expected to be negative. An increase in domestic income supposedly leads to an increase in the consumption of imported goods. Therefore, δ� is expected to be positive. A rise in world income and real currency depreciation would stimulate exports, suggesting a positive sign for θ� and θ� . The ML condition can be tested by estimating Eqs. (1) and (2), and then checking whether the sum in absolute value of the elasticities ( δ� and θ� ) is greater than 1.

However, even if a devaluation improves the trade balance in the long-run under the aforementioned condition, it may worsen it in the short-run as trade in goods tends to be inelastic while import prices increase in the immediate aftermath of a change in an exchange rate (Bahmani-Oskooee and Ratha, 2004). Although the balance of trade may deteriorate in the short-term, it will improve in the long-term as consumers adjust to the new prices. This is commonly referred to as the _J_ -curve effect. The _J_ -curve refers to the trend of a country’s trade balance following a real exchange rate devaluation.

# **Empirical Framework**

The empirical analysis employs the cointegrated vector autoregressive (CVAR) methodology. The baseline model is specified with two lags and a linear trend restricted to the long-run relations: where x� is a p�1 vector comprising the above-mentioned variables (where _p_ is the number of variables), i.e. �ex�, im�, reer�, y�, y��� ; β�x��� are r long-run (cointegration) relations; α is a p�r matrix of adjustment coefficients (denoting the speed of adjustment to equilibrium); Γ� is a p�p matrix capturing short-run effects; μ� is a vector of constant terms; ε� is a p�1 vector of error terms; and ∆ is the first difference operator. Given that all variables are in logs, their differences represent growth rates.

To ensure valid statistical inference, the analysis controls for three outliers (1985, 1992, 2009) using impulse dummies. The years 1985 and 2009 coincide with periods of severe famine and global recession respectively, while 1992 marks the advent of market-oriented reforms. Of the three outlying observations, the 1992 outlier was found to have significantly caused a mean shift in the growth rates. The sharp turn from a ‘state-led’ economy to a ‘market-oriented’ one appears to have placed some of the variables on a higher growth trajectory. An algorithm searching for breaks developed in Doornik _et al_ . (2013) was used to determine the existence, timing, and significance of breaks in mean growth rates. Accordingly, the above-mentioned event was modeled using a broken linear trend �t����� in the longrun relations, β<sup>�</sup> x� (to account for the change in trend slopes underlying the long-run equilibrium relationships) and a step dummy �D�92�� in the equations, ∆x� (to model the mean-shift in the growth rates of the macroeconomic variables). See Haile (2015a) for more details.

Note that the annual sample encompasses two starkly distinct political and economic regimes: the socialist Derg regime (1974-1991) and the incumbent EPRDF regime (post-1991). Therefore, to make sure that the estimated coefficients represent constant parameter regimes, the empirical model is reestimated using quarterly data for the period 1993-2013. The model for the quarterly data included a number of impulse dummies to account for extraordinary observations.

# **Results**

## **The long-run impact of a devaluation on the trade balance**

Table 3 reports the identified long-run structure of two long-run relations. The first long-run relation is between export, REER, and world income. Only export is equilibrium correcting to the relation, signifying its importance as an export relationship: The signs of the coefficients are in line with the theoretical expectation. The results suggest that REER and world income are significant determinants of long-run movements in exports. A devaluation or depreciation of the REER leads to an increase in the exports of goods and services. The coefficient estimate indicates that the effect of a 1 percent depreciation of the REER would be to increase exports 28