Behaviour and Determinants of Real Effective Exchange Rate in Ethiopia: a Co-integration and Vector Error Correction Approach

A closer look at the data evidence on Ethiopia shows that both actual and equilibrium real effective exchange rates have been depreciating from the first quarter of 1993 to the fourth quarter of 2004. After 2004, while the actual value started to significantly appreciate, the equilibrium value has followed a fairly constant trend. An econometric analysis (Vector Autoregression) reveals that government consumption spending and growth in net domestic credit depreciates the real effective exchange rate both in the short run and the long run; while the ratio of fiscal deficit to high powered money and real international price of oil also lead to currency depreciation in the short run. The real international price of oil has an opposite impact in the long run. On the other hand, the degree of foreign exchange and capital controls lead to currency appreciation in the long run. Furthermore, long run equilibrium exchange rate in Ethiopia hasn't been constant and misalignment ranged from 30.7% to -34.3% during the period between 1993 and 2008. Such trends call for closer attention to combat a fall in international competitiveness and possible currency crises.