for domestic absorption and. The implication first, here is there is a switch of resources between domestic investment and traded goods production. Second the higher the more the trade balance deficit improves.

Further, the absorption approach to the impact of devaluation on trade balance was illustrated by authors like S. S. Alexander (1954) and Leland B. Yeager (1970). These authors stated that countries may still face trade balance deficit despite the favorable condition of M-L elasticity condition due to excess domestic absorption or spending over production. Accordingly exchange rate devaluation [4] as a tool for trade balance improvement comes through its influence on total domestic absorption that in turn depends on price elasticities. Leland B. Yeager (1970) reconciled absorption and elasticity approach by stating the elasticities that matter for devaluation to work as a policy tool are “Total” [5] unlike M-L condition of partial elasticity approach. Currency overvaluation/devaluation is considered as a subsidy/taxation by importers (i.e., importers exaggerate/understated their real income); and taxation/subsidy by exporters (i.e., exporters understated/exaggerate their real income). As stated by. Leland B. Yeager (1970), “On the import side, upward revaluation of the home currency stimulates purchases and so tends to raise prices paid to foreign suppliers in their currency; but it does so to the smaller extent, the less elastic home import demand and the more elastic the foreign supply. On the export side, upward revaluation raises prices to foreign customers in their currency, and does so to the greater extent, the more inelastic the foreign demand and the more elastic the home export supply.”

The last approach of devaluation to trade balance is the monetary approach. Gary A. Craig (1981), on the monetary approach of trade balance emphasized as the balance of payments is determined by the net excess supply or demand for money so does its sub-accounts, in particular the dominant balance of trade account. Further Chau-nan Chen and Tien-wang Tsaur (p, 1149, 1981) argued that the balance of trade “depends on the aggregate relationship between domestic expenditure and income and does not depend on the composition of expenditure between exportables and importables” the monetary approach to devaluation has two main characteristic, namely; the tight money effect that arises due to decline in the real value of ash balance and

This approach tries to discuss by considering capital movement in its analysis, unlike the elasticity and absorption approach.

Literature survey

The relationship between devaluation, i.e., deterioration of terms of trade has gained attention of many scholars for empirical investigation on trade balance of countries. Accordingly either aggregate data or bilateral data for trade balance has been utilized to see whether the trade balance improves with Marshal-Learner condition in the long run depicting the J curve shape. Findings were not inconclusive in one direction.

Robert W. Gillespie and Philip J. (1973) made analysis on expenditure switching-expenditure reducing approach of currency devaluation and trade balance on 13 developed countries. During the analysis period countries who devalued their currency, such as Canada and France, showed an increase in their domestic resource availability defined as and incurred a trade balance improvement. In contrast, countries that appreciated their currency like, Germany and the Netherlands faced a constant. In the two countries case there was expenditure switching from traded sector to investment sector rather than to consumption.

From the early work of Magee (1973) on elasticity approach of devaluation and trade balance, the US deficit trade balance has not improved regardless the 1971 devaluation of the US dollar. Accordingly adjustment lags such as currency contracts prior to devaluation; post devaluation currency contracts, termed as pass-through and the sluggish quantity adjustment were reasons behind the persistent deteriorating trade balance.

With regard to the first lag, expectation of currency devaluation or appreciation plays a role in contract settlements in the international trade. While a rational exporter prefers payment with an appreciating currency, a rational importer prefers payments settlement with a depreciating one. The currency for contract settlement, therefore; will be determined by export market share dominance in the trading. Hence, a trade balance deteriorates for a currency devaluing country “… the larger the share of import contracts relative to export contracts denominated in foreign currencies…” Bahmani-Oskooee and A. Ratha, p. 1378, 2004).This is a period where immediate post devaluation on worsening trade balance is observed due to earlier import contracts made in foreign currency dominates. The pass-through period is the time for early adjustment of quantity. During this period trade balance worsens as a result of inelastic import demand (delayed consumption pattern from imports to import substitutes) even if faced with higher import prices in domestic currency and an inelastic export supply due to delayed change in production. Finally quantity adjustment period reflects where the M-L condition of elasticities to improve in longer period that trade balance improvements can be attained. Cited on Kimbugwe, H, November, 2007, Junz and Rhomberg (1973) presented five lags; namely: recognition lags, decision lags, delivery lags, replacement lags and production lags in relation to the delayed changing pattern of consumption and production that hinders trade balance improvement depicting “J curve” after devaluation.

