TESTING the VALIDITY OF MARSHALL

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TESTING THE VALIDITY OF MARSHALL- LEARNER
CONDITION IN THE ETHIOPIAN ECONOMY
By AberaFekaduHaile Mariam
Email- fbernabas@gmail.com
P.O.Box 5550

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Abstract
Devaluation of a currency has an ambiguous effect on economic growth of a country. In this
paper, The analyzed the effects of devaluation on trade balance and weather the Marshall-
Learner Condition is valid or not in the Ethiopian Economy using time series data from 1980 to
2015. In order to do so, import and export equation where estimated separately with respective
independent variables. The finding of the study showed that devaluation has insignificant impact
on both import and export of Ethiopia and the Marshall Lerner condition does not hold because
the sum of import and export elasticity is less one in absolute value. Co integration techniques
are also used to see the long run relation between the variables of both the export and import
equations. The results indicated that there is long run relationship between the variables of the
export equation such as export, exchange rate and world income and the import equation such
as import, exchange rate and domestic national income.

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Key words: MLC, Co integration, Devaluation
1.1 INTRODUCTION
According to many economists, weakening of the currency could actually strengthen an
economy, since a weaker currency will increase the production, which in turn will uplift
employment and raising the economic growth. The increase in the demand for domestic goods
and services increase their production, triggering the economic growth. Hence in order to keep
the economies going, economic policies must target to improving the aggregate demand. And the
demand for domestic products originates from outside the country, termed as exports. Likewise,
local residents demand for the imported goods and services. Therefore the increase in exports
increase the overall demand for domestic output, and increase in imports decreases the demand.
Because the increases in demand of import mean that domestic consumers are more interested in
foreign goods than domestically produced goods eventually demand for domestic output will
decrease. Hence exports are the determinants of economic growth, while imports detract the
growth of the economy. But, import may have positive impact on the economy of developing
country which is unable to produce capital goods domestically. International demand for a
country's goods and services is an important for boosting the economic growth and to increase
the demand of domestically produced goods in the foreigner market attractive prices of these
goods should be set, making them more attractive. But, for the country like Ethiopia in which
they are taker of international price are unable to set price for their export. Traditionally there are
three main approaches to devaluation or currency depreciation: the elasticity’s approach, the absorption
approach and the monetary approach. According to the elasticity’s framework, devaluation improves a
country’s balance of trade when the Marshall-Lerner Condition is satisfied, when the sum of the import
demand elasticity’s of the two trading partners exceeds unity. In the absorption methodology, however,
the elasticity do not matter, and the trade balance improves only if the nation’s GDP increases faster than
domestic spending. In the monetary approach, by contrast, only money demand and supply matter, and

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devaluation always improve the trade balance. According to the monetary approach to the exchange rate,
a devaluation or depreciation decreases the real supply of money, resulting in an excess demand for
money. This leads to hoarding and an increase in the trade balance
1.2 Statement of the problem
Positive trade balance can enhance the economic growth of a given nation through adding value
to GDP and bringing hard currency which is vital to compete in international market. Despite, its
importance most developing countries runs negative trade balance or trade deficit. Background
of their economy and the types of commodity that developing country’s transact in international
market is the primary reason behind trade deficit of developing country. Ethiopia, one of
developing country experiencing a huge gap between export and import for a long period of
time. As a developing country Ethiopia’s export commodities are mainly agricultural product
and raw material which are seasonal by their nature and highly price inelastic on the other hand
the country’s import is composed of basic commodities like fuel, and capital goods like
machinery which are very essential for the economic growth as the result the gap between export
and import is widen from time to time. Negative trade balance or trade deficit affect the overall
economic performance of a given nation in one way of another. GDP which is a proxy of
economic growth is a sum total of consumption expenditure, privet investment, and government
expenditure and net exports. Therefore its straight forward that negative value of net export can
reduce the total value of GDP. Shortage of foreign exchange resulted from trade deficit is
another negative impacts of trade deficit. Therefore policy makers provide a Varity of policy
measure to overcome the problem of negative trade balance. Devaluation (reducing the value of
domestic currency in terms of international currency) is the most widely used policy measure to
bring positive trade balance. But, devaluation may not necessarily cause improvement in balance
of trade. Marshall- Learner condition sets a pre-condition for devaluation to cause improvement
of trade balance i.e. the absolute sum of the long-term export and import demand elasticity must
be greater than unity. The government of Ethiopia is also following devaluation policy starting
from the year 1992/93 with the major objective of boosting the trade balance but, the country is

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still running in trade deficit. Though the country is experiencing negative trade balance, it is
impossible to conclude the MLC is not holding because the MLC is indicating improvement in
trade balance not necessarily positive trade balance. Unfortunately, there is limited study done in
the weather MLC is achieved in the existing negative trade balance or not. Therefore, this paper
would solve this gap.
1.3 Objectives of the Study
The general objective of the study is to test weather devaluation improve trade balance or not in
the Ethiopia economy.
Specifically the study address the following issues,
 Investigating determinants of trade balance in Ethiopia economy.
 Determining the direction of those determinants affecting the trade balance.
 Investigating the strength of each determinant in affecting the trade balance.
1.5 Significanceof the study
Exchange Rate has an effect on almost all macro and micro economic variables in the economy
implying that Exchange Rate has a significant impact on the economic growth of the country.
That’s why many central banks, including the National Bank of Ethiopia, take Exchange Rate
stability as the main Objective of the bank. This study has tried to asses, both theoretically and
empirically the impacts of Exchange Rate on the Ethiopian economy and also tried to find out
the weather the MLC is valid or not. Thus, policy makers on hand will be benefited from this
study, as it will give them an input on what types of exchange rate policy is need to adopted .

