The effect of currency devaluation on output: The case of ethiopian economy

This paper assesses the short and long run effects of currency devaluation on output growth in Ethiopia. The study is conducted by using quarterly time series data over the period ranging from 1998.Q1 to 2010.Q4 and employing a vector auto regression (VAR) model. By controlling the monetary and fiscal policies, it is found that currency devaluations are contractionary in the long run and neutral in the short-run. Other results are that monetary policy has positive effect on output growth, while total government expenditure has negative effect. Moreover, this study clarifies that devaluation explains a considerable part of real gross domestic product change in Ethiopia. Since the Ethiopian export is dominated by primary agricultural products, it is insensitive for the change in exchange rate; it is not also possible for the government to allow market forces to determine the value of Ethiopian birr. Policy intervention is needed to balance the adverse impact of exchange rate movements until the economy is well transformed from agricultural sector to industrial sector and then, the economy becomes less dependent on imported raw materials. Thus, monetary policy plays a bigger role since it affects the total output positively and significantly.   Key words: Currency devaluation, output, vector auto regression (VAR).