Exchange rate development in Ethiopia
The legal tender currency of Ethiopia was issued on 23 July 1945 by defining the monetary unit as the Ethiopia dollar (E$) with a value of 5.52 grains (equivalent to 0.355745 grams) of fine gold. The linkage with fine gold was in accord with the monetary system established by the Bretton Woods Agreement of 1944. For the five years following the proclamation of the national currency (1945–1950), money supply of the country was determined by the balance of payments (reflected in the volume of currency issued) and the supply of domestic credit. However, the impact of domestic credit on money supply was small as the government was running a budget surplus; private credit was limited to trade (particularly external trade), consumer credit was unknown and other users of credit (such as manufacturing industries) were virtually nil. Following the introduction of saving deposit, broad money came to the scene in 1946 with growth rate of 8.8% as compared to 17.3% growth rate during the 1945–1950period. This is due to the substitution of the national currency during the early years of the period particularly in 1945 and 1946. Nevertheless, the expansion of money supply during 1945/1946 had to be explained more by exogenous factors vis-avis domestic needs. During the 1950–1963 period, money supply was explained by balance of payments and domestic credit. The impact of domestic credit on money supply was enhanced in response to growing economic activities. Thus, domestic credit came to play the dominant role in determining the growth rate of money supply in the 1950s and early 1960s. Money supply increased from E$259.6 in December 1963 to E$694.3 million in December 1974. Broad money also increased from E$306.6 million in 1963 to E$1,075 million in 1974. The main factor behind the expansion of money supply during 1964– 1975 was again the expansion of domestic credit to both the private sector and the government. The drastic increase in broad money supply during the Derge regime and the 1993–1996 period was mainly attributed to domestic deficit financing (which mainly took the form of borrowing from the banking system) and the domestic credit expansion to the private sector specifically during the latter period.
Exchange rate determination
There are different theories and approaches that deals with factors affecting exchange rate among them the major ones are:
1- Parity Conditions
2- Balance of payment approach
3- Asset Market approach
Each of these approaches won’t be able to fully explain the complex global currency markets individually but it is necessary to combine them all in order to have a good sense how currency markets work.
1- Parity Conditions
The theory of purchasing power parity, the most widely accepted of all exchange rate theories, states that the long run equilibrium exchange tare is determined by the ratio of domestic prices relative to foreign prices.
Under conditions of freely floating rates, the expected rate of change in the spot exchange rate, differential rates of national inflation and interest, and the forward premium and discount are all directly proportional to each other and mutually determined. A change in one of these variables has a tendency to change all of them with a feed back on the variable that changes first. The absolute version of the absolute version of the theory of purchasing power parity states that the spot exchange rate is determined by the relative prices of similar baskets of goods. While the relative version of the theory of purchasing power parity states that if the spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate. While the purchasing power parity tries to relate how price of goods in different countries should be related...
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