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2. LITRTURE REVI
2.1 THEORYS OF DEVALUATION
Devaluation is an official downward adjustment to the value of the nation’s currency, relative to
another currency, group of currencies or standard. Or devaluation is a means of letting the
devaluating country to lose some percentage of the value of its currency relative to dollar or any
other currencies. (Folks and Stansell, 1979)Devaluation is often confused with depreciation, and
is in contrast to revaluation. Even if the domestic currency becomes relatively weak in both of
devaluationanddepreciationcases,thetypeofexchangerateregimeisdifferentforthem.Devaluationca
n occur either in fixed or managed floating exchange rate regime and the government has some
rights over controlling the foreign exchange market whereas, depreciation occurs only in free
floating exchange rate regime and the government never decide about the value of domestic
currency, which is fully decided by the markets demand and supply interaction. On the other
hand, revaluation is a calculated increment to a country's official exchange rate relative to some
other currencies or standard measures like gold. Revaluation occurs either in fixed or managed
floating exchange rate regimes and the decision of the price of domestic currency that exchanged
for another currency is made by the central bank. In contrast, when the price of domestic
currency increases through the demand and supply interactions, without any intervention of the
government, it’s called appreciation. There is debate on the effectiveness of devaluation in
improving the nation’s trade based on their theoretical and empirical researches. According to
(Solomon 2010), the application of Devaluation in an economy might result contraction of both
aggregate demand and aggregate supply.
To start with the reasons that make aggregate demand to contract following the adoption of
devaluation as a policy measure; devaluation results a redistribution of income towards those

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with high marginal propensity to save. In other words, exporters who have high marginal
propensity to save would be beneficiary from devaluation and the nation’s aggregate demand
would remain constant. As a result, a fall in investment would be a case or it could stay stagnant.
Devaluation leads to a low government marginal propensity to spend out of tax revenue. This is
specially a case if the nation imports machineries or other construction materials in order to
realize infrastructures or other government projects. Real income declines under an initial trade
deficit which happens following the adoption of devaluation in the economy. In other words,
whenever devaluation implemented in an economy, both importers and export suppliers will not
react immediately either to decrease the volume of imports or increase the level of export since
contracts has to be signed couple of days before trade therefore, the nation “trade balance would
face deficit immediately after devaluation and leads real income to decrease..Reasons which
make aggregate supply to decrease following the realization of devaluation are:- Firstly, more
expensive imported production inputs; if exporting companies use imported goods as an input,
devaluation would be discouraging for the companies that import production inputs and it would
have an adverse effect on the aggregate supply of exportable goods. Secondly, a frequent
devaluation stimulates speculation and leads to confidence erosion; Continuous devaluation
makes the domestic currency to lose its purchasing power continuously so that it creates
distortion in many economic variables such as house hold real income, consumption, industrial
growth, public finance, imports, exports, manufacturing growth, money supply and the like. It is
known fact that if the consumers consumption pattern decreases, the producers production
pattern also decrease and the companies production pattern has a direct relationship with public
finance or government revenue. Thirdly, demand for export is not only determined by export
prices but also on trade reliability, perception of the inhabitants of importing nation towards the
quality of the product to be exported and the like. Therefore, the nation’s aggregate supply might
decrease following the adoption of devaluation if there is no change in import demand of the
importing nations of our export commodities. (Solomon, 2010)In contrary, according to
expenditure switching policy, devaluation makes imported goods expensive in domestic market
and exported goods relatively cheaper in the world market. As a result, the nation’s trade balance
improves following the adoption of devaluation. On the other hand, (Bahmani-Oskooee and
Niroomand, 1998) described that the effect of devaluation on trade balance could be determined
by the sum of elasticity of demand for import and export in absolute value. If the sum of the

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absolute value of elasticity of demand for import and export is greater than1, devaluation results
improvement for the nation’s trade balance and if it is less than 1, the trade balance gets more
worsen as devaluation adopted as a policy. Devaluation has its own effect on the nation’s trade
balance and different countries would like to adopt devaluation as a monetary policy, so as to
overcome their economic constraints caused by over valuation of their own currency but the
effect of devaluation on developed countries is quite different from that of the developing ones.
This reality leads economists to come up with three different approaches of devaluation namely
the elasticity approach, the absorption approach and the monetary approach.
2.2 Elasticity Approach
The Elasticity Approach focuses on balance of trade which is one of the main subcategories of
current account balance and it assumes that relative international prices are main explanatory
variable determining current account balance. This approach analyses the impact of a potential
devaluation on balance of trade (Erkılıç, 2006: 17). According to (LeKhalk, 2006) elasticity
approach is all about two important models that are the Bicker dike-Robinson-Metzler (BRM)
model and Marshall-Lerner (ML) condition. Both of the models are tries to look at the
responsiveness of demand for imports and exports following the adoption of devaluation in once
economy. Bicker dike-Robinson-Metzler (BRM) model was described by Bicker dike in 1920
for the first time but later on it got developed by Robinson and Metzler in 1947 and 1948
respectively. This model checks the response of imports and exports following change in price
caused by the realization of devaluation. (Le Khak, 2006) The model did formalization in order
to separate export and import markets of the two nations and finally reach at one statistical model
that enables to show the elasticity of imports and exports as exchange rate changes of
devaluation. According to (Le Khak, 2006:6) the model can be stated as follows:-
𝐝𝐁
𝐝𝐄
= (PxXs
│(1+ε)η*
/(ε+η*
)|)-(PmMd│(1-η)ε*
/(ε*+η)|)
Where dB is stands for the derivative of trade balance and dE is also the derivative of nominal
exchange rate. Px is an export price while Pm represents the import price. Xs and Md are
domestic supply and demand for export and import respectively. Similarly ε and η are represent
the absolute values of elasticity of domestic demand for export and import respectively and ε*
and η* are stands for the foreign price elasticity of export and import demand respectively. The

