Exchange rate pessimism in Tanzanian macroeconomic policy

Abstract

To correct balance of payments disequilibria many developing countries are experiencing, attention is focussed on visible trade deficit because capital markets are almost non-existent, capital mobility is strictly controlled and service trade is underdeveloped. Economic theory recommends devaluation if quicker response is needed and the destabilizing effects of contraction of money supply is to be avoided. Results of Marshall-Lerner condition test of some empirical studies indicate that devaluation may not be effective in developing countries thus making policy makers pessimistic on its use. This study resolves the contradiction between theory and empirical findings by using modified assumptions of Marshall- Lerner condition which suit developing economiea. It studies the stability of price elasticities of demand for imports in the Tanzanian economy during the period 1954-1981 with respect to changes in trade policy during the period. The study takes a trade defici t as t.he initial condi tion and denominates all trade in local currency. Lagged regression models are used to capture the delay between price change and response for both exports and imports. Real producer prices and quan t i ty of agricultural export crops produced are used. For imports, relative unit value and quantity of commercial imports are used. iii • The study finds that elasticity of supply of exports are positive 0.68 with a standard error of 0.247. Elasticity of demand for"imports are positive, long-run two year elasticity is \ 1.156 with standard error of 0.399 and for period 197~-1981, the three year elasticity is 1.528 with a standard error of 0.599. Trade policy and abnormal rise in prices of petroleum products had no effect on the elasticities. For devaluation to be effective if the response of only exporters is to be relied on the ratio of value of imports to value of exports has to be less than 1.2. If the response of only consumers of imports is to be relied on, the ratio should be less than 1.9. The findings confirm the potential for devaluation to correct a trade deficit in Tanzania.