Background of the study
Exchange rate policies can, however, make a high impact on the trade balance in most
developing economies such as Ethiopia. The balance of trade, being an excess of export over
imports, or vice versa, indicates an economic stability benchmark. To promote export
competitiveness and lower its trade deficits, the Government of Ethiopia has pursued periodic
devaluation policies in addition to managed floating regimes. The country has continuously
been experiencing a trade gap owing to reliance on agriculture for exports and high reliance on
imported goods, such as machinery and fuel (National Bank of Ethiopia, 2021).
Theoretical frameworks such as the Marshall-Lerner condition suggest that devaluation can
improve the trade balance if the price elasticity of exports and imports is sufficiently high
(Krugman & Obstfeld, 2009). However, Ethiopia’s structural challenges, including limited
industrial capacity and reliance on imported inputs for production, constrain the effectiveness
of exchange rate adjustments (Gebregziabher, 2018). Furthermore, factors like inflationary
pressures, foreign exchange shortages, and global market dynamics complicate the outcomes of
such policies.
The problem statement
The trade balance has always been in deficit, which made the Ethiopian government adopt
different exchange rate policies to enhance export competitiveness and reduce imports. Despite
these efforts, the effectiveness of such policies is still questionable. Previous studies have
focused mainly on the theoretical relationship existing between exchange rate adjustments and
trade balance, with very scant consideration of the unique structural and institutional challenges
facing Ethiopia, including limited export diversification, reliance on imported inputs for
production, and weak industrial capacity.
Furthermore, most of the available studies tend to generalize findings from other developing
economies without adequately capturing the specific context of Ethiopia, such as its dependence
on agriculture and exposure to external shocks like fluctuating commodity prices. Empirical gaps
also exist in capturing the long-term effects of exchange rate policies on the trade balance, as
many studies focus only on short-term outcomes. Moreover, little consideration has been given
to other supporting policies that would assist the adjustment of exchange rate in its effectiveness,
for instance, trade facilitation measures and macroeconomic stability.
These gaps highlight the need for a comprehensive analysis of how exchange rate policies
influence Ethiopia’s trade balance, considering the structural and policy-related constraints that
undermine their success. Addressing these gaps is critical for designing effective strategies to
improve the trade balance and foster sustainable economic development.
Literature Review
The relationship between exchange rate policy and trade balance has been studied extensively,
with a focus on developing economies like Ethiopia. Exchange rate adjustments, such as
devaluation or depreciation, are usually used to improve the trade balance by making exports
cheaper and imports more expensive. The theoretical basis of this relationship is based on the
Marshall-Lerner condition, which states that currency devaluation enhances the trade balance if
the sum of the price elasticities of exports and imports is greater than one (Krugman & Obstfeld,
2009). On the other hand, empirical studies indicate that this effect is not certain, especially in
economies with structural and institutional constraints.
In the context of Ethiopia, various studies have analyzed the impact of exchange rate policies on
the trade balance. Gebregziabher (2018) estimated that devaluation improved export
performance in the short run but did not have long-run effects due to the country's heavy reliance
on imported inputs for production and limited export diversification. Similarly, Alemu and
Getahun (2019) observed that devaluation could improve agricultural export competitiveness,
but its effect was weakened by inflationary pressures and higher import costs. These findings are
consistent with the general literature on developing countries, where exchange rate policies are
often ineffective due to structural weaknesses such as low industrial capacity and reliance on
primary commodities (Edwards, 1989).
Moreover, studies have highlighted the role of macroeconomic conditions in determining the
effectiveness of exchange rate policies. For instance, Teklu (2020) noted that foreign exchange
shortage and domestic inflation seriously depress the potential gains from devaluation in
Ethiopia. Besides, global factors, like fluctuations in commodity prices and demand shocks,
might work against the expected impacts of exchange rate adjustments (World Bank, 2022).