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model tells us that a change in exchange rate will affect the trade balance depending on the
values of price elasticity of domestic supply and demand. If │ε│>│η│, the absolute value price
elasticity of export supply is greater than that of import demand, the nation’s trade balance would
be improved after the adoption of devaluation and the vice versa. (Le Khak, 2006)
The second important model that Elasticity approach concerned about is MLC which is also the
main issue of this study too.
2.3 Marshall-Lerner Condition
It got its name after the English economist called Alfred Marshall (1842-1924), Romanian
economist Abba Lerner (1903-1982), and John Robinson (1903-1983) and sometimes it’s called
(MLR condition). (Kenen 2000: 323). The Marshall-Lerner Condition states that a change in
exchange rate (devaluation) can improve the trade balance and BOP as well if the sum of the
absolute values of elasticity of demand for import and export is greater than 1. (Davidson
Poul,2009)The Marshall-Lerner condition assumes some simplifying assumptions to show the
impact of change in exchange rate on the trade balance. These assumptions are: (1) Trade is
initially at its equilibrium level. (Le Khak, 2006). (2) Supply of both domestic and foreign
currencies is not affected by any factors other than changes in the relative price of currencies
which results from exchange rate changes itself. That means everything which may affect the
supply of domestic and foreign currency is constant except change in the relative price of
currencies because of change in the exchange rate. (Lencho, 2013)Third, the demand for both
domestic and foreign currencies is also not affected by other factors rather than the change in the
relative price of currencies due to the Change in exchange rate. Lastly, the supply elasticity of
domestic goods to be exported and the demand elasticity of foreign countries to import the
products of home country as a relative price changes because of change in exchange rate is
infinity. As a result, change in demand doesn’t results change in price, the price of imported
goods in international market, exported goods in domestic market and import and export
substitute goods will stay constant and only the relative price of imported or exported goods can
be changed as exchange rate changes. (Lencho, 2013)The nation’s trade balance is the difference
between exports and imports. And it is standard to measure a country’s trade balance in terms of
home goods. Which is mathematically expressed as follows:-
NX = X - RM, R = EP*/P, substitute for R ……(1)
NX = X - (EP*/P) M …………..(2)

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Where P is the price of domestic goods in domestic currency, P* is price of foreign goods in
foreign currency, M is volume of imports of the domestic country, X is volume of exports of
domestic country, NX is the net export of the nation (export surplus or trade surplus) and R is the
real exchange rate (it is the relative price of foreign goods to domestic goods and can be
computed by multiplying the domestic spot rate with the price of foreign goods and divide it to
the price of domestic goods in domestic currency.
The first order derivative of NX with respect to R from equation (2) can be written as,
dNX/dR = XR – RMR – M
According to (Asmamaw, 2000), trade balance could be affected by the above three different
variables those are import, export, and exchange rate. Theoretically it is known that devaluation
promotes export of the devaluating nation by making the price of exported goods relatively
cheaper in the world market. Likewise, the relative price of goods which are produced in other
countries could be expensive in the domestic market of the devaluating nation therefore the
demand for the goods of devaluating nation could increase both in domestic and international
market; as a result, the nation’s trade balance could reach some improvement following the
adoption of devaluation and we call this event a quantity effect. But sometimes, the nation’s
import demand will increase as a result of currency devaluation, in this case, the nation’s trade
balance may worsen as devaluation realized and we call it price effect. Since there are both
positive and negative consequences of the realization of devaluation, we need to check which
effect is affecting more and weather devaluation can improve the trade balance or not. Therefore,
if devaluation is needed to improve the trade balance, the sum of elasticity of the foreign price of
demand for exports and domestic price elasticity of imported goods have to be greater than one.
(Lencho, 2013)
Mathematically:-
│εX + εM│> 1
Lencho, (2013) has also mathematically stated the Marshal Learner condition as follows by using
the above mentioned equation (4)
dNX = X(εX + εM -1) dE (5)

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Where X is the initial amount of export in which equilibrium trade balance has reached (X=M),
dE is change in exchange rate, dNX is change in trade balance (Net export), εX and εM are
elasticity of export and import respectively. Whenever εX + εM >1, a change in exchange rate
(devaluation of domestic currency) will have a positive effect on the trade balance and the vice
versa. According to (Le Khak, 2006) Marshall Lerner Condition is a development on the
Previous equation (1) of elasticity by adding just one assumption and that is the elasticity of both
imports and exports are infinity. And (Le Khak, 2006) describes the final equation as follows:-
dNX*= X*(Nx + Nv -1)(de/e) (6)
Where dNX is stands for the derivative of Net Export (trade balance) and d represents the
differential of exchange rate. X, Nx, Nv and e represents export, export elasticity, import
elasticity and exchange rate respectively. And the stars denoted for the values of the coefficients
in foreign currency. Le Khak, (2006)Like (Lencho, 2013), (Le Khak, 2006) is also expressed that
following the adoption of devaluation, balance of trade will improve if and only if the sum of the
elasticity of demand for imports(domestic demand for foreigners commodity and foreigners
demand for domestically produced goods) exceed 1.Tosum up, if we start our analysis from
assuming that trade was initially balanced, the M-L condition will tell us devaluation will
improve the trade balance if and only if the sum of the price elasticity of demand for export and
import in absolute value is greater than one. If the sum is less than unity, devaluation will creates
a worst condition for the nation’s current account balance. On the other hand if the sum of price
elasticity of demand for import and export is equal to zero, devaluation will never have any
effect on the trade balance. (Asmamaw, 2008) Though Marshal Lerner condition is a necessary
condition to affect trade balance, it is not a sufficient condition and it has some limitations. (Le
Khak, 2006) The limitations of Marshall-Lerner condition can be described as such; the model
assumes that export and import elasticity are infinite but in reality the above assumption will be
easily disproved. Devaluation may not necessarily make trade balance better off because trade
balance is not only related with exchange rate but also with the potential production and supply
of the nation‟s output. (Yi Chung) describes that, if a nation has a comparative advantage over
fishing like Bangladesh, and if it realizes devaluation in the economy, the nature of fish will not
allow them to exploit too much fishes beyond its capacity therefore, even if the demand for fish
is very high, the suppliers might not be able to offer the demanded amount of supply and which
results an increment in the price of a fish rather than improving the trade balance. There are