Further Miles (1979) strengthened the conclusion for the deficiency positive effect of currency devaluation on trade balance through incorporating additional variables that are relevant to see the overall impact of devaluation. With this Miles (1979) considered variables such as government monetary and fiscal policies as well as growth rates into his analysis. Using aggregated data on 14 countries Miles found out currency devaluation by these countries did not bring the intended trade balance improvement rather brought balance of payment improvement through capital account. Accordingly, the balance of payment showed such result due to the surplus in capital account through portfolio readjustment caused by devaluation. In contrary, Himarious (1985) claimed the conversional agreement of M-L condition for devaluation to improve trade balance works. Himarious (1985) pointed out that nominal exchange rate utilized by Miles (1979) as a short fall of Miles analysis. Hence, correcting for this defect and modifying Miles (1979) analysis frame work to fit as absorption approach of devaluation on trade balance, nine countries under the study showed a trade balance improvement (cited on Bahmani-Oskooee and A. Ratha, 2004).

In 1994 Bahmani-Oskooee and Alse, noted that differenced variables Miles used for his analysis were stationary. In contrary level variables used by Himarios (1989) were non-stationary [6] . With this Bahmani-Oskooee and Alse (1994) were skeptical on the result of Himarios. Further Bahmani-Oskooee and Alse (1994) employed the Engle-Granger Cointegration technique [7] to analyze the impact of devaluation on trade balance based on real effective exchange rate and trade balance quarterly data for 19 developed and 22 less developed countries. Their result confirmed the positive long-run impact of exchange rate as in the M-L condition for three developing countries; negative for Ireland and no effect at all for the majority of developed courtiers.

The sector wise J curve approach towards devaluation was first analyzed by Meade (1988) for US economy. The non-oil industrial supplies faced short lived trade balance deterioration and realized fast improvements after wards. While capital goods excluding automobiles showed no negative portion on trade balance response curve net trade in consumer goods was totally unresponsive to devaluation (cited on Bahmani-Oskooee and A. Ratha, 2004). In familiar approach of sector wise study, Colin A. Carter and Daniel H. Pick (1989) studied the J curve effect on balance of trade of US agricultural sector. The responsiveness agriculture trade balance was found to depict a J curve effect after devaluation impact was analyzed through exchange rate impact on agricultural export and import unit values. This was because of time lag as Carter and Pick (1989) put forward, “…the result of the immediate and almost complete pass through of exchange changes to the agricul-tural import unit value and the slower and incomplete pass through to the agricultural export unit value.”

In the mid 90s of Reinhart, Carmen (1995) made an investigation looking for some evidence on currency devaluation [8] as an export promotion and trade imbalances correction policy tool from developing countries angle.

On The relationship between exchange rate and trade balance has attracted many scholars Philip R. L. and Gian Maria M-F., 2002, also highlighted that the relative price of none traded goods was the important channel that links trade balance and the real exchange rate in their investigation. This has an implication for a country to run a trade surplus, a weak or devalued real exchange rate was at the center. According to these researchers among many factors the three reasons are as follows. First due to devaluation the purchasing power of the domestic currency lowers that “…the negative wealth effect of maintaining absorption below production lowers demand for nontradables” Philip R. L. and Gian Maria M-F., 2002, p. 6. Second labor supply increases as workers would be forced to provide their labor even at cheaper wages in order to lower their declining demand. Third as there is a declining demand for nontradables their relative prices to tradables also decline, which can be an incentive for shifting factors of production from domestic good and service production (nontradables) to export production (tradables). Depending on the above three argument Philip R. L. and Gian Maria M-F., 2002 stood firm on the inverse relation between trade balance and relative price of nontradables.

Foreign Trade and Export Promotion Efforts in Ethiopia

Before going in to the econometrics analysis on the impact of exchange rate in the case of Ethiopia, it is worthwhile to empirically see in to the foreign trade and promotion efforts of the country. Hence, this discussion has been presented in the following sub sections.

Structure and Performance of Imports, Exports and trade balance

As in many Sub Saharan countries the commodity structure of the Ethiopian export sub sector is dominated by agricultural output. From figure 1 below on six years average starting from the year 1990/91 until 2007/08, with a declining share coffee export covers the largest share of the total export. For the last six years on average coffee export has declined to 34% from the first six years average of 55%. Oil seeds, Chat and gold exports have shown an increasing pattern on export share. Such primary commodity dominance in the export sector has exposed Ethiopia’s export to be affected easily by highly fluctuating world market prices. Moreover, Ethiopia’s share in the world coffee market has been under 2 percent for the last twenty years besides its declining trend (Gemechu, D., 2004)

Figure 1 Six Years Average of major exports (in % of total export)

Source: computed from EEA/EEPRI Statistic Data Base CD 2009

Petroleum products account more than 15% of the country’s import in average for the last six years. Further the import structure is composed starting from consumer goods such as textiles, medical and pharmaticular products, food irrespective of agriculture being the back bone of the economy to capital goods and equipments.

