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THE DETERMINANTS OF CURRENT ACCOUNT

DEFICIT IN THE ETHIOPIAN ECONOMY

By: Gizaw Gezahagn

Submitted to: Daniel Abraham

ARBAMINCH UNIVERSITY

Faculty of business and economics

Department of economics

ArbaMinch, Ethiopia

March, 2012


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Table of contents

CHAPTER ONE PAGES

INTRODUCTION......................................................................................... 1

1.1 Background ............................................................................................................4

1.2 Statement of the problem....5

1.3 Objectives of the study........6

1.3.1 General objective. ....6

1.3.2 Specific objective .6

1.4 Hypothesis of study..7

1.5Significance of the study .8

1.6 Delimitation/ scope/ of the study.8

1.7 Limitation of study............................................................................... ...............................8

1.8 Organization of the study.8

CHAPTER TWO

LITERATURE REVIEW.......9

2.1 Theoretical Literature9

2.1.1 Current Account....9

2.1.2 Theories of International Trade10

2.1.3 Trade concepts related to Current Account .14

2.1.4 Theories/approaches/ of Current Account Determination............................................19

2.1.4.1 Elasticity approach.......19

2.1.4.2 Absorption Approach..................20

2.1.4.3 Inter temporal approach...21

2.2 Empirical Literature .........25


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2.2.1 Cross-Country Studies on Current Account.........25

2.2.2 Current Account Studies in Ethiopia26

CHAPTER THREE..283. RESEARCH METHODOLOGY....28

3.1 Source of data .... .28

3.2 Model specification..28

3.3 Variables Description ...29

3.4 Method of Data Analysis ......................32

Bibliography. 33


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CHPTER ONE

INTRODUCTION

1.1 Background of the study

Ethiopia is a country with a population about 84 million in 2010/11. It is one of the developing

country which faces the problem of low GDP growth, high inflation, current account budget

deficit and food scarcity .The high growth rate of population which is (2.4 %) per year growth

rate ,didnt much with the production of the output. (NBE, 2001)

Developing country are characterized by low level of macroeconomic performance of high total

population, low percept income or low real GDP growth, under unemployment , budget balance

deficit high rate of series in inflation, unfavorable terms of trade and market instability

(Os.sherivastiva,1996).

The high number of total population having high growth rate of the country (2.4 % in 2009,CSA),

increases the total amount of food consumptions and other thing which the country is unable to

provide it and lead to import good and service from other country rather than exporting and cause

the country current account deficit and volatile over time. The current account balance (CA) is an

important barometer for both policy maker and investor as it is an indicator of a countries

economic performance. While many countries have experienced current account deficit, large and

persistent short falls are of concern to both policy maker and investor, because it cause many

economic and financial problem to the country.

In other case, the country exports agricultural products. In open economy policy maker are

concerned with two macroeconomic goals, internal balance and external balance. Internal balance

is achieved when the economies resources are fully utilized and stability of price level is attained.

External balance is achieved when an optimal level of current account balance attained. By optimal

balance it is meant that a countrys current account is neither so deeply in deficit that the country

may be unable to repay its foreign debt in the future nor strongly in surplus that foreigners are put

in that position, (krugmman and Obstfeld, 2003). Movement of this macro economic indicator


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conveys information about action and expectation of all market participants in an open economy

(Bannaga, 2004).

There are several theoretical models existing in the literature that try to explain the behavior of the

current account balance. Each of them gives different prediction about the elements determining

the current account balance and the sign and magnitude of the relationship between current

account fluctuation and its determinants. Therefore understanding the determinants and empirical

analysis could help to distinguish among competing theories. A countrys international trade in

goods and service, and international borrowing and lending are recorded in its balance of payment

account. The Balance of payment consists of two main accounts. The current account and capital

account. The current account measures the change over time in the sum of three separate

components. These are Trade account, the Income account and Transfer account. On the other

hands, capital account measures the transaction into domestic currency (capital inflows) and

foreign currency (capital out flows) and the capital records purchases and sales of assets, such as

stocks, bonds, and land.

1.2Statementof the problem

The major challenge confronting most of developing country such as Ethiopian is Current

account deficit and instability from time to time which has a negative impact on macroeconomic

variable of the country. Policy-makers view the evolution of the Current Account balance as a

key indicator of the health of a nations economy.

A Current Account deficit is a reflection of the strength of a developing countrys economy such

as Ethiopia as it measures the resources coming into a country to finance investment demand in

excess of national savings. On the other hand, it can also reflect a dangerous and unsustainable

imbalance between national savings and domestic investment and the accumulation of debts that

cannot be serviced (Roubini and Watchel, 1997). The Current Account balance is also a focal

point for measuring the economic performance of an open economy for various reasons (Ibid).

In case of Ethiopia it has problems of unstable export markets and worsening terms of trade.

Ethiopia's exports are concentrated on a small number of products. In terms of value, the shares

of major export items have been fluctuating over time due to volatile behavior of price and

unpredictable demand in the international market. On the supply side, the agricultural items are


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influenced by policy problems, war, structural constraints, natural factors (drought, disease), etc.

there is an ever increasing.

Knowing the determinants of the Current account is one of the main things that are expected

from policy maker and every individual. The current account of Ethiopia is affected or

determined by many things from time to time. There is no sustainable increase on surplus of the

current account of Ethiopia.

This paper will dig out those determinants of current account and their insignificance value on

the term. The gap that I will full fill in the study is described as follow,

1) What are the determinants of current account balance of Ethiopia?2) What is trend investigation of current account of Ethiopia from 1980/81-2009/10

1.3 Objective of the study

1.3.1 General objective

The main objective of this study is to investigate the major determinants of current account deficit

in the Ethiopian economy.

1.3.2 Specific objective

The specific objectives of the study are:

To investigate the trend of Ethiopia current account and its component over theperiod from 1980/81-2009/10

To estimate the elasticity of the major determinants of current account deficit inEthiopia: consumption, real GDP, openness, and real effective exchange rate.

To forward a necessary suggestion towards the improvement of current accountbalance of Ethiopia

1.4 Hypothesis of study


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The hypothesis of this study is expected that the determinants of current account have significant

value/effects on determining current account balance of Ethiopia.

Real GDP and change in trade regime are negativelycorrelated to Ethiopian currentaccount.

Consumption is negatively related to the current account. Real exchange rate have negatively related to current account balance. Openness (Ex - Mp)are negatively related to current account balance

1.5 Significance of the study

The significance of the study is to generate new information that helps to design appropriate

polices. It is also important for other researchers used as ground who are interested to carry out

researches on this area. It is very imperative and essential as a reference for other researchers

who have desire to conduct a research on similar topic.

1.6 Delimitation (scope) of the study

This research project is focused on the typical determinant factors that affect current account

Balance of Ethiopia from 1980/81-2009/10. It would be conducted through a time series

quantitative data.

1.7 Limitationof study

The success of every study greatly depends on the availability of resources with conductive

environment. But for this paper; there will be a lot of limiting factors that the researcher faced in

conducting it

Financial constraint: to get realizable data requires more fund but the available fund doesnot allow caring out the study deeply and properly since it required more expenditure.

Lack of access of internet service because of this I forced to incur additional cost forexternal use plus there is lack of possessing important material.


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1.8 Organization of the study

The paper will have to be organizing in four chapters; the first chapter will have to focus on

introduction under which background and statement of the problem concerned. In addition,

objective of the study, significance and scope, and limitation of the study will be presented. Inthe second chapter I will try to discuss literature review with related theoretical and empirical

evidence. The third chapter of the study also present methodology of the study that I used both

econometrics regression and descriptive data analysis. The fourth chapter talks about the method

of data analysis and its interpretation. The last part will present the conclusion and

recommendation of the study.