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difficulties in the availability of data during the process of testing the Marshall-Lerner condition.
As (Le Khalk, 2006) described the reasons mentioned by (Yi Chung), in order to know the
elasticity of imports and exports, it is must to know the average price of import in both in base
year and current year, average quantity of import both in base and current year, average price of
exports both in base and current year and average quantity of export both in base and current
years. In the countries where the Marshall-Lerner condition holds, following the actualization of
devaluation, a slight increase in the level of trade deficit could be observed at the beginning and
when time goes on, trade surplus could be observed due to the fact that devaluation makes
exported goods cheaper for international buyers and imported goods expensive for domestic
consumers in the long run and which is called J curve effect. (Petrović, and Gligorić, 2010)
2.3.1Mathematical derivation of MLC
Here e is defined as the price of one unit of foreign currency in terms of the domestic currency.
Using this definition, the trade balance denominated in domestic currency (with domestic and
foreign prices normalized to one) is given by:
𝑁𝑥 = 𝑋 – 𝑄𝑒
Differentiating with respect to 𝑒 gives:
𝜕𝑁𝑥
𝜕𝑒
=
𝜕𝑋
𝜕𝑒
−
𝑒𝜕𝑄
𝜕𝑒
− 𝑄
Dividing through by X:
𝜕𝑁𝑥
𝜕𝑒
1
X
=
𝜕𝑋
𝜕𝑒
1
X
−
𝑒
𝑋
𝜕𝑄
𝜕𝑒
–
𝑄
𝑋
At equilibrium, X = eQ. Therefore:
𝜕𝑁𝑥
𝜕𝑒
1
X
=
𝜕𝑋
𝜕𝑒
1
X
−
1
𝑄
𝜕𝑄
𝜕𝑒
–
1
𝑒
Multiplying through by e:

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𝜕𝑁𝑥
𝜕𝑒
e
X
=
𝜕𝑋
𝜕𝑒
e
X
−
𝑒
𝑄
𝜕𝑄
𝜕𝑒
– 1
This can be expressed as
𝜕𝑁𝑥
𝜕𝑒
e
X
= Ƞ 𝑋𝑒- Ƞ 𝑄𝑒 − 1
Where Nx denotes for net export, X exports and Q imports and Ƞ Xe and Ƞ Qe are common
notation for the elasticity of exports and imports with respect to the exchange rate respectively.
In order for a fall in the relative value of a country's currency (i.e. a rise in e using the above
definition) to have a positive effect on that country's trade balance, the left hand side of the
equation must be positive (i.e. for a rise in e to cause a rise inNx).
Therefore: Ƞ 𝑋𝑒- Ƞ 𝑄𝑒 − 1>0 =: Ƞ 𝑋𝑒- Ƞ 𝑄𝑒 > 1
This can be written as: │Ƞ 𝑋𝑒+Ƞ 𝑄│> 1
2.3 J-Curve Effect
'J curve' refers to the trend of a country’s trade balance following devaluation under a certain set
of assumptions. A devalued currency means imports are more expensive, and on the assumption
that the volume of imports and exports change little immediately, this causes a deterioration of
the current account (a bigger deficit or smaller surplus). After some time, though, the volume of
exports may start to raise because of their lower more competitive prices to foreign buyers, and
domestic consumers may buy fewer of the costlier imports. Eventually, if this happens, the trade
balance should improve on what it was before the devaluation (Feenstra and Taylor) Robert and
Alan (2014). International Macroeconomics. New York,NY 10010: Worth Publishers. pp. 261–
264 Immediately following the depreciation or devaluation of the currency, the total value of
imports will increase and exports may remain largely unchanged due in part to pre-existing trade
contracts that have to be honored. This is because in the short run, prices of imports rise due to
the depreciation and also in the short run there is a lag in changing consumption of imports,
therefore there is an immediate jump followed by a lag until the long run prevails and consumers

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stop importing as many expensive goods and along with the rise in exports cause the current
account to increase (a smaller defect or a bigger surplus). Moreover, in the short run, demand for
the more expensive imports (and demand for exports, which are cheaper to foreign buyers using
foreign currencies) remains price inelastic. This is due to time lags in the consumer's search for
acceptable, cheaper alternatives (which might not exist).Over the longer term a depreciation in
the exchange rate can have the desired effect of improving the current account balance. Domestic
consumers might switch their expenditure to domestic products and away from expensive
imported goods and services, assuming equivalent domestic alternatives exist. Equally, many
foreign consumers may switch to purchasing the products being exported into their country,
which are now cheaper in the foreign currency, instead of their own domestically produced
goods and services. The shape of the J curve can conclude as, first, the trade balance falls due to
the price effects mentioned above, gradually after a lag quant’s gradually adjust and effectively
the trade balance rises and hence creates the shape of a J-curve.
2.4 Exchange Rate Theory and Exchange Rate regimes
For many years Matters related to exchange rate have been the focus of both theoretical and
empirical analysis worldwide. The exchange rate plays a very fundamental role in the flow of
goods and service between countries using different currencies. An individual who needs to
purchase a commodity in another currency first has to convert his currency to that of the sellers.
The rate at which one currency can be traded for another is exchange rate (Jhingan,2003). Theses
topic emphasized on providing theoretical analysis of exchange rate theory like distinction
between real and nominal exchange rate, bilateral and multilateral exchange rate and
methodologies of calculating them.
2.4.1 Nominal Exchange Rate
Abel and Bernanke (2005) define nominal exchange rate as the number of unit of foreign
currency that can be purchased with the unit of domestic currency. Fourie (1997) lists two
methods used in quoting exchange rate, Direct (American), which shows the unit of domestic
currency which can exchanged for one unit of foreign currency the inverse is true for indirect
(European) quotation methods.

