Modeling Exchange Rate Dynamics Determination a Study from the Emerging Market Economy of Tanzania

Abstract

This study constructs a macro-econometric model to analyze the exchange rate dynamics of the emerging market economy of Tanzania. After analyzing the exchange rate dynamics, the study develops an exchange rate forecasting model based on the macroeconomic variables dynamics which co-integrate with the exchange rate dynamics. The model enables the identification of key economic variables that dictate the exchange rate dynamics in Tanzania, as well as enabling determining of the impact of exogenous shocks on these economic variables and the policy implications on the nominal exchange rate. This study provides a basis for comparing alternative options in regard to determining exchange rate dynamics and hence determining the foreign exchange rate risk. In order to see the short-term and long-term effects of Government policies, dynamic policy simulations are conducted for the period 1986-2006. The short-term effect of a certain economic policy, which is connected to the econometric model, is measured through the difference between the shocked (disturbed solution) and control solution. The model developed, and the policy implications derived from it, provides important guidelines for Tanzanian policy makers, as the results suggest that Tanzania would benefit from the effects of monetary and external trade policies reform. This study not only provides a framework for determining and forecasting nominal exchange rate dynamics for the emerging market economy of Tanzania, but is also applicable to other emerging market economies in Africa, including member states of East African Community, which also have been experiencing the same economic evolution.