MODELLING THE EFFECT OF REAL EFFECTIVE EXCHANGE RATE ON EXPORT AND IMPORT OF ETHIOPIA: APPLICATION OF VECTOR AUTOREGERSSIVE MODEL

Abstract

This paper is empirically examine the effect of real effective exchange rate on import and export value in Ethiopia using Vector Autoregressive (VAR) model by considering twenty six years quarterly time series data (period 1992/1993 to 2017/2018) obtained from National Bank of Ethiopia in order to address the research objective. The co-integration relations among REER, Import and Export were identified by applying Johansen co-integration tests and the test result revealed that there was no co-integration relationship between the study variables between them. So, the VAR framework was preferred to estimate the parameter and its result revealed that real effective exchange rate has positive significant effect on import and export value. Since, Ethiopia imports intrinsically are highly price inelastic which are either necessities in production or consumption or very strategic commodity and are invariably required by the country. So, even if the country adopts devaluation as a monetary policy in order to discourage import but it cannot do it. But, devaluation of exchange rate has positive significance effect for export value in Ethiopia. Since, one of the basic of devaluation exchange rate is to increase its export value so what happen in this study also. While, the potential causal relations between them were also examined by employing Granger’s causality tests analysis and the result show that there was bidirectional causality relationship between import and export value in Ethiopia but there is unidirectional causality between REER to export and REER to import during the study period. Moreover, the short run and long run interactions among the variables were also determined through by application of impulse response analysis and variance decomposition. Therefore, a competitive and stable real exchange rate policy should be the target policy of a country because poor exchange rate policy risks misrepresenting on export and import opportunities resulting in misallocation of resources.