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2.4.2 Real Exchange Rate
Fosu (1992) defines RER as the concept that entails the adjustment of a particular nominal
exchange rate for relative price between the domestic economy and the foreign economy in order
to establish the effect on incentive to produce, purchase, and store goods and service.
Catao (200; 46, quoted by chiloane 2013) defines RER as the measure of the value of country’s
goods against those of another country at a prevailing NER. As provided by Abel and
Bernanke(2005) ERE can be calculated as
RER =eP*/Pd Where, e is NER, P* stand for foreign price and Pd is Domestic price.
2.4.3 Multilateral Effective Exchange Rate
The nominal and real exchange rate introduced in the previous sections is rate between two
countries or currencies, also known as bilateral exchange rate. In a global environment where a
country has relations with numerous foreign trading partners, it is important to consider the
exchange of one currency against a basket of a number of currencies, most importantly that of its
trading partners. In such instance the term effective exchange rate is considered.
Black (1976;615, as quoted by Chiloane) defines the effective exchange for a country as a
weighted average of the exchange rate of its trading partners ,with all rates being measured
relative to some base year. The concept of EER was developed by Hirsch and Higgins (1970,
chiloane)
2.5 Exchange Rate Regimes
2. Free Floating (Flexible) Exchange Rate Regime
It is a type of exchange rate in which the value of a nation's currency is allowed to fluctuate
based on the demand and supply of the foreign exchange market. The price is determined by
market forces of the demand and supply of the foreign currency without any intervention by the
government. These fluctuations will lead us to say that there is either depreciation or
appreciation of domestic currency. Depreciation: is the loss of value of a country's currency with
respect to another currency. In other words if the nation obligated to use more domestic
currencies in order to get the same amount of foreign currency, we call the domestic currency
loses its purchasing power or depreciated. The reverse is called appreciation. (Calvo and

16
Reinhart, 2000) describes that depreciation of domestic currency occurs when the central bank
increases the money supply and which is highly related to inflation although the empirical result
of the paper which was conducted by (Kiguel and Ghei 1993) in the case of developing nations
evidenced that most depreciations are not caused by inflation and the effect of inflation on
exchange rate depreciation is almost negligible.
2.5.1 Fixed (Pegged) Exchange Rate Regime
In a fixed exchange rate, a country’s currency is fixed against the value of another single
currency, or to another measure of value, like gold. It is a system in which government plays a
significant role regarding the value of its currency in terms of either a fixed weight of gold, or a
fixed amount of another currency. When there is a mismatch between the nations fixed exchange
rate and free market rate of foreign exchange which is determined by the demand and supply of
hard currency in the nation, the government obligated to fill the gap by taking from its foreign
exchange reserve. The government may interfere into the market through two different ways.
First, it can interfere through buying or selling of its own currency or foreign currencies. Under
the fixed exchange rate system, commercial banks have to buy and sell the domestic currency at
the determined rate.
But the market equilibrium exchange rate may not coincide with the pre announced spot rate.
Due to this reason the central banks always maintain reserves of foreign currencies and gold
which they can sell in order to intervene in to the foreign exchange market to make up the excess
demand or take up the excess supply. Second, Government can simply make trading currencies
at any other rate is illegal. In fact this method is rarely used because it is hard to enforce and
sometimes it leads to a black market in foreign currency. If the nation faces shocks which arise
from money demand or supply primarily, the policy of a fixed exchange rate regime looks
attractive.
2.5.2 Managed Floating Exchange Rate Regime
We can say that Managed floating exchange rate system is a system which combines both fixed
and floating exchange rates. On one hand, it allows the market to adjust the exchange rate and
arrives at its equilibrium level and on the other hand it allows the government to intervene in to
the exchange market whenever intervention is needed so as to protect the domestic currency,

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trade balance and nations economy from external shocks, it might be through buying and selling
of currencies or through some other means. In managed floating exchange rate regime, not only
the central bank intervenes in to the foreign exchange market but also international agencies such
as IMF.
2.6 Empirical Review
Bahmani-Oskooee and Niroomand (1998) asserted that demand elasticity of export and import is
inelastic in the short run and elastic in the long run by using data of 27 countries in the period of
1960-1992. For this reason, while devaluation has negative impacts on current account balance
in the short run, it has positive impacts in the long run .Baharumshah (2001) also investigated the
impacts of macroeconomic factors of USA, Japan, Thailand and Malaysia on balance of trade
through VAR model by using data of 1980-1996 period. In conclusion, he inferred that exchange
rate is an important variable affecting balance of trade in the long run. Narayan (2004) analyzed
the relationship between exchange rate and balance of trade in New Zealand’s economy applying
co integration method by using data of1970-2000 period and he could not find a co integration
relationship between exchange rate and balance of trade in New Zealand.
Mahmood et al. (2004) estimated elasticity of export and import prices of 6developed countries.
Based on these estimations, they showed that Marshall-Lerner Condition is partially satisfied in
some periods and it is valid in fixed exchange rate regime.Hooy and Chan (2008) made analysis
through Bounds Testing Approach (ARDL)and generalized impulse response analysis by using
data of January 1990-January2008 period and found results which support Marshall-Lerner
Condition. Jamilov (2011) investigated the validity of J curve for Azerbaijan’s economy and
concluded that an increase in exchange rates affects balance of trade negatively in following 12
months and after that positive impacts can be seen and J curve will be valid.
Peker (2008) analyzed the relationship between exchange rate and balance of trade in Turkey
through co integration method by using monthly data of 1992- 2006 period and they concluded
that Marshall-Lerner Condition is not satisfied. Hepaktan (2009) investigated Marshall-Lerner
Condition in Turkey through co integration method by using data of 1980-2008 periods and
concluded that this condition does not work accurately. Çil Yavuz et al. (2010) investigated the