Figure 2 Six Years Average Major Imports in percentage of total import

Source: computed from EEA/EEPRI Statistic Data Base CD 2009

Figure 3 shows annual growth rate of both export and import shows a fluctuating trend in both pre and post devaluation periods. It is also observed that the growth rate of imports out weight the growth rate of exports. This is situation is also depicted on the deteriorating trade balance to percent of GDP trend of the country on figure 4. As in figure 4 after the devaluation of exchange rate in 1992, the trade balance has been deteriorating. One reason behind this can be referred back to figure 1 that shows the composition of commodities of the export is highly dominated by primary commodities.

Figure 3 Growth rate of Imports and exports (in % from 1990 – 2008)

Source: computed from WB, Online WDI data base

Figure 4 External Balance on Goods and services (in %)

Source: computed from WB, Online WDI data base

Efforts made to correct trade balance deficit

An inward-oriented development strategy adopted by the country prior to the current government was characterized by long lived over valuation of the “Birr”, high tariff and non-tariff barriers as well taxation on exports. These policies had an influence on the trade balance directly or indirectly through their impacts on exports.

During the Imperial government of Ethiopia (IGE) three five-year development plans had been executed. The first five-year development plan (1957/58 – 1962/63) focused on import substitution development planning with a little attention to export promotion. In the second five-year development plan, an initial export sector promotion was attempted through setting a numeric share for agricultural exports to decline from 93.6 percent in 1962/63 to 72.3 percent in 1967/68 and manufactured exports to increase. Foreign trade got a great attention in the third five-year plan of the IGE. The decline in agricultural exports share was further supported through export diversification. Among others incentives such as profit tax holidays, minimizing barriers to export licenses, strengthening the chamber of commerce were set to encourage for non-traditional products exporters (Gemechu, D., 2004).

The aspiration of increasing manufactured exports was further propagated by the military government of Ethiopia (MGE). Designing a first ten-year development plan (1985/86 – 1994/95) after, the government aimed at reducing traditional export share from 73.5 percent in 1985/86 to 53.2 percent in 1994/95. In the same period projection other sectors majorly the manufactured sectors export share was aimed to increase from 26.5 percent to 46.8 percent. Measures such as favorable tax provision, improving quality of exports, provision of world market prices, tariffs revision, export subsidies and so forth were practiced to attain objectives in the international trade sector (Gemechu, D., 2004).

Never the less in both past regimes one component that lack among the incentives taken was the exchange rate value. As different theories of exchange rate explains, Appropriate exchange rate regime is a sufficient condition among other things such as export diversification, luxurious commodities expenditure reduction, channeling of foreign aids towards long term production instead of consumption, etc, to have to promote export of a country. The ‘Washington Consensus’ [9] by John Williamson in 1989 on exchange rate regime of number (5) pointed out also ” Sufficiently competitive exchange rates which induce a rapid growth in non-traditional exports” is among other measures to perform out ward development strategy through export promotion (Priewe J., and Herr, H., 2005, p.2-3 ).

Accordingly when the current government took over, the first thing it proclaimed was its development strategy being an out ward oriented one. As the Structural Adjustment Program (SAP) was famously prescribed by the international institutions of IMF and WB to LDCs at that time, Ethiopia has also adopted it directly or indirectly. SAP, in its fundamental nature, had two components. One side was stabilization which follows the economic equilibrium theory aiming at balancing supply and demand side of an economy through prudent monetary and fiscal policy. The result expected from these actions was to reduce international indebtedness of the poor countries. The other side was structural reform whose main action included relative prices majorly through altering or exchange rate adjustment, if necessary. Hence in 1992, the current government of Ethiopia took devaluation of the currency as one policy actions in hope for the economy to recover and boost up export production, win competitiveness and attain the aimed growth.

One reason given for the case of devaluation in Ethiopia was

Looking at the balance of payment and the appropriateness or the misalignment of that time exchange rate, that time transitional government, the current EPRDF government forwarded some reasons for the devaluation measure.


