and 4) are based on quarterly data for Ethiopia from 2005 to 2013. As discussed above, a 1 percent devaluation increases total exports by 0.5 percent. Disaggregation of exports uncovers that an additional depreciation induces a larger increase in exports in the manufacturing sector than in the other sectors of the economy. This is to be expected as depreciation expands manufacturing exports via resource reallocation in the export sector and particularly through incentivizing firms to enter into new export products and new markets. Conversely, real appreciation has a more negative impact on manufacturing than agricultural exports. This is in line with the well-established empirical finding that an overvalued currency is particularly damaging to the manufacturing industry. Despite the fact that the manufacturing sector in Ethiopia remains relatively nascent and might be currently less important than the agriculture and services sectors, this was also the case for many historically fast-growing countries when they first kick-started development. Expansion of manufacturing activities served as an important engine of their growth take-off.

# **5.3    The impact of devaluation on the current account balance**

In Ethiopia, most of the external current account deficit could be arrested by allowing for a significant real exchange rate depreciation (Portugal and Zildovic, 2014). Figure 11 shows that REER appreciation accounts for most of the current account deterioration over the period 2010-13. This is not too surprising given the previous finding that an appreciation of the REER has a fairly large negative and positive impacts on exports and imports, respectively. As mentioned earlier, the country’s rapidly expanding current account deficit is principally attributed to a worsening trade deficit, which is in turn on account of weak export performance and soaring imports of capital goods for public investment programs. The significant contribution of changes in the effective exchange rate to movements in the current account balance indicates that devaluation would be an important step toward reversing the downward spiral in the current account balance.

# **6.    Major Policy Trade-offs of Nominal Devaluation**

# **6.1    Will a devaluation of the birr cause inflation?**

Nominal exchange rate depreciation did not cause inflation during 2004-13 in Ethiopia (Haile, 2015a) and thus future devaluation measures will not necessarily trigger higher inflation. Perhaps the foremost cause for concern for policy makers is that rapid exchange rate adjustment will be counter-productive by increasing domestic prices and possibly leading to an inflationary spiral. Nominal depreciation drives up import prices, which feeds into higher domestic production costs and, if left unchecked, might cause higher inflation rates. Nonetheless, imported goods account for a fairly small share of the consumer price index and thus the impact of nominal devaluation on inflation is likely to be less marked. The analysis finds that, over the past decade, inflation was mainly caused by strong economic growth, monetary expansion, and international oil and food price rises (Haile, 2015a).

Demand-driven inflation and supply shocks were the dominant forces behind the inflation surges since the mid-2000s. The empirical results indicate that excessive growth in aggregate demand gave rise to an inflationary gap and that the demand-pull inflation was at least partly monetary in origin, a phenomenon commonly referred to as “too much money chasing too few goods.” The finding that expansionary monetary policy partly explains the dramatic increase in inflation is unsurprising as rapid growth of base money characterized the post-2004 period. The average annual growth in the monetary base jumped from 6 percent in 1992-2003 to about 20 percent in 2014-13, during which inflation reached astronomical proportions. In addition, significant increases in global food and oil prices contributed to the higher inflation rates.

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