18
validity of Marshall-Lerner Condition in Turkey through bounds testing approach by using data
of 1988-2007 period and they concluded that this condition is invalid in Turkey. Gafar (1981)
conducts a study to find the effects of devaluation on the balance of payments of Jamaica and he finds
that the Marshall-Lerner condition for exchange rate stability is satisfied, implying that devaluation is an
effective adjustment of trade balance. On the other hand, Ogbonna (1982) analyzes the 1973 devaluation
of the Naira (Nigerian currency) in Nigeria’s balance of payments and he concludes that devaluation fails
to improve the balance of payments.
Briguglio (1989) investigates to see whether a decrease in the external value of the Maltese Lira would
improve the Maltese balance of trade. The estimates of export and import demand price elasticity’s
indicate that the Marshall-Lerner condition is satisfied and therefore devaluation would improve trade
balance. Rose (1990) also examines the empirical impact of the real exchange rates on trade balance of
several developing countries using the three-stage least squares and he finds that there is little evidence to
show that their trade balances are significantly affected by the real exchange rates.
Rose (1991) estimates directly the responsiveness of the trade balances of five OECD countries
to real exchange rates in the post Britton Woods era using a number of techniques and he
concludes that there is little to support the view that real exchange rates affects the trade balance.
Bahmani-Oskooee (1991) conducts a study on the long run relationship between the trade
balance and the real effective exchange of eight LDCs, using quarterly data over 1973-1988
employing the co-integration analysis. The results suggest that the trade balance and real
effective exchange rate are co-integrated and that in the long run devaluation improves the trade
balance of most LDCs under study.
3. Methodology
In order to prove whether the Marshall Lerner (MLC) condition holds in the Ethiopian economy
or not, price elasticity of imports and exports should be estimated separately with their own
respective explanatory variable. In order to say that the Marshall Lerner Condition holds, the
sum of price elasticity of imports and exports in absolute terms should have to be greater than 1
(│εX +εM│>1). Therefore, the following Autoregressive Model of Order one ((AR (1)) equations
is used to check the validity of Marshal Lerner Condition for Ethiopian economy.
LnXt = β0 + β1 LnRWGDP + β2LnREERI + β3Ln Gov exp+ β4TOT+ β5AR1 (1)
β6DP+e1 …… (1)

19
Ln Mt = α0 + α1 LnRGDP+ α2 LnREERI + α3LnM2+α4AR2(1) α5Dp + e2 …..... (2)
Where X stands for Export, M stands for Imports, REER represents Real exchange rate, TOT
represents Term Of Trade,M2 is for Broad Money Supply, RWGDP and RGDP represents real
World and real Domestic income respectively, Dp stands for dummy for Policy Change, and e1
and e2 are error terms. Additionally Ln stands for the natural logarithm of the data. If the absolute
value of the sum of the parameters β2 and α2 is greater than one, then the Marshal Lerner
Condition holds and vice versa.
3.1 Data description and Data sources.
To conduct this paper the annul time series data for the period ranging from 1980-2015 is used.
This study is limited to testing validity of Marshall-Learner condition in Ethiopia. Broad Money
supply (M2), Real GDP, Real Exchange Rate Index (REERI), Government Expenditure, Real
world GDP and Term of Trade are the independent variables included in the model. Export and
Imports are the dependent variables of the equation. Data’s required for this study are obtained
from National Bank of Ethiopia (NBE).
3.2 Econometric Model Specification
Explanation of the Variables with respective Hypothesis
LnXt is the dependent variable of equation one and it indicates the natural logarithm of Export
from the time 1980-2015., LnRWGDP Represents world real income and its calculated by
taking the average Real Domestic Income of the major trading partners and its sign is expected to
be positive because other thing remains constant as the income of foreigner rise the demand for
domestic goods will rise which will have a positive impact on Domestic export. LnREERI is the
main regressor of the Equation and it represents the natural logarithm of Real Effective
Exchange Rate it’s expected to have positive sign. Citrus paribus, rise in REER encourages
export volume of a given Nation and vice versa. AR (1) is, export and its is known as
Autoregressive of order one. LnMt is the logarithm of import from 1980-2015 and it is the

20
dependent variable of equation two. LnRGDP is domestic income and other things remains
constant it expected to have positive sign because rise in domestic income level, Individuals may
shift from using domestically produced goods to foreign good. DP is dummy for exchange rate
policy change and AR, indicates one year lag of dependent variable.
3.4 Estimation
3.4.1 Unit root Test
In time serious analysis the stationeritry of the variable is the first thing need to do so as to
overcome spurious regression. Off course, there where scholars who argued that non stationery
of variable may not necessarily results spurious regression.(vebrek) But, for the purpose of this
paper all variables are tested weather they unit root or not. There are various unit root testing
techniques like Dukey fuller test, Augmented Dukey fuller test, F-test, Philip Peron unit root test
e.t.c. Augmented Dukey fuller test (ADF) is the most widely used technique and in this paper
augmented Dukey fuller test is used.
3.5 ADF tests of unit root Result
The guide line for ADF test to determine whether the variables got unit root or not is that if t-
statistics is greater than critical value at 5% in absolute value then one can reject the null
hypothesis or the variable is stationery. The following table shows the ADF unit root test result
with the respecting differencing.
Table. 1 ADF Unit root test result of export equation.
Variable t-statistics Critical value
at 1%
Critical
Value at 5%
Critical
Value at
10%
P-value Order of
Integration
LNX -4.535575 -3.639407 -2.951125 -2.614300 0.0009 I(1)
LNRWGDP -4.034525 -3.639407 -2.951125 -2.614300 0.0036 I(1)
LNTOT -4.188007 -3.639407 -2.951125 -2.614300 0.0024 I(1)
LNREERI -5.454437 -3.639407 -2.951125 -2.614300 0.0001 I(1)

21
LNGOV_EXP -4.246623 -3.639407 -2.951125 -2.614300 0.0021 I(1)
Table 2. ADF Unit root test of Import equation.
Variable t-statistics Critical
value at 1%
Critical
Value at 5%
Critical
Value at
10%
P-value Order of
Integration
LNM -5.549785 -3.639407 -2.951125 -2.614300 0.0001 I(1)
LNRGDP --4.255074 -3.639407 -2.951125 -2.614300 0.0036 I(1)
LNREERI -5.454437 -3.639407 -2.951125 -2.614300 0.0001 I(1)
DP -5.830952 -3.639407 -2.951125 -2.614300 0.0000 I(1)
3.5 Summary of Estimation Result
Table3. DependentvariableLNX
Variable Coefficient Std.Error t-Statistics P-value
LNTOT 1.227450 0.206376 5.947653 0.0000
LNRWGDP -0.203683 0.876117 -0.232484 0.8177
LNREERI 0.370350 0.271714 1.363011 0.1830
LNGOV 1.449115 0.156114 9.282408 0.0000
DP 0.670614 0.321131 2.088287 0.0454
C
5.958740 19.86844 0.299910 0.7663
R-squared 0.964335
Adjusted R-squared 0.958391
Durbin-Watson stat 0.610725
Table 4 Dependent Variable LNM
LNM2 0.022200 0.130463 0.170163 0.0866
LNREERI -0.122747 0.138131 -0.888631 0.0381

