The Effect of Exchange Rates on Economic Growth in Ethiopia

Abstract

This study attempts to investigate the effect of exchange rates on economic growth in Ethiopia using annual time series data spanning from 1985/86 to 2014/15. The explanatory variables in this study were real effective exchange rate, government final consumption expenditure, gross fixed capital formation, broad money supply and trade openness. The multilateral real exchange rates are used to measure real exchange rates. Results from Vector Error Correction Model revealed that real effective exchange rates, broad money supply and trade openness have a positive long run effect on economic growth, while government final consumption have a negative long run effect on the economic growth of Ethiopia. From the regression results, it was noted that undervaluation of the currency is contractionary in the long run and neutral in the short- run. As such, the effect of exchange rates on economic growth works through the supply channel. It is the reflection of various economic and policy shocks, mainly a strategy shift of the government. Based on the findings of this study, the researcher recommended that since the Ethiopian output is dominated by primary agricultural products and is insensitive for the change in exchange rate, government intervention is needed to balance the adverse effect of exchange rate movements until the economy is well transformed from agricultural lead economy to industrial lead economy and becomes less dependent on imported raw materials.