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CHAPTER TWO

LITERATURE REVIEW

2.1 Theoretical Literature

2.1.1 Current Account

The current account records exports and imports of goods and services and unilateral transfers.

Exports of goods and services are by convention entered as positive items in the current account

and imports are entered as negative. Unilateral transfers are receipts, which the residents of a

country receive for free. Receipts from abroad are entered as positive items, while payments

abroad are entered as negative items (Sodersten and Reed, 1994). The current account can be

written equivalently as income minus absorption or as saving minus investment (Persson and

Svensson, 1985).

Since the current account is concerned with goods and services, it is generally considered to be

the most important component of balance of payments. What makes a current account surplus or

deficit important is that a surplus means that the country as a whole is earning more than it is

spending and increasing its stock of claims on the rest of the world. On the other hand, a deficit

means that the country is reducing its net claims on the rest of the world. The current account is

likely to be a cause of changes in other economic variables, such as changes in the real exchange

rate, domestic and foreign economic growth, and relative price inflation (Pilbean, 1998). Someeconomic analysts also argue that there is a strong link between large current account deficit and

financial crisis (Edwards, 2001).

The current account of the balance of payments plays several roles in policymakers' analysis of

economic developments. Since a country's balance of current account is the difference between

exports and imports, it reflects the totality of domestic residents' transactions with foreigners in

the market for current goods and services. At the same time since the current account balance

determines the evolution overtime of a country's stock of net claims on (or liabilities to) the rest

of the world, it reflects the inter-temporal decision of domestic and foreign residents; their

behavior with saving, investment, the fiscal position, and demographic factors (Knight and

Scacciavillani, 1998). Thus, it is important for policy makers to focus on the current account as

an important macroeconomic variable, to explain its movements, to assess its sustainable level,

and to seek to induce change in the current account balance through policy actions.


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It is worth mentioning that current account deficit is not necessarily a negative phenomenon for a

country's economic development. The country's opportunities for investing the borrowed

resources are more important than paying back loans to foreigners because a profitable

investment will generate a return high enough to cover the interest and the principal on those

loans. In this case, a deficit in current accounts is likely to be followed by future surpluses.

Similarly, a surplus in current account is not undisputedly a positive phenomenon for economic

development.

A current account deficit means that the concerned country is increasing its indebtedness or

reducing its claims on the rest of the world. If the country is a net creditor it can usually afford to

do this, whereas, if it is net debtor the deficit may be regarded as more serious problem. Another

point to bear in mind is that if a country has a large deficit due to a large government budget

deficit, then the remedy may lie in reducing government expenditure and /or raising taxes. If

however, the deficit is due to high investment then there is a good chance that future export

growth will reduce the deficit. Finally, if a country has a current account deficit, high inflation

and low economic growth, then the problem is more worrying than if the deficit is accompanied

by high economic growth and low inflation (Pilbean, 1998:54).

2.1.2 Theories of International Trade

International trade is the purchase, sale or exchange of goods and services across national

borders (Wild, Wild & Han, 2006).International tradeproduces many benefits to countries both

exporting and importing products. For countries importing products, the benefit is that they get

goods or services they cannot produce enough of on their own. Likewise, for the exporter, one of

the benefits is through the trade they can also get either the goods or services they need or the

money in which to purchase these goods from another country or source. International trade also

helps the economies of the countries by providing more jobs for people in order to process these

various commodities. The economy of countries affects the world output of international trade. If

a country's economy is slow so does the volume of international trade while a higher output

produces more trade. If a currency is weak in one country as compared to the other countries of

the world then the imports are going to be more expensive than domestic products. In relation to
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trade walking hand in hand with world output, trade has consistently grown faster than output.

(Ibid)

A systematic theoretical analysis of international trade could be said to have started with the

classical school of economic thought. Adam smith is dubbed as the founder of the school with

his famous book An Inquiry in to the Nature and Cause of Wealth of Nations published in

1776.

He was the first to propose a concrete theory of international trade. According to smith,

international trade occurs due to the presence of absolute cost differences in production of

various products across countries and trade is mutually beneficial to all trading partners as it

allows the maximum utilization of the benefits of specialization in production. (Mannur, 1996)

The argument for free trade based on smiths theory becomes weak if one country has absolute

advantage or disadvantage in the production of all goods.

Hence this weakness of smith is replaced by a stronger argument by David Ricardo.

Ricardo developed a principle to show that mutually beneficial trade could occur where one

nation was absolutely more efficient in the production of all goods. According to Ricardos

comparative advantage principle, comparative cost, even if a nation has an absolute cost

disadvantage in the production of both goods, a basis for mutually beneficial trade may still

exist. The less efficient nation should specialize in and export the good in which it is relatively

less inefficient and the more efficient nation should specialize in and export that good in which it

is relatively more efficient (Salvatore, 1993). The theory assumes technological differences

across countries which imply differences in factor prices across countries. As an attempt to

modify the Ricardian theory, the Heckscher - Ohlin factor endowment theory came about. The

basic model originates from the works of the two Swedish economists, Eli Heckscher (1919) and

Bertil Ohlin (1924).

According to Ricardian economics, comparative advantage was based on the differences in the

productivity of labor (as labor is the only factor of production) among nations. But according to

the H- O theory, the difference in relative factor abundance or factor endowment among nations

is the basic cause or determinant of comparative advantage and international trade. Each nation

specializes in the production of and exports the commodity intensive in its relatively abundant

and cheap factor, and imports the commodity intensive in its relatively scarce and expensive

factor. (Salvatore, 1993)


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In comparison to the Ricardian theory, the factor proportions theory neglects the notion of

technological differences and instead focuses on showing how factor endowments are the basis

for trade. But despite its acceptance, the H-O model performs poorly empirically. (Zinabu, 2006)

To avoid such inconvenience, Haberler reformulated the law of comparative advantage by basing

it on the opportunity cost theory rather than on the unacceptable labor theory of value. According

to the opportunity cost theory, the cost of a commodity is the amount of a second commodity that

must be given up to release enough resources to produce one additional unit of the first

commodity (Salvatore, 1993). The cost of the commodity shouldnt necessarily be inferred from

the labor content.

In this respect, there is the vent for surplus theory which assumes that when a country inters in

to international trade, it possesses a surplus productive capacity. Hence the function of trade here

is the surplus resources that would have remained unutilized in the absence of trade. This

indicates that production would be easily increased without necessarily reducing domestic

production. (Berhane, 2000)

Other theories of trade under the name contemporary theories of external trade, which are

outgrowths of the major trade theories mentioned above, have also been developed to modify

certain aspects of the conventional theory of external trade. (Iyoha, 1995)

One such theory is developed by Burenstam Linder (1961). The basic idea of the Burenstam

Linder (BL) hypothesis is that differences in preferences constitute a significant trade barrier

between countries. For him, countries with similar demand structures will trade more with one

another.

The more similar the demand structure of the two countries, the more intensive potentially is the

trade between the two countries.

Linder suggested that PCI can be used as a proxy for preferences. The hypothesis can then be

tested by comparing PCI between trading partners (Linder, 1961 as cited in Bohmann and

Nilsson, 2006). The BL hypothesis departs from the neoclassical theories of trade where supply

conditions are the most important factors for trade. BL rather argues that the structure of

preferences is the major determinant of trade flows between countries. For Linder, countries

should export the goods for which they have a large domestic market. (Ibid)

The other contemporary theory is the size and distance theory called the gravity model developed

by Linneman. He puts it that trade varies directly with size and inversely with the distance


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among countries. In testing the theory, Linneman tried to explain how variation in the volume of

exports is affected by size (population and national income) and distance (Elias, 1998). In

Heckscher- Ohlin theory, however, distance wasnt considered to be a barrier to trade.

