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arch adopts and modifies the model of Rose and Yellen (1989) on aggregate analysis of the relation between Exchange Rate and trade balance. The theoretical back ground behind Rose and Yellen (1989) model was the Marshal-Lerner condition of exchange rate impact on trade balance. In the original model of Rose and Yellen (1989), domestic import demand depends on relative price of imports and domestic income level while domestic export demand is determined by foreign income and relative price of domestic export, among other things.

The functional relationship for domestic imports demand can be restated as follows:

Where: quantity of goods imported domestically,

relative price of imported goods to domestically produced goods in home currency real domestic income

Let’s represent the nominal exchange rate of the domestic currency to foreign currency. Then the relative price of imported goods can be expressed as:

Where: the foreign currency price of foreigners exports equivalent to the foreign currency price of domestic imports domestic price level

By incorporating foreign price indexes equation (2) can also be rewritten as:

Where: = foreign price level

From the definition of real exchange rate as home price deflated nominal exchange rate, can be calculated from as:

On the assumption of being constant or minimum, equivalently equation (3) can be rewritten as:

Replacing equation (4) in equation (1) we have quantity demand of import being a function of both exchange rate and income level as follows:

From the side of foreign demand for imports (home country export demand), the functional relationship can be depicted as:

Where: quantity of goods imported by foreigners or domestic quantity of goods exported is home country’s export relative prices real foreign income

Where: the domestic currency price of domestic exports

= foreign price leve and domestic price level

Again on the assumption of being constant or minimum, equivalently equation (7) can be rewritten as:

Replacing equation (8) in equation (6) we have quantity demand of export being a function of both exchange rate and income level as follows:

With the concept of domestic imports are foreign exports and vice versa, we have:

and ; Where = foreign exports and = domestic exports

From the definition a real trade balance given by Rose and Yellen (1989), we have

And the partial reduced function trade balance can be written as:

The log-linear approximation for the above relation for a time series data analysis is depicted as:

The above model of Rose and Yellen (1989) is a “two-country” model. However, in real economy, countries have many trading partners. Since the analysis of this paper also is based up on aggregate trade balance, the model used here is taking real effective exchange rate instead of real exchange rate which is the weighted real exchange rate of a country according to its major trading partner. Moreover, being a least developing country, Ethiopia‘s economy is highly supported by capital receipts such as ODA and remittances. Practically, ODA and remittances are used either directly for importing of commodities (in particular) capital goo