Real exchange rate volatility and international trade flows in Tanzania

This study empirically examines the effectof real exchange rate volatility on trade flows in Tanzania for period of 1968 to 2007. This is implemented by estimating export and import functions which included real exchange rate volatility as one of the explanatory variables. The study used two multilateral real exchange rate indices as a measure of real exchange rate namely, export-based index and import-based index. The reason for having two indices was because Tanzania's leading trading partners on the export side and import side are not the same. Therefore, the indices were computed using ten leading trading partners on the export side and the import side. The study employed recent ARCH family models to measure volatility. Firstly, the GARCH (1,1) model was employed but when it was found to violate the non-negativity condition, the EGARCH(1,1) was employed to resolve the problem. The two-step Engle-Granger technique was used to test cointegration of variables, and ultimately error correction models for both export and import functions were estimated using Ordinary Least Squares. The results show that real exchange rate volatility has no effect on trade flows in Tanzania. The coefficient on real exchange rate volatility was negative but insignificant at the 10 percent level. The study found that it is the real exchange rate rather than its volatility that actually affects trade flows. Therefore, any policy action to reduce volatility with the aim of improving trade flows will be unjustified. However, the study does not dismiss the possibility of real exchange rate volatility to affect the economy through other channels and therefore appropriate policies could be applied to avoid large exchange rate fluctuations.