Navigating Economic Ripples: How Real Exchange Rate Volatility Shapes Real Gross Domestic Product with Evidence from Tanzania

Abstract

This article aimed at examining the effects of the real exchange rate on real gross domestic product (GDP) in Tanzania using a data set spanning from 1964 to 2019. The Gregory–Hansen test was employed to check the long-run relationship between the real exchange rate and real economic growth. Structural vector autoregressive and vector error correction models were employed to establish the effects of the real exchange rate on real economic growth, while fully modified least-squares and Granger causality tests were used for robustness check and determination of the direction of causality between variables, respectively. Findings show a long-run relationship between the exchange rate and economic growth. In addition, when the Tanzanian shilling appreciates, it significantly and negatively affects real GDP. A 1% appreciation leads to a 0.13% decrease in GDP in the long run and 0.01% in the short run. Merchandise exports had a positive effect, while inflation had a negative effect both in the long and short run. The impulse response function shows that the real exchange rate affects the real GDP through the merchandise export channel and inflation. This implies that the appreciation of the Tanzanian shilling makes merchandise exports more expensive, reduces foreign exchange inflows and thus reduces actual output. Stabilising the exchange rate, targeting inflation, improving productive capacity and promoting export-led growth are important.