Another theory, developed by Vernon (1966), is called the product cycle (Imitation,

Technological gap) theory. Vernon puts it that a country extracts comparative advantage from

goods innovated internally at least for some time when exporting these goods to the world

market. The comparative advantage exists till other imitators start to produce the same

commodity. The product cycle refers to the different phases that a given product passes through

till it finally gets imitated. The crux of the theory is the time lag between innovation and

imitation. (Elias, 1998)

The theories which are commonly known as new trade theories are developments of the 1980s.

New trade theories base international trade on economies of scale and imperfect competition.

Relaxing the following two assumptions of the H-O model leads to the new trade theories.

(Alemayehu, 1997)

I) while the H-O theory assumed constant returns to scale, international trade can also

be based on increasing returns to scale.

II) Relaxing the assumptions of perfect competition can also lead to the new trade

theory.

About half of the trade in manufactured goods among industrialized nations is based on product

differentiation and economies of scale, which arent easily reconciled with the H.O factor

endowment model. Hence to explain intra industry trade, we need new trade theories. (Ibid)

Though, it is a bit digressive, a theory relating international capital flows and international goods

trade is getting much support in recent decades. (Springer, 2000)

Overall, though most of the theoretical literature reviewed above are inclined towards the notion

of trade as an engine of growth in which export leads to economic growth; there are divergent

views on the causality. Roderick (1997) argued that lack of strong domestic economy has forced

countries to be poor participants in international trade. In agreement with this, Mannur (1996)

has labeled foreign trade in less developed countries as proverbial engine of growth. Not

taking positions, there are some who forward an intermediate view like Kravis (1970) who

considered trade not as an engine of growth but as a handmaiden to growth, but it is not by itself

a source of growth( sited by Daniel,2007).


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2.1.3 Trade concepts related to Current Account

I) Current Account and Budget Balance

Theoretically, there are four possibilities about the relationship between budget and trade

deficits. The first is called the Twin Deficit Hypothesis. According to this, budget deficit has

positive and significant effect on trade deficit or the main cause of trade deficit is the excessive

budget deficit (Akbostanc and Tunc, 2000). Economic reasoning for the connection between

budget deficit and current account balance may be traced from the national income identity:

Y = C + I + G + (X-M)

Here the national income (Y) equals consumption (C), investment (I), government expenditure

(G), plus the net exports (X-M). One can easily rewrite this identity by using after tax (T) income

minus consumption equals saving (S), relationship:(X-M) = (S-I) + (T-G)

In this case, net export i.e., the trade balance simply equals to the private saving investment gap

plus the budget balance. Thus, assuming a stable saving investment gap, an increase in public

sector deficit will directly increase the trade deficit, which is the traditional twin deficit

relationship.

Theoretically, the mechanism behind the twin deficit could simply be explained through the

Keynesian income-expenditure approach. An increase in budget deficit (due to government

expenditure) will increase domestic absorption and, therefore the domestic income. Increased

income will induce imports and eventually will reduce the surplus or increase the deficit in the

trade balance. An additional linkage can be explained using the Mundell-Fleming model.

Assuming high capital mobility, an increase in the budget deficit will cause an increase in the

aggregate demand and domestic real interest rates. High interest rates will cause net capital

inflow from abroad and result in appreciation of the domestic currency. This in turn will

adversely affect net exports due to higher value of domestic currency and thus there will be

deterioration in the current account. This conclusion is valid both under fixed and flexible

exchange rate regimes (Pilbean, 1998).

The Twin Deficit Hypothesis, however, has its own limitation because the analysis is based on

the assumption that private investment remains stable while government spending increases. In

reality however private investment cannot be neutral of government spending. Government


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spending should affect private sector expenditure at least in two ways. First, an increase in

government expenditure should induce a decrease in private sector if the government and private

expenditures are substitute or an increase in private sector if they are complements. Second, an

increase in government expenditure may induce a decrease in private sector expenditures, due to

the change in the present discounted value of tax burden.

The second possible relationship is the reverse of the first relationship i.e., trade deficit might

cause budget deficits. The third relationship states that the two deficits might also be mutually

interdependent. However, these two possibilities are not theoretically very well explained. The

fourth alternative to all these three possibilities states that there exists no relationship between

the two deficits, they are independent. Proponents of the Ricardian Equivalence Hypothesis

(REH) claim that there is no causal links between public sector deficit and external sector deficit.

According to this hypothesis, the equilibrium levels of current account, interest rates, investment

and consumption will not be affected by changes in the level of budget deficit. This can be

regarded as the extension of the Permanent Income -Life Cycle Hypothesis including

government expenditure, taxes and debt. In this framework a change in the level of budget deficit

will not change the lifetime budget constraint and real wealth of the consumer. If agents can

borrow at a constant interest rate, a reduction in tax (or an increase in expenditure) will be

regarded as an increase in the present value of future liabilities. The consumers will adjust their

savings to the change in the budget deficit and therefore, the amount of desired national savings

will not differ. In this model, it is assumed that consumers have infinite horizons. Also there are

no liquidity constraints and there is no uncertainty about the public sector behavior (Barro, 1974

pp.1096).

II) Current Account and Real Exchange RateThe effect of devaluation on the current account has been extensively addressed in traditional

open economy macroeconomics. In the Mundell-Fleming model devaluation will improve the

trade balance if the Marshall-Lerner conditions are fulfilled. This represents an intra-temporal

condition that depends up on the elasticity of demand for home and foreign goods.

Instead of having prices set in producer's currency, however, there is a possibility that some

firms in one or both countries (home country and foreign country) might set prices in the

currency of final sales. This type of pricing structure is referred to as short-run pricing-to-market

(PTM) (Devereux, 1999). The impact of devaluation on the current account can be dominated


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either by an intra-temporal elasticity consideration, or by inter temporal, consumption smoothing

considerations. Which effect dominates depends on critically on the extent of pricing- to -market.

With pricing -to-market, real interest rate and consumption growth can differ across countries,

due to deviations from purchasing power parity. The response of consumption to real interest

rate is determined by inter temporal elasticity of substitution. With extensive pricing-to-market,

devaluation will improve, leave unchanged, or deteriorate the current account, as the elasticity of

inter-temporal substitution is less than, equal to, or greater than unity, respectively. The impact

of devaluation on real exchange rate also depends up on the relative country size. For instance, if

the foreign country sets all its export prices in its own currency, and if the home country is very

large, then the real exchange rate is affected only slightly by devaluation.

III) Current Account and Stage of Development

The stage of development hypothesis for balance of payments suggests that as countries move

from a low to an intermediate stage of development typically import capital, therefore, run

current account deficits. Overtime, as they reach an advanced stage of development, countries

run current account surpluses in order to pay off accumulated external liabilities, and also to

export capital to less advanced countries (Chinn and Prasad, 2000). The relationship between

stage of development and current account balance is therefore expected to be non-linear. First,

development affects the current account negatively then after some time it starts to affect it

positively (Calderon et al., 1999).

IV) Current Account and Openness

There are two opposing arguments with regard to the impact of openness on current account. The

first argument suggests that the openness variable might well be indicative of attributes such as

liberalized trade that make a country attractive to foreign investment. Furthermore, international

trade often serves as an important vehicle for transfer of technology to developing countries.

Thus, countries with more exposure to international trade tend to be relatively more attractive to

foreign capital, allowing them to undertake more investment and to finance the resulting current

account deficits with capital from abroad. Also, as noted earlier, more open economics are likely


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to have a better ability to service their external debt through export earnings (Chinn and Prasad,

2000)

However, some analysts, especially those who are concerned with developing countries are

against this thinking. For example, Ghosh (2001) points out that both financial and trade

liberalization can play a role in building up to crises like those in East Asia, or in causing

recessions or declining in domestic manufacturing industry in several developing counties. He

indicates two important factors behind the adverse combination of payment deficits and lower

growth: terms of trade losses and rapid liberalization.

