Unravelling the devaluation puzzle: Empirical insights into the transmission channel on balance of payments and output in Ethiopia

Abstract

Background: Empirical studies on the impact of devaluation in developing countries, including Ethiopia, have revealed diverse and mixed results. The effects can be positive or negative depending on the specific economic context and policies in place.This study addresses the devaluation puzzle by providing a more comprehensive and nuanced understanding of how devaluation affects the balance of payments and output. Methods: To achieve this, we employ a recursive structural vector autoregressive (SVAR) model focusing on Ethiopia from 2001Q1 to 2023Q4. Results: The estimation results indicate that the real effective exchange rate channel effectively influences both the balance of payments and output in Ethiopia. Additionally, while foreign asset reserves, money supply, and inflation channels have a stronger impact on output, their effect on the balance of payments is relatively weak. The analysis further indicates that currency depreciation can improve the BOP in the short period by enhancing export competitiveness; however, it may have negative long-period effects due to rising import prices. Similarly, although an increased money supply can stimulate economic activity and strengthen the BOP, excessive expansion risks inflation and trade deficits. Furthermore, inflation negatively impacts both the BOP and GDP by escalating import costs and diminishing competitiveness. Foreign exchange reserves play a crucial role in supporting external liquidity and investor confidence, essential for economic stability. Conclusion: The interconnectedness of these factors emphasizes the need for policymakers to implement effective management strategies, including enhancing foreign reserve management, controlling inflation, and adopting a balanced exchange rate policy. Continuous monitoring of these policies will help address emerging challenges and improve Ethiopia's competitiveness in the global market.