Determinants of Trade Balance in Ethiopia : An ARDL Cointegration Analysis

This article examines the short-run and long-run relationships of trade balance with the explanatory variables such as income, money supply, real exchange rate, budget balance and foreign income in Ethiopia. Income and money supply are included in the model in order to examine the absorption and monetary approaches to the balance of payment (trade balance) besides the conventional approach of elasticity, using exchange rate. The inclusion of budget balance is purposely to examine the existence twin deficit hypothesis in the Ethiopian context. The foreign income of top 20 trading partners of Ethiopia is also included in the model to test the effect on trade balance of Ethiopia. The bound testing approach of cointegration and error correction model, developed within the autoregressive distributed lag, (ARDL) model frame work is applied to annual data for the period of 1970/71 to 2010/11 to investigate whether a long run relationship exists between trade balance and its determinants. Additionally, the variance decomposition (VDC) and impulse response functions (IRF's) are used for further inferences. Using this approach we find evidence of long run relationships between trade balance and its determinants. The estimated results show that exchange rate appreciation (depreciation) is negatively (positively) related to the trade balance in the long-run and short-run consistent to economic theories. The empirical results provide strong evidence that exchange rate play a weaker role in determining the behaviour of trade balance in Ethiopia. Income, budget balance and money supply have a stronger impact on trade balance