Trade Balance and Exchange Rate Evidence from Ethiopia: Impulse Response Function (IRFs) and The Forecast Error Variance Decompositions (VDCs) based on VAR and VECM

Abstract

The paper attempted to analyze trade balance and exchange rate based on impulse response function and the forecast error variance decompositions. The short run effect of devaluation can be captured by the impulse response functions.

Impulse response results show that trade balance in Ethiopia after real depreciation of currency follows J-curve patter .More importantly the obtained estimates suggest that upon real depreciation in the first three years trade balance deteriorates (‘short run’) and subsequently improves. The forecast error variance decomposition for each variable reveals the proportion of the movement in this variable due to its own shocks versus the shocks in other variables. Further information on the linkages between the trade balance and its determinants can be obtained from variance decompositions, which measure the proportion of forecast error variance in a variable that is explained by innovations (impulses) in itself and the other variables. Discussion was conducted on analyzing trade balance variance decomposition over a period of 10 years.

The variance decomposition of trade balance reveals that changes in its own shock, trade balance is the predominant source of variation in the logarithm of trade balance. The result showed own series shock of trade balance explain most of the forecast error variance of the series in both based on VAR and VECM. The change in the real effective exchange rate represents the second source of variation in trade balance with a percentage of 1.4%, and 1.28% in the second and third year forecast horizons based on VAR respectively.

Finally, the results also prove the relative ineffectiveness of the industrial production index in affecting trade balance in Ethiopia based on both in VAR and VECM

Keywords: Trade Balance, Real Exchange Rate, impulse response function (IRFs), The Forecast Error Variance Decompositions (VDCs),