Relationship between inflation and exchange rate in Tanzania: the vector error correction model

Abstract

The study aims at analyzing the relationship that exists between the inflation rate and the exchange rate in Tanzania. The study uses annual time series data from 1981 up to 2018 and employed Vector Error Correction Model to examine long-run and short-run relationships. The results indicated that both a short-term and a long-term relationship was found. Therefore, the government of Tanzania is required to control the inflation rate through the proper use of fiscal and monetary policy effectively to control the inflation rate in Tanzania. This will affect the exchange rate in Tanzania. Granger causality test also shows that the inflation rate influences the exchange rate in Tanzania and through the use of a CUSUM square test it shows that the model lies within a 5 per cent level. Based on the findings, it is recommended that the Tanzanian government should implement stringent fiscal and monetary policies to maintain low inflation rates. By stabilizing the inflation
rate, the government can positively influence the exchange rate, thus ensuring economic stability. Future research should explore additional macroeconomic variables that may affect this relationship to provide a more comprehensive understanding. Moreover, continuous monitoring and adjustment of these policies are essential to adapt to the dynamic economic environment. Overall, maintaining a stable inflation rate is crucial for the favorable management of the exchange rate, which in turn supports sustainable economic growth in Tanzania.