The terms of trade losses reflect the growing number of developing country exporters crowding

into already saturated markets, pushing down prices further, and reducing the income gains from

additional exports. The process of relative price decline occurred for both primary and non-

primary goods exported by developing countries. The decline in commodity prices is due to both

slow growth of aggregate demand in industrial countries as well as substitution away from the

use of such commodities because of technological change. The problem has been aggravated by

in adequate market access for developing country exports in developed markets. While

developed country markets have not become more open for developing country exports, the

markets of developing countries have been significantly liberalized. Rapid trade liberalization

drastically changed the structure of domestic demand in favor of imports, while viability of

domestic manufacturers has been eroded.

On the issue of openness, Lopez and Rodric (1989) investigated the impact of trade restrictions

on current account. Their study suggests that when non tradable are intensive in imported

intermediates, tariff acts as a supply shock in this sector. As a result, resources will be released

from non tradable to exportable and current account improves. When the input tariff leads to a

contraction of the exportable sector the net effect on current account is ambiguous.

Focusing on another instrument of trade restriction, Dyadic (1987) postulates that the effect of a

temporary import quota on current account is determined by the interaction between two

opposing forces.The inter temporal relative price effect tends to improve the current account,

while the wealth effect contributes to deterioration. Import restriction raises relative price of

present in terms of future consumption leading to a reduction in aggregate spending and

improves the current account. A temporary quota also generates a negative wealth effect. A

household attempts to spread the welfare loss over its entire planning horizon and consume in


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excess of its income. The corresponding increase in indebtedness contributes to current account

deterioration. With regard to flow of funds perspective, Debelle and Faruqee (1996) suggest that

countries that maintain a relatively closed capital account through barriers and controls, or

countries with limited access to foreign borrowing due to country risk, are likely to have smaller

current account imbalances than otherwise.

V) Current Account and Terms of Trade

Analyses on the effects of terms of trade on current account have come out with different

predictions. Harberger (1950) and Laursen and Metzler (1950) postulate deterioration in terms of

trade decreases real income, and the decrease in real income reduces saving out of a given

income, both measured in terms of exportable. Thus if investment is constant and there is no

government deficit, the change in saving is equal to the change in the current account surplus,

and hence the Harberger-Laursen-Metzler effect implies that current account will deteriorate in

response to a terms-oftrade deterioration (sited by Sevensson and Razin, 1983).

However, findings of theoretical analysis by Sevensson and Razin (1983) suggest that the effect

of terms of trade consist of wealth and inter-temporal substitution effects. A temporary

deterioration in terms of trade generates two effects: a temporary fall in real income and a change

in the real interest rate. The fall in real income leads to deterioration in trade balance due to

consumption smoothing behavior. The fall in real interest rate leads to a substitution effect on

spending and hence reinforces the wealth effect. Thus, the current account must unambiguously

deteriorate. Using a standard inter-temporal representative-agent model with a non durable goods

and no investment assumption, Kent (1997) predicts that a temporary positive shock to income

will lead to an improvement in the current account. Similarly, if there is no borrowing constraint,

a temporary negative shock will lead to a fall in the current account. However, the effect of

investment works in opposite direction to consumption-smoothing effect.

If there is a positive shock to terms of trade, there will be an incentive to alter the capital stock.

The change in the capital stock will be greater for more persistent shocks. The author concludes

that the longer the duration of the shock, the more likely is that investment effect dominates

consumption smoothing effect. Cashin and McDermott (1988) develop the analysis of current

account response to terms of trade shock using a three-good (importable, exportable and non-


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tradable) inter temporal model. According to them, adverse transitory terms of trade shock will

have three effects:

1) It will lower current national income relative to future national income (the Harberger

Laursen-Metzler consumption smoothing effect).

2) It will make current imports and current consumption more expensive relative to future

imports and future consumption, and so should induce agents to tilt their consumption to the

future, leading to a rise in current aggregate saving.

3) It will make consumption of importable more expensive than consumption of non-tradable,

causing agents to substitute in to non-tradable. This in turn raises the relative price of non-

tradable. As the higher relative price of non tradable temporarily rises, the general level of prices

rise making current consumption relatively more expensive, and inducing a rise in current

aggregate savings. On balance, the effect of terms of trade shocks on private saving and the

current account will be determined by which of these has the greater relative strength.

In a small oil importing country, changes in oil price will have significant impact in terms of

trade shocks. Marion (1982) provides the analysis of current account response to oil price

increases using an inter-temporal maximizing model. His model indicates that in the absence of a

non-traded good sector, a permanent oil price increase will improve current account because

absorption will further be reduced. Introducing a non-traded sector, however, increases in oil

price affect current account through several channels. If capital is easily substitutable for oil in

the production of the non-traded good, a future oil price increase will stimulate investment and

possibly lead to current account deterioration. However, if oil and capital goods are net

complements in the production of non-traded good sector, future oil price increase will

discourage investment leading to improved current account balance.

2.1.4 Theories/approaches/ of Current Account Determination

Several theoretical models try to explain the determinants of the current account balance.

Different model offers different predictions about the factors underlying the current account

dynamics and consequently provides different economic policy implications. In general, three

basic frameworks are commonly adopted in modeling the behavior of current account. These are

the elasticity approach, the absorption approach, and the inter-temporal approach.


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2.1.1. Elasticity approach

The elasticity approach treats the current account balance as the sum of trade balance and net

international investment income. It is mainly based on the analysis of price elasticity of demand

for imports and that of demand for exports, with respect to changes in exchange rate. In a typical

elasticity approach, the current account balance is mainly determined by real exchange rate,

domestic output and foreign output. This approach is largely applied to evaluate the effect of

currency depreciation or appreciation on the current account balance. In particular, it is used to

examine whether currency depreciation can help to improve the current account balance or no.

Therefore, the elasticity approach highly emphasizes the role of exchange rate and trade flows in

current account adjustments. Many economists and policymakers take this approach as granted

and use it to construct the current account models due to its general appeal and simplicity.

However, the main weakness of this approach is that it is a partial equilibrium based analysis. In

particular, it only looks at the traded goods market and ignores the interaction of other various

markets in an economy.

Originally, the current account was thought of as the net export balance of a country (i.e. the

trade elasticity approach). Consequently, relative international prices and their determinants were

viewed as central to the dynamics of the current account.

The Marshall- Lerner condition

The Marshall-Lerner condition (also called the Marshall-Lerner-Robinson, hereafter, MLR,

condition) is at the heart of elasticity approach to balance of payment. It is named after the three

economists who discovered it independently. Alfred Marshall (1842-1924), Abba Lerner (1903-

82) and Joan Robinson (1903-83). The condition seeks to answer the following question: when

does a real devaluation (in fixed exchange rates) or a real deprecation (in floating exchange

rates) of the currency improve the currentaccount balance of a country?

For simplicity, assume that trade in service, investment-income flows, and unilateral transfer are

equal to zero, so that trade account is equal to current account. In its simplest version, the MLR

condition states that a real devaluation (or a real deprecation ) of the currency will improve the

trade balance if the sum of elasticity ( in absolute value) of the demand for imports and exports

with respect to real exchange rate is greater than one (E+E 1).


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Note :( the real exchange rate is the relative price of foreign good in terms of domestic goods. A

real deprecation is equal to a nominal depreciation if the domestic price and foreign price levels

remain unchanged). To see this, suppose that the trade balance is expressed in units of home

currency.

At one extreme, if the demand for imports has zero elasticity, then the value of imports in home

currency will go up by the full percentage of real devaluation/deprecation. For the trade balance

to improve, the value of exports in home currency has to go up by more than full percentage of

real devaluation / deprecation. This is the case when the export elasticity is greater than one. At

other extreme, suppose the elasticity of demand for export is zero.