22
LNRGDP 2.557785 0.279024 9.166890 0.0000
DP 0.488276 0.183916 2.654883 0.0124
C -15.04964 2.570672 -5.854358 0.0000
R-squared 0.992592
Durban–Watson d-static test is one of the techniques to indicate whether there is serial
autocorrelation in the model or not. The model having D-W statistics value between 1.7 up to 2.2
is more or less free from the problem of serial correlation (Guajarati), but the D-W d-statistic
result of the above regression is around 0.6 and 1.1 for export and import equation respectively.
It is an indicator of the presence serial correlation in the model.
Taking one period lag of dependent variable and regress it as independent variable (converting
the model in to Autoregressive order one (AR (1)) can avoid the problem. The table below
proves the theory.
Table 5. Dependent Variable LNX, AR (1) model.
LNTOT 0.899830 0.127305 7.068280 0.0000
LNRWGDP 3.680329 1.881291 1.956278 0.0605
LNREERI 0.398260 0.236988 0.414622 0.6816
LNGOV 0.547600 0.214047 2.558318 0.0162
DP 0.771166 0.274010 2.814367 0.8018
C -78.93327 44.59645 -1.769945 0.0876
AR(1) 0.894326 0.072108 12.40267 0.0000
R-Squared=0.889, Adjusted R-Squared =0.886, Durbin- Watson stat= 1.85
Ln Xt = β0 + β1 Ln TOT+ β2Ln REERI+ β3LnRWGDP+β4GOV+ β 5 DP β6 AR1 (1) +e1
Ln Xt = -0.78 + 0.89 Ln TOT+ 0.09Ln REERI+ 3.3LnRWGDP+ 0.54GOV+ 0.77 DP
+0.89AR1 (1) +et1 ………….(1)

23
Table 6. Dependent Variable LNM, AR (1)
LnM2 0.651017 0.243995 2.668162 0.0124
LnREERI 0.091724 0.173352 0.529118 0.6008
LnRGDP 1.116938 0.526408 2.121810 0.0425
DP 0.576534 0.213394 2.701728 0.114
C -4.836603 4.541362 -1.065012 0.2957
AR(1) 0.821462 0.122644 6.697944 0.0000
R-Squared=0.894, Adjusted R-Squared =0.895, Durbin- Watson stat= 2.15,
Inverted AR Roots = 0 .82
Ln Mt = α0 + α1 Ln M2 + α2 Ln REERI+ α3Lnα4RGDP+AR2(1) α5Dp + e2
LnMt=-0.82+0.65LnM2+0.09*LnREERI+1.1LnRGDP+4.8AR2 (1) + 0.574DP
+et……..….. (2)
3.6 Heteroscedasticity Test
One of the assumptions of the classical linear regression model is that there is no Heteroscedasticity.
Breaking this assumption means that the Gauss–Markov theorem does not apply, meaning that OLS
estimators are not the Best Linear Unbiased Estimators (BLUE) and their variance is not the lowest of all
other unbiased estimators. Heteroscedasticity does not cause ordinary least squares coefficient estimates
to be biased, although it can cause ordinary least squares estimates of the variance (and, thus, standard
errors) of the coefficients to be biased, possibly above or below the true or population variance.
Thus, regression analysis using heteroscedastic data will still provide an unbiased estimate for the
relationship between the predictor variable and the outcome, but standard errors and therefore inferences
obtained from data analysis are suspect. Biased standard errors lead to biased inference, so results of
hypothesis tests are possibly wrong. For example, if OLS is performed on a heteroscedastic data set,
yielding biased standard error estimation, a researcher might fail to reject a null hypothesis at a given
significance level, when that null hypothesis was actually uncharacteristic of the actual population

24
(making a type II error) The Breusch-Pagan-Godfrey Heteroscedasticity test result of the model is shown
below
Table. 7 Heteroscedasticity Test of export equation: Breusch-Pagan-Godfrey
F-statistic 0.708257 Prob. F(5,29) 0.6220
Obs*R-squared 3.808853 Prob. Chi Square(5) 0.5773
Scaled explained SS 1.488091 Prob. Chi-Square(5) 0.9144
Table. 8 Heteroscedasticity Test of Import equation: Breusch-Pagan-Godfrey
F-statistic 1.759304 Prob. F(5,29) 0.1623
Obs*R-squared 6.660313 Prob. Chi-Square(5) 0.1550
Scaled explained SS 5.687710 Prob. Chi-Square(5) 0.2237
3.7 Single Equation Co integration test result
If error term of the model is stationery at level then one can conclude that there is short run
association ship between the dependent and independent variable. The result below shows that
the error term is stationery at level.
Table 9 Residual unit root test result of export equation.
at 1%
Critical value at
5%
Critical value at10% P-value
ECM -5.268034 -3.639407 -2.951125 -2.614300 0.0001
Table 10. Residual unit root test result of import equation.
at 1%
Critical value
at 5%
Critical value
at10%
P-value
ECM -3.545516 -3.632900 -2.948404 -2.612874 0.0124
The stationeritry of error term at level is an indication of the presence of short-run relationship
between dependent and independent variable and the next step will ruining of Error Correction
Model.

