External shocks and real exchange rate movements in Tanzania

This study analyzes the role of external shocks on the real exchange movements in Tanzania during the 1960-2013 periods. The study tests whether external shocks are responsible for or play part in the real exchange rate fluctuations in Tanzania. In this study, the role of external shocks on the real exchange rate movements in Tanzania is investigated using annual time series data and a fully modified ordinary least squares model. Empirical results of the study reveal that external shocks do impact the real exchange rate and more so, the two are cointergrated in the long run. The terms of trade as well as Foreign Direct Investment (FDI) appreciate the real exchange rate in Tanzania while trade openness depreciates the real exchange rate. The foreign interest rate and foreign aid were found to be insignificant in impacting on the real exchange rate movements in Tanzania. The policy implications of the study include the need for a stabilization policy that is; in case of a rapid depreciation of the local currency, the Central Bank can promptly act to restore currency stability by imposing trade restrictions on the import of goods and services, encourage FDI inflows and increase exports. In case of a rapid appreciation then, the Central Bank can reverse these policies by removing trade restrictions on importation of goods and services as well as discouraging exports and FDI inflows.