Then, following a real devaluation /depreciation, the value of export in home currency will

remain the same. For the trade balance to improve following a real devaluation/deprecation, the

value of imports in home currency has to go down. This is the case when the elasticity of

demand for imports is greater than one. So what the MLR condition states is that, in the event of

real devaluation, if each elasticity is less than one, but the sum is greater than one, then the

increase in imports(measured in home currency) will be more than offset by the increase in

exports( also measured in home currency ) and the trade balance will improve. The algebraic

proof of this can found in any respectable textbook on international economics (e.g. caves

Frankle and Jones, 2002)

This elementary condition rests on two assumptions. The first assumption is that we start from a

situation of balanced trade. The second assumption is that the supply elasticity is infinite. It

remains to examine each of this assumption in turn

If the initial situation is a trade deficit, then the MLR condition is a necessary, but not sufficient,

stability condition (when measured in home currency).

Indeed, consider (again) the case where the elasticity of demand for imports is zero. Thus, thevalue of imports in home currency will go up by the full percentage of real

evaluation/deprecation. But, because of the trade deficit the initial value of import was greater

than the value of exports. To improve the trade balance, the required percentage increase in

exports has to be larger than the percentage of real devaluation (in part to compensate for the

relative smaller size of exports). It should be donated when the trade balance is expressed in


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foreign currency, and if the initial situation is trade deficit, then the MLR condition is sufficient,

but not necessary, stability condition.

A more complex version of the MLR condition involves supply elasticitys that are less than

infinite. It can easily be shown that the smaller the sum of the supply elasticitys, the more likely

it is the MLR condition will be met (even if E+E3 less).

Marshall (1923, p.354), who was the first to formulate this stability condition could not imagine

that it would not be met. Nothing approaching to this has ever occurred in real world: it is

inconceivable, but it is imposable. He did not, supply any proof for his affirmation. Early

econometric estimates found trade elasticity has to be Lowe to satisfy the MLR condition (chang,

1951). This led to fear of elasticity pessimism (Machlup, 1950). After a careful reexamination

of statistical problems involved, these early pessimistic estimates were refuted by Orcutt (1950)

and other (sited by Gebreegziabher, 2003).

Hooper et al (2000, pp8-9) have estimated the short run and long-run price elasticitys of export

and imports for the group of seven (G7) countries.

2.1.2. Absorption Approach

The absorption approach considers the current account balance as the difference between income

and absorption, or equivalently, the difference between savings and investment. This approach is

a macroeconomics-oriented approach. It investigates the effect of exchange rate change on trade

balance through the absorption channel where income and relative prices changes by adjust. This

approach states that if an economy spends more than what it produces (i.e. absorption exceeds

income), it must import from other countries for its excess consumption and spending. This

economy thus runs a current account deficit. On the other hand, if this economy spends less than

it produces (i.e. income exceeds absorption), it runs a current account surplus. Since the sum of

current account and capital account must equal zero ex postin a flexible exchange rate regime,

shocks that occur first in capital account will obviously affect current account, vice versa.

Therefore, the absorption approach argues that it is necessary to include determinants of capital


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account balance when modeling the behavior of current account. This approach argues that the

exchange rate is unimportant in current account adjustments (Krugman, 1987).

This is the macro economics-oriented approach. It is based on a few simple macroeconomic

identities. Its strength is simplicity and practically. Its weakness is the lack of deep theoretical

foundation. But maybe this approach is more useful for looking at the real situation of your

country. (It can be said that the inter-temporal optimization model above is a much stronger

model than this because it is not only satisfies obvious identities but also assumes optimization).

Let starts with well known national income identity.

Y= C +I+G +X-M

(Y-income, C- private consumption, I- private investment, G- government expenditure

X- Export, M- import)

C+I+G are often called domestic demand. However, here we use more technical term

absorption or A they are the something. A= C+I+G.

The current account (CA) is X-M (here we ignore other items in CA like factor income, etc)

From above we can easily see that X-M = Y-A or simply CA= Y-A

In other word the CA is an excess of a nations production (y- income) over absorption (domestic

demand or A), Y is what the countries produces and A is what it spend for consumption and

investment and the gap is CA. Increasing Y is supply side problem. The IMF thinks that

economies liberalization (free trade, privatization, deregulation, etc) will unleash private sector

dynamisms and boost output, but this will take time, even if it is successful.

2.1.3. Inter temporal approach

Alternatively, the inter temporal approach to the current account views the current account (CA)

as the difference between domestic saving (S) and domestic investment (I): As Noted earlier, the

saving investment approach is very similar to absorption approach because it based on one

additional simply identity. It is simple, microeconomics oriented, and useful for discussing the

reality. Recall the previous national income identity on expenditure side:

Y= C+I+G+X-M


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To this we add the national income identity on the disposal side,( how people earn income and

allocate it to different uses). Y=C+S+T, (S- saving, T- tax). This side at income is divided

consumption, saving and taxes. (Sequentially, it may be more reasonable to say, first we pay

taxes, and then spend and saving the remainder or maybe you saves first?

CA = S Iand focused on macroeconomic factors that determine the two variables, SandI. The

Inter temporal approach recognizes that saving and investment decisions result from forward

looking calculations based on the expected values of various macroeconomic factors. It tries to

explain the current account developments through closer examination of inter temporal

consumptions, saving and investment decisions. This approach has achieved a synthesis between

the trade and financial flow perspectives by recognizing how macroeconomic factors influence

future relative prices and how relative prices affect saving and investment decisions (Obstfeld

and Rogoff, 1995). In addition to this, the basic insight of the inter temporal approach to the

current account is that the current account can act as a shock absorber that enables a country to

smooth consumption and maximize welfare in the presence of temporary shocks in a countrys

cash flow or net output. While the basic permanent income model has been very helpful in

explaining current account movements at business cycle frequencies, the consumption smoothing

perspective has generally had less to say on sustained current account imbalances and trend

developments.

Nevertheless, the model can be used to analyze longer-term variation in current account

balances, as illustrated by the relation between the current account, investment and the stage of

economic development in the permanent income model.

In particularly, inter- temporal approach suggests that the stage of economic development is an

important factor in explaining current account developments in the long-run. To be more

specific, a small open economy that is initially capital and income poor, provided it has access to

international capital markets, will run current account deficits for a sustained period of time to

build its capital stock while maintaining its long-run rate of consumption. During the adjustment,a relatively high marginal product of capital will attract capital inflows and raise external

indebtedness. Eventually, as output grows toward its long-run level and the return on capital

converges to its value abroad, the current account will improve toward (zero) balance as net

exports move sufficiently into surplus to pay the interest obligations on the accumulated external

debt.


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2.2 Empirical Literature Review

2.2.1 Cross -Country Studies on Current Account

In the early stage, the empirical literature concentrates more on analyzing the current accounts in

developed economies rather than in developing economies or emerging Asian economies mainly

due to the lack of data. After the 1997 Asian financial crisis, the literature has a tendency to

focus more on the behavior and determinant of current account balances in emerging Asian

economies and developing countries, especial after the emergence of global current account

imbalances. Despite the heterogeneous current account behavior in each emerging Asian

economies, most of the empirical studies have been carried out in a multi-economy framework.

This section reviews some of these studies below, which have examined on the determinants of

current account using different estimation approaches and giving different findings.

Chinn and Prasad (2003) investigate the medium-term determinants of current accounts by

adopting a structural approach that highlights the roles of the fundamental macroeconomic

determinants of saving and investment. Their basic data set has annual data for 18 industrial and

71 developing countries and covers the period 1971-1995. Both cross-section and panel

regression techniques are used in their study to examine the properties of current account

variation across countries and over time. They find that initial stocks of net foreign assets and

government budget balances have positive effects on current account balances. In addition, they

also find that measures of financial deepening are positively correlated while indicators of

openness to international trade are negatively correlated with current account balances among

developing countries.

