Thirlwall's Law with Terms of Trade and Capital Flow: Evidence from Ethiopia

This paper seeks to answer ‘Is Thirlwall’s growth law valid and do the long run joint effect of relative price movement and changes in net capital inflow converge to zero in the case of Ethiopia?”. Vector Error Correction with Johansen approach to Cointegration and, Stock Watson Dynamic Ordinary Least Square approach to Cointegration were used to estimate long run parameters using annual data obtained from Penn World Table databases of version 10.0 and 10.1 for the period spanning from 1952 to 2019. The estimated long-run income elasticity of demand for import and export is 1.17 and 1.42, repectively. And the estimated price elasticity of -0.69 and -0.7 for import and export, respectively, confirms that the estimated price elasticities satisfy Marshall Lerner Condition. Parametric test approaches similar to McCombie (1999) and Alonso (2003) methods were used to test research hypothesis. The weak and the strong version predicted long run growth rate of 5.3 and 3.98, respectively while the average annual real income growth rate is 4.92 percent over the period of 1953-2019. First, based on the parametric test results obtained from McCombie’s approach, the Balance of Payment Consistent growth rates predicted by both versions of Thirlwall’s law are not significantly different from the actual growth rate. However, since prediction of the weak version shows the country has been growing below the Balance of Payment consistent rate and the fact on the ground that Ethiopia is not enjoying trade surplus, the strong version better explains the growth experience of Ethiopia and is asserted valid. Second, the Parametric test result obtained from Alonso’s approach show that relative price movement and changes in net capital inflow trade off each other and have zero sum effect on real income growth in the long-run. Therefore, in this paper, it is asserted that the strong version of Thirlwall’s growth law is valid in the case of Ethiopian Economy. Hence, to relax Balance of payment constraints and improve long run economic growth, a Successful implimentation of policies that promote non-price compititiveness of export and constrain the income elasticity of demand for imports are recommended