25
3.8 Error Correction Model
An error correction model belongs to a category of multiple time series models most commonly used for
data where the underlying variables have a long-run stochastic trend, also known as co integration. ECMs
are a theoretically-driven approach useful for estimating both short-term and long-term effects of one time
series on another. The term error-correction relates to the fact that last-periods deviation from a long-run
equilibrium, the error, influences its short-run dynamics. Thus ECMs directly estimate the speed at which
a dependent variable returns to equilibrium after a change in other variables.
Table11. Error correction model estimate of export equation.
Variable Coefficient Std. Error t-Statistic Prob.
DLNGOV -0.557737 0.293582 -1.899765 0.0713
DLNREERI_1 0.655792 0.186907 3.508657 0.0021
DLNREERI_3 0.358560 0.183699 1.951888 0.0644
DLNTOT 3.978293 0.468251 8.496073 0.0000
DLNTOT_1 0.943620 0.519994 1.814675 0.0839
DLNTOT_2 1.497826 0.653984 2.290311 0.0325
DP 0.356492 0.081723 4.362177 0.0003
ECM_1 -0.547926 0.215561 -2.541857 0.0190
C 0.005424 0.065490 0.082828 0.9348
DLNREERI_2 0.432076 0.186303 2.319212 0.0305
R-squared 0.858857
Prob(F-statistic) 0.000000
Table 12 Error correction model estimate of import equation.
Variable Coefficient Std. Error t-Statistic Prob.
DLNM2_1 0.998833 0.389425 2.564891 0.0173
DLNREERI_3 0.353501 0.096626 3.658460 0.0013
DLNRGDP 0.918323 0.447896 2.050306 0.0519
DLNRGDP_2 -1.191982 0.385461 -3.092356 0.0051
DLNRGDP_1 -1.065792 0.370108 -2.879677 0.0085

26
DP 0.225232 0.056404 3.993206 0.0006
ECM_1 -0.686354 0.190232 -3.607989 0.0015
C -0.081410 0.053215 -1.529834 0.1397
As shown the table above the coefficient of error term is negative and it is significant having p-
value of 0.019 and 0.0015 for export and import equation respectively. Which is desirable and it
is an indicator of the presence of long run equilibrium association ship in the model. The
coefficient,-0.54 and -0.68 refers the speed of adjustment in which the model back to their
equilibrium position. In other word it means that the model correct its dis equilibrium at the rate
of 54% per year for export equation and 68% for import equation.
3.9 Interpretation of the result
The coefficient of RWGDP is around 3.7 which means that a percentage change in real foreign
income results a 3.7 rise of the volume of domestic export hence it is significant and its sign is
positive as expected. Even though the coefficient of real effective exchange rate is 0.39, since
its insignificant it doesn’t have the strength to affect the export volume. The analysis of the
model shows that government expenditure has appositive impact on export volume with the
coefficient of 0.54. Which mean that a percentage change in government expenditure leads to
raise export volume by 0.54. The one year lag of export volume affects the current export
volume positively; the logic behind the result is that if the volume of export in year one is higher
it enables the exporting country to earn hard currency which plays a very important role in
competing in international market.
It may help the country to expand its export capacity for the next year and the same is true if the
export volume is low in year one. Therefore, the volume of past export has significant direct
impact on the current export volume.
Money supply has positive impact on the value of import as expected. As drawn from import
equation estimation table money supply is both significant and positive sign, 0.01 of p-value and
coefficient of 0.65. A percentage change in money supply leads to 65% increase in import. The
possible argument behind the theory is the theory of monetary economist. According to Professor
Milton freedman who is a prominent leader and founder of monetary economic school of
thought, argue that inflation in any where is a monetary phenomena. Therefore the rising money
supply results the higher inflation which makes the price of domestic goods expensive to both

27
domestic and foreign consumer as a result domestic consumers are forced to import goods from
abroad than using domestic goods. Hence, citrus paribus the rise in money supply leads to rise in
import. Like that of export equation real effective exchange rate is insignificant in import
equation having coefficient of 0.09 and 0.6 p-values. RGDP is another significant variable of
import equation besides Money supply. Even thou it is expected to be significant its sign is
unexpected. The analysis shows that RGDP has rising impact on import. Literally it is straight
forward that the production will results the higher domestic supply of goods and the lower price
and finally the higher domestic consumer uses domestic goods than that of foreign goods. But
the well known Keynesian economist and Noble winner of 1987, Robert Solow argue that for
developing country whose Development is at infant age, the source of their growth is mainly
from abroad. In order to produce more those developing country needs more advanced
machinery and capitals which are not produced domestically. Therefore the higher production,
the higher capital goods and machinery and the higher volume of import. Policy change plays a
insignificant role in both export and import equation.
Conclusion and Recommendation
In order to check the validity of Marshall-Lerner condition for Ethiopia, multiple linear
regression models are estimated by using the OLS (ordinary least square) method. Specifically,
in order to see the relationship between the nation’s import demand and devaluation as well as its
export demand and devaluation, import and export demand equations are estimated. The results
of the estimations show us that as devaluation applies in the economy, the nations export will be
positively affected so that export will increase to some extent but unlike the theoretical
expectations, instead of decreasing the nation’s import demand, devaluation has a positive
impact on Ethiopian imports. Additionally, since the coefficient of the real exchange rate
variable is not statistically significant it can be said that exchange rate is not one of the
determinant factors of import demand for Ethiopian economy. Since the nation “production is
highly dependent on imported goods (we need to bear in mind that even essential inputs for
agricultural products like fertilizers, pesticides, sophisticated outputs, machineries petroleum and
so on are goods that the nation imports from outside world) the adoption of the policy of
devaluation makes the cost of production to rise and this might lead the domestic production to
decrease or not to grow up as it was expected. Therefore, in order to fill the gap between the

28
domestic demand and domestic supply of the economy, import is the only choice that the nation
has even if it’s very expensive and hard to afford.
Besides ,the sum of the change in the value of Ethiopian import with respect to exchange
rate(import elasticity ) and the change in the value of Ethiopian export with respect to real
exchange rate (export elasticity ) is less than one |εX + εM <1|,(0.39+0.09=0.48) it is not possible
to conclude that the Marshal Lerner condition is hold.. This study shows that the demand side
policies like devaluation are not effective in making the nation’s trade balance better off
therefore, rather than focusing only on demand side policies, supply side policies need to be
considered and implemented in the economy so as to produce more outputs and achieve
economic growth. Since there is a huge gap between the demand and supply of many
commodities in the economy, the only means of solving the problem in the long run should be
producing them domestically though in the short run it is a must to import those commodities
from abroad.

29
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