Gruber and Kamin (2007) assess some of the explanations that have been put forward for the

global pattern of current account imbalances that has emerged in recent years, particularly the

large U.S. current account deficit, and the large surpluses of the developing Asian economies.

Their work is based on the work of Chinn and Prasad (2003), using a panel data of 61 countries

over the period 1982-2003, and including the standard current account determinants (per capita

income, relative growth rates, fiscal balance, demographic factors and international trade

openness). They find that the Asian surpluses can be well explained by a model that

incorporates, in addition to standard determinants, the impact of financial crises on current


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accounts. However, their model fails to explain the large U.S. current account deficit even when

the model is augmented by measures of institutional quality.

Debelle and Faruqee (1996) try to explain both short-run dynamics and long-run variations of

the current account by using a panel data of 21 industrial countries over the period 1971-1993

and an extended cross section data that includes an additional 34 industrial and developing

countries. They adopt a saving-investment perspective to motivate empirical specifications that

contain the structural determinants of current accounts. Their work finds that relative income,

government debt, and demographic factors play a significant role on the long-run variation of the

current account in the cross section, while fiscal surplus, terms of trade and capital controls do

not. In addition, by estimating partial-adjustment and error-correction models using panel data,

they find that fiscal policy has both short-run and long run impacts on the current account in the

time series. Furthermore, they find that the real exchange rate, the business cycle, and the terms

of trade also have short-run effects on the current account.

Calderon, Chong and Loayza (2002) attempt to extend the work of Debelle and Faruqee in

(1996) by applying more advanced econometric techniques to control for joint endogeneity and

by distinguishing between within-economy and cross-economy effects. They used a panel data of

44 developing countries over the period 1966-1995 to examine the empirical links between

current account deficits and a broad set of economic variables proposed in the literature. By

adopting a reduced-form approach rather than holding a particular structural model, they find

that current account deficits in developing countries are moderately persistent. Higher domestic

output growth, increase in the terms of trade and the real exchange rate appreciation tend to

worsen the current account deficit. On the other hand, increases in the public and private savings,

higher growth rates in industrial countries and higher international interest rates have favorable

impacts on the current account balance.

2.2.2 Current Account Studies in Ethiopia

In case of Ethiopia even-though there is no many researches regarding to determinant of current

account, some topics or researches that goes with microeconomic theory and policy areas are the

following:

According to Asmerom Kidane (1997) - conduct a study on the macroeconomic consequence of

Ethiopia exchange rate policy. The models/equations are estimated by ordinary least squares


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(OLC) by using annual covering the period between1974 and 1991. He indicated that the

exchange rate overvaluation was among the consequence of poor macroeconomic management

during 1974-1991. The overvaluation of currency discourages exports and made imports

artificially cheep. This resulted or leads to persistent current account deficit over the period. The

government was forced to balance the deficit mainly through money creation, which resulted in

double-digit inflation. Prices of non-tradable increased as much as the ratio of inflation rate.

Imposition of exchange rate control led to the emergence of parallel markets. The gap between

the parallel and official exchange rate was widening. The author also described some changes

after the October 1992 devaluation. The ratio of parallel to the official exchange rate reduced

from 3.62 before devaluation to 1.25 in September 1993. The extent of smuggling of coffee

through the borders had been reduced. On the contrary, the supply of coffee through official

market increased. There was slight improvement in the balance of payments position over 16

quarters after the devaluation. However, he admitted that the period was too short to reach in to a

consensus.

In his master thesis Mulu Woldeyes (1997) examined the effect of budget deficit on the current

account deficit during the period 1970-1995. Using Rodriguezs model he constructed the current

account function. The results of his study suggested that more than half of the changes in the

budget deficit were found to spill over to the same direction change in current account deficit. He

concluded by saying that fiscal adjustment should be taken as a prerequisite for current account

adjustment.

According to Haile kibret (2001) adopted the Monterey approach to the Balance of payment in

Ethiopia. The study investigated the role of money market in determining the Balance of

payment deficit using Johansen maximum likelihood vector error corrective modeling technique.

The empirical result suggested that money played a significant role in enplaning Balance of

payment. The writer conclude his study by suggesting that Monterey authorities have to pay

attention in controlling domestic credit creation in order to improve external balance. The

relationship between Ethiopian current account and its determinant will be analyzed in relation to

nature of economy, persistence of shocks and with respect to the impacts of the determinants on

traded and non tradable sector. The specific contribution of the study on Ethiopian current

account is that they have identified the impact of monetary and fiscal policies on Ethiopian


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current account balance. However they did not make comprehensive empirical investigation on

determinant of current account balance.


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CHAPTER THREE

3.1 Research Methodology

3.1.1 Source of data

For the study secondary source of data will be used due to availability of data. The time series

data ranging from1980/81 to 2010 will be considered on determinant factors that affect current

account deficit of the Ethiopia economy and other variables for descriptive analysis.

All the data is gathered from secondary source, and most of data are found from world bank

report and data bank, the research department of national bank of Ethiopia, Central Statistic

Agency, Ministry of Finance and Economic Development and other national and international

organizations study, different policy document, research paper, books, magazines bulletins, news

paper, survey and analyze on the current account balance of Ethiopia would be considered and

others necessarys to the issue. This data will be used to develop the model or inferential

analysis.

3.1.2 Model specification

Model specification is important part of research since if the model did not specify correctly it

lead to spurious regression.

In developing countries model it is difficult to include all the impact and determinant factors that

affect current account balance of the country because of the unavailability of all data required

and unquantifiable of determinants, consider the following variable are used as determinants of

current account balance of Ethiopia.

The model specification shows the regression of Ethiopian current account balance on set of

macroeconomic variables. First current account can be defined as follows by three forms:

1.

Income minus absorption CA=Y-A

2. Saving minus investment. CA=S-I+T-G3. Net export of good and service plus net transfer. CA=X-M+NT

Where, Yincome I-Investment M-import


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S-saving T- tax revenue NT- net transfer

X-export G-government expenditure A-absorption

This identity implies that factor which determine export, import, income consumption, saving

and investment also determine the current account balance of Ethiopia.

CAGT=o+ 1CONt+ 2RGDP t +3OPP t+ 4REERt + U t

Whereas: - CAGT- ratio of current account to GDP

CON-Consumption RGDP- Real gross domestic product OPP- Openness REER- Real exchange rate U t -Error termt- Period of time t=1, 2, 3.n

Relationships between economic variables are generally in exact. To allow for the inexact

relationships between economic variables, the econometrician would modify the deterministic

current account balance function by adding Ut.

Where U, known as the disturbance or error term or is a random (stochastic) variable that has

well-defined probabilistic properties. The disturbance term U may well represent all those factors

that affect or determine current account balance of the country but are not taken into account

explicitly.

3.1.3 Variables Description

A. Dependent variableCurrent account ratio to GDP (CAGT)


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1. CAGT is the differentiation between the total value of export and the total value of import of

goods in the country to gross domestic product. If the differentiation is positive, it is CA surplus

and it shows exportable surplus and boom of economic activity of the country whereas the

differentiation is negative, it is CA deficit and it shows exportable deficit and huge amount of

goods consumed by the resident of the country and also indicates export is not at competitive

position.

B. Independent variables

1. Consumption (CON): A variety of models predicts a negative relationship between total

consumption and current accounts over the medium term. Since when increase in consumption

net saving of individual decrease. According to inter temporal or saving and investment approach

of current account factors that decrease saving would cause negatively effect on current account

balance of the country.