A. The interventionist foreign trade policy and the exchange rate regime (fixed)

During the military government there had been a strong trade restricting rules. There had been high tariffs, duties and export taxes in the name of government budget earning. These measures further widen the gap between the real effective and nominal or official rate. For instance with the fixed official rate of 2.07 birr/$ at that time let the tariff for export say was 30%. Here the real effective rate exporters face will be 1.449 birr/$, being appreciated that worsen their competitiveness internationally. (2.07 birr/$ – 2.07birr/$*30%) From the importers side let’s say the import tariff was 40%. Then the real effective rate importers face will be 2.898 birr/$, being depreciated that makes intermediate goods dearer which distort productivity. (2.07 birr/$ + 2.07birr/$*40%)

B. Government domestic financing measures

Due to the domestic and neighboring persistent war engagement the military government used to print money for domestic financing. This type of budget financing indeed triggers inflation. According to Priewe J., and Herr, H., 2005, p.279 one factor determining the quality of a currency is the inflation level of a country.

3.3. The position of the BOP; Unsustainable and persistence trade balance deficit.

Unsustainable is characterized by large foreign debt and high debt financing

Persistence is characterized by longer period of imbalance

When we look at the BOP of Ethiopia on table 1, from 1984/85 up to 1991/92 (pre devaluation period of October, 1992), we observe unsustainable and persistence trade and current account imbalance tilting to deficit.

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Financing this persistence and unsustainable trade that contributed for current account deficit requested high amount of public transfers in particular ODA plus borrowing abroad. This situation made Ethiopia to be counted among the HIPICs with high rate of debt to GDP ratio being as high as 33 % in 1989/90. This is extreme ratio compared to the EU membership criteria of less than 3% public deficit.

Econometrics Application

Formulation of Model and Expected Signs

The research adopts and modifies the model of Rose and Yellen (1989) on aggregate analysis of the relation between Exchange Rate and trade balance. The theoretical back ground behind Rose and Yellen (1989) model was the Marshal-Lerner condition of exchange rate impact on trade balance. In the original model of Rose and Yellen (1989), domestic import demand depends on relative price of imports and domestic income level while domestic export demand is determined by foreign income and relative price of domestic export, among other things.

The functional relationship for domestic imports demand can be restated as follows:

Where: quantity of goods imported domestically,

relative price of imported goods to domestically produced goods in home currency

real domestic income

Let’s represent the nominal exchange rate of the domestic currency to foreign currency. Then the relative price of imported goods can be expressed as:

Where: the foreign currency price of foreigners exports equivalent to the foreign currency price of domestic imports

domestic price level

By incorporating foreign price indexes equation (2) can also be rewritten as:

Where: = foreign price level

From the definition of real exchange rate as home price deflated nominal exchange rate, can be calculated from as:

On the assumption of being constant or minimum, equivalently equation (3) can be rewritten as:

Replacing equation (4) in equation (1) we have quantity demand of import being a function of both exchange rate and income level as follows:

From the side of foreign demand for imports (home country export demand), the functional relationship can be depicted as:

Where: quantity of goods imported by foreigners or domestic quantity of goods exported

is home country’s export relative prices

real foreign income

Where: the domestic currency price of domestic exports

= foreign price leve and domestic price level

Again on the assumption of being constant or minimum, equivalently equation (7) can be rewritten as:

Replacing equation (8) in equation (6) we have quantity demand of export being a function of both exchange rate and income level as follows:

With the concept of domestic imports are foreign exports and vice versa, we have:

and ; Where = foreign exports and = domestic exports

From the definition a real trade balance given by Rose and Yellen (1989), we have

And the partial reduced function trade balance can be written as:

The log-linear approximation for the above relation for a time series data analysis is depicted as:

The above model of Rose and Yellen (1989) is a “two-country” model. However, in real economy, countries have many trading partners. Since the analysis of this paper also is based up on aggregate trade balance, the model used here is taking real effective exchange rate instead of real exchange rate which is the weighted real exchange rate of a country according to its major trading partner. Moreover, being a least developing country, Ethiopia’s economy is highly supported by capital receipts such as ODA and remittances. Practically, ODA and remittances are used either directly for importing of commodities (in particular) capital goods or accumulation of reserves. Hence, it is worthwhile to analyze the effect of exchange rate on trade balance by considering the existence of ODA and remittances taking them out of the term. Further this new variable is de-trended by taking its log form. Therefore, the modified model of Rose and Yellen (1989), considers trade balance to be a function of the real effective exchange rate (), real domestic income (

), real foreign income () and income rec

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