2. Real Gross domestic product (RGDP). An increase in the domestic output growth rate

(RGDP) has the effect of expanding the current account deficit. As theoretical domestic

economic growth accelerates demand for foreign goods and services and consequently

deteriorates the current account balance (Abel and Bernanke, 2001). Although a rise in domestic

output growth may be associated with a greater savings rate, it seems that its correlation with the

investment rate is somewhat stronger, thus leading to a worsening of the current account balance.

So real GDP will be expected to have a negative relationship with current account balances,

which is by encouraging import and bringing about deterioration in current account.

3.Openness (OPP): The trade openness is measured as the difference of exports and imports toGDP ratio. It not only measures the degree of an economys openness to international trade, but

also reflects some of the macroeconomic policies that could be relevant for the current account

determination.In fact, the openness variable could be indicative of attributes such as liberalizedtrade, receptiveness to technology transfers, and the ability to service external debt through

export earnings (see MFR, 1996). Thus, transitional countries with greater exposure to

international trade tend to be more attractive to foreign capital. For examples such as liberalized

international trade, receptiveness of technology transfers, and ability to service external debt

through export earnings. In general, this variable measures the degree of various trade


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restrictions, which are likely to impede a flow of goods and services from abroad. An economy

with more trade restrictions is likely to send an adverse signal to foreign investors. On the other

hand, an economy with less trade restrictions and more exposure to international trade tends to

be relatively more attractive to foreign capital (Chinn and Prasad (2003)). Therefore, trade

openness is likely to be associated negatively with the current account balance. The common

empirical literature usually expects a negative relationship between trade openness and current

account balance. International trade in goods and services is a principal channel of economic

integration, which has an impact on the determination of current account. Gruber and Kamin

(2005) mentioned that more open economies are likely to have larger tradable goods sectors and

thus be able to adjust their external balances more flexibly. In addition to this, economies that are

more open to international trade they have more capacity to generate foreign exchange earnings.

However, the expected sign of the openness ratio is ambiguous. Gruber and Kamin (2005) find

that larger current account balances are associated with greater degrees of economic openness.

4. Real effective exchange rate (REER): The REER can affect the current account balance in

various ways. First, based on the elasticity approach, the Mundell-Fleming model suggests that

an increase in the REER can have a negative effect on an economys international trade

competitiveness. It is quite likely to lower exports and increase imports, leading to a worsening

current account balance. However, the overall effect on the trade balance depends on the relative

size of the import and export volume elasticity assuming full pass-through of the exchange rate

to relative prices. The absorption approach also suggests that a home currency appreciation can

lead to a switch in spending from domestic to foreign goods through its impact on the terms of

trade and domestic production, and thus deteriorates the current account balance. Second, the

Balassa-Samuelson effect states that an appreciation in home currency reflects productivity gains

in the domestic manufacturing as well as the demand side influences, for examples, the use of

capital inflows and high government spending to build up infrastructure. Moreover, after a home

currency appreciation, the purchasing power of current and future income increases, as does that

of monetary and property assets already accumulated. This positive wealth effect has a negative

impact on the propensity to save. Therefore, an increase in the REER is negatively associated

with it. In this study, an increase (decrease) in the REER series denotes a real appreciation

(depreciation) in the home currency the propensity to save, and consequently with the current

account balance. Third, the consumption-smoothing hypothesis suggests that the current account


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acts as a buffer to smooth consumption in the face of shocks to national cash flow (i.e. output

less investment). In response to an increase in the REER, an open economy would prefer to run a

current account surplus and invest abroad rather than allow consumption to increase. As a result,

a home currency appreciation can result in an improvement of the current account (Herrmann

and Jochem, 2005). Finally, an increase in the REER can also have a negative balance sheet

effect on an economys NFA and affect remittance flows (Faini, 1994). After all, the link

between the REER and the current account balance can only be determined empirically.

3.1.4 Method of Data Analysis

In this study, two method of data analysis is used to explain the relationship between the

dependent and independent variable. To do this descriptive data analysis will be used that is

useful to look the variation of dependent variable to be explained and compare it with the

characteristics of variation in explanatory variable. Hence conducting descriptive analysis is used

before under taking regression analysis help us to learn much about the relationship between

dependent and independent variable.

I used econometrics analysis or economic data in order to lend empirical support to the economic

model and obtain numerical result and quantitative analysis.

Since the important part of econometric model is empirical model. In addition to descriptive

analysis, in order to capture the degree of influence of some of the determinants of current

account balance, econometric analysis would be applied. The time series data to run the

regression covers the year between 1980 and 2010 in using a time series data but there is a

possibility of getting a dubious (suspicious, full of doubts) result because of non-stationary of the

data. This kind of regression is called spurious regression due to this kind of problem a stationary

test(it is a test of whether the data has constant mean, variance, covariance with time variation.

since the need for stationary test arises because estimating regression using non-stationary

variables based on ordinary least squares (OLS) leads to spurious and inconsistent results

(gujirat,1995).In addition, if variables are non-stationary, it is difficult to conduct hypotheses

testing because classical assumption on the property of error term, which zero mean constant

variance and non-auto correlated, will be violated (harris,1995).Therefore, stationary test is very

essential.) will be applied in this study. The estimation of model will be made using ordinary


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least square method (OLS) with different tests. If the model is not correctly specified we

encounter the problem of model specification error or model specification bias(exclusion of

variables or unobserved heterogeneity, incorrect mathematical form(if we wrongly apply

quadratic form while it not),neglecting dependent variable lags, generally, leads to model

important specification bias and those are cause for auto-correlated, heteroskedasticity. The

model may have omitted important variables or have used the wrong functional form(Wrong

functional form:Even if we have theoretically correct variables explaining a phenomenon and

even if we can obtain data on these variables, very often we do not know the form of the

functional relationship between the regressand and the regressors. Is consumption expenditure a

linear (invariable) function of income or a nonlinear (invariable) function? If it is the former, Yi

= 1 + B2Xi + uiis the proper functional relationship between YandX,but if it is the latter, Yi =

1 + 2Xi + 3Xi2+ ui may be the correct functional form. In two-variable models the functional

form of the relationship can often be judged from the scatter gram. But in a multiple regression

model, it is not easy to determine the appropriate functional form, for graphically we cannot

visualize scatter grams in multiple dimensions. To aid us in determining whether model

inadequate is on account of one or more problem we can use some of the following test (test of

Stationary, Co-integration test, Error Correction Method (ECM) test, Specification error test,

Test for heteroskedasticity ,Test for Multicollinearity, Test for autocorrelation). Test is useful in

econometric analysis, since the data may face some error, which leads to wrong decision making.

3.2 Estimation procedures and Results

3.2.1 Stationary and Non-stationary series

In Economic research involving time series data before any kind of statistical estimation takes

place, the data of all variable in the model have to be tested for their stationary. This is mainly

because the model may contain non-station any variable that would lead to problem o f spurious

regression.

Theoretically time series is a collection of random variables such collection of random variables

ordered in time is called a stochastic process. A stochastic is said to be stationary if it is mean(x)

and variance (var(x)) are constant over time and value depends on the distance or lag between


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two time periods and not on the actual time at which the covariance (cov(x)) is computed.

(Gujarat, 1992)

If the time series is not stationary has both economic and statistical implication. The statistical

implication is that the variable will not have constant mean, variance and covariance if they are

plotted against time (Gujarat, 1995).

A given series is said to be stationary if its mean and variance are constant over time and the

value of the covariance between any two time periods depends only on the distance or gap or lag

between the two time periods and not the actual time at which the covariance is computed.

Generally the concept of stationary can be summarized by the following conditions. A time

series {yt} is said to be stationary if:

Constant mean( E[yt]=E[yt-s]=) Constant variance(E[yt- ]2=E[yt-s- ]2=y2 and Auto covariance(E[yt-][yt-s-]=E[Yt-j-][yt-j-s-] = (s)Where ,y

2,(s) are all constant (free from t)

Stationary may be weak or strong stationary (i.e. the whole distribution of the variable does notdepend on time). Time series to be weak stationary if, E (Yt) is constant and independent of time,

var (yt) is infinite, positive constant and independent of time and cov(yt, yk) is a finite function of

t-k but not of t or k.

The assumption of stationary is somewhat unrealistic for most macroeconomics variables. The

non stationary process arises when at least one of the conditions for stationary does not hold.

Let us consider an autoregressive of order 1, AR (1) process:

yt=yt-1+t [1]

Where, t denotes a serially uncorrelated white noise error term with a mean of zero and a

constant variance.

Equation [1] can be expressed as follows


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Yt=TYt-(T+1) + t +t-1 +

2t-2 +3t-3 +4t-4++t-T [2]

Non-stationary can originate from various sources but the most important one is the presence of

so-called unit roots, which means when = 1 in equation [1] or remain equal to one as T

goes to infinity in equation [2]. Equation [1] and [2] becomes random walk without drift model.

If a variable is stationary in level, i.e. without running any differencing, then the variable is said

to be integrated of order zero, denoted by I(0). Similarly, if it becomes stationary by differencing

once, then the variable is side to be integrated of order 1, written as I (1). Unit-root test helps to

detect whether a variable is stationary or not. It also provides the order of integration at which

the variable can be stationary.

A spurious regression occurs when the regression results are detected and there is a positive and

significant relation between variables, but the variables do not have a meaningful and cause-

effect relationship. It results when one regress a non-stationary variable on another.

To avoid such spurious trend and conduct a meaningful econometric regression, we have to

avoid the unit roots. The most widely used method to avoid the problem of unit roots is

transformation of the variables by way of differencing to remove the non- stationary (stochastic -

trend).

The other usual method to take care of spurious regressions is to use the technique of co

integration (making the difference stationary rather than the individual variables).In any time -

series; however, we test for the presence of unit roots before proceeding to undertake other

analysis.

3.2.2 Tests for unit roots (not stationary)

A test of stationary (or non-stationary) that has become widely popular over the past several

years is the unit root test. For a number of reasons, it is important to know whether or not an

economic time series has a unit root. A Nelson and Plosser (1982) pointed out; non stationary

often has important economic implications. It is therefore very important to be able to detect the

presence of unit roots in time series, normally by the use of what are called unit root tests. For

these tests, the null hypothesis is that the time series has a unit root and the alternative is that it is

I (0).The widely used unit-root tests are Augmented Dickey Fuller test (ADF).

I) Dickey Fuller (DF) test


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The simplest form of the DF (Dickey fuller, 1979) test amounts to estimating

Yt =yt-1 + ut [3]

One could use a t- test to test the hypothesis =1 against < 1. Alternatively, one can rearrange

the model as follows:

Yt-yt-1=yt = ( -1) yt + ut

Or, in short,

yt= yt + ut [4]

Where ut is IID (0, 2) with =-1

The test hypotheses are H0: =0 against H1: >0.However, using regression equation like

equation [4] is valid when the overall mean of the series is zero.

When the underline data generating process is not known, it is better to allow a constant or/ and a

time trend and then to test for a unit root. In that case, the model needed to be tested for the null

hypothesis of stochastic trend (non stationary) against the alternative of stationary up to

deterministic trend. In practice, the model may involve a constant or a trend. Dickey and Fuller

(1979) actually considered the three models

1. yt =yt-1+ut2. yt =+yt-1+ut and3. yt =+ ct+yt-1+ut

For each model, one will need to use different critical values. The reason is that, under nonstationary the t-like statistic computed does not follow a standard t-distribution, but rather a DF

distribution.

II) Augmented Dickey Fuller (ADF) test


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The ADF test is comparable with the simple DF test, but it is augmented by adding lagged values

of the first difference of the dependent variable as additional regressors which are required to

account for possible occurrence of autocorrelation. Consider the AR (p) model:

Yt = +1yt-1+ p yt-p + t [5]

We can write equation [5] as:

Yt = +1yt-1 + yt-1 + t

=-(1- ) and i =

The test statistics is t DF =

where hat is OLS estimate of = ( -1), tDF has to be

compared against the 95% critical value of the appropriate DF distribution,which depends on the

inclusion of the linear trend and the lag structure. Then we use the t-statistic on the coefficients

to test whether we need to difference the data to make it stationary or we need to put a time trend

in the regression model to correct for the variables deterministic trend. The null hypothesis for

the test is given as H0: = 0, there exists a unit root problem.

The econometrics model will be valid if and only if the variables in the model passed stationarytest because this test shows a long-term relationship between dependent and independent

variables of the model.

3.2.3 Co-integration

Estimation of non-stationary time series data and analysis of short run dynamics is often done by

first eliminating the trend in the variables, usually through the process of differencing till

stationary is achieved.

This procedure, however, throws away potential valuable information about long run

relationships which economic theories have a lot to say about (Maddala,1992).These problems of

loosing long run information can easily be amended if it is possible to find a co integration

vector through a co-integration analysis.


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The concept of co-integration mimics the existence of long run equilibrium to which an

economic system converges over time, whereas the absence of co-integration leads to the

problem of spurious regression (Harris, 1995: Harris and Sollis, 2003). Two broad approaches

for co-integration have been developed. These are Engle and Granger (1987) method and the

Johansen approach, due to Johansen (1998), based on vector autoregressive model (VAR)

(Green, 2003).

On the other hand, the usual approach used to handle unit root problem (non stationary at level)

is to difference all non- stationary variables used in the regression. But, while the use of

differenced variables avoids the spurious regression problem, it will also remove any long run

information that may be of interest (Paulos, 1999). Our interest here is to investigate whether the

explanatory variables (Consumption, Real GDP, Real Effective Exchange Rate (REER), and

Openness) have a significant role in determining the long run path of Current Account Deficit.

Thus, if the variables co integrates at levels, we will proceed to estimation of the model.

Co- integration is defined as a situation where two or more series are linked to form an

equilibrium relationship across time. In plain terms, even if the individual time series data are

non- stationary, their linear combination could be stationary and they will move closely together

over time to make their differences stable (stationary). This is to say, the linear combination

cancels out the stochastic trends in the two series (Gujarati, 2003); and a common stochastic

trend should be shared among them in the long run. That is, they should not drift apart from each

other as time goes on.

3.2.4 Co-integration TestsTwo variables will be co-integrated if they have a long-term, or equilibrium relationship between

them. A test for co-integration can be thought as a pre-test to avoid spurious regression situation.

There are the two test that most used to test co-integration which are the Engle - Granger, and

Johnsons test. But in this study, I use the case of Engle - Granger (EG) test.

In the Engle-Granger two-step procedure, there are two steps to attend to if Yt = I (1) and

Xt = I (1):

Step 1: The residual from a long run model OLS regression is tested for unit roots based on

ADF statistics.


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Step 2: Order of integration is tested whether the error term t = I (0) against its alternative t

= I (1) from the first OLS regression.

The EG twostep procedure is easy to implement but is constrained in some ways. The method

assumes only one (single) co-integrating vector and is thus unable to trace more than one co -

integrating relationship. Moreover, it presumes that the explanatory variables are weakly

exogenous (determined outside the model) while the dependent variable is endogenous. But in

many instances, there exists endogenous character among variables and, inferences made based

on such pre-supposition may sometimes be misleading.(Mohammed, 2005).

As Enders (1995) puts it, perhaps the major limitation is that, the estimation of the long run

equilibrium regression using EG requires that the researcher places one variable on the left and

use others as regressors.

Johansens procedure has improved up on these pitfalls but since the model to be estimated in

this study fulfils the requirements of the EG methodology, we wont use the alternative approach

though it has the benefit of a single step procedure that is absent in EG procedure.

3.2.5 E

ethiopia tax

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