The Role of the Exchange Rate and Dollarization in Monetary Transmission Mechanism: The Case of Tanzania

Abstract

The main objective of this study is to investigate the extent of Tanzania’s dollarization
and trace whether it has impacted the country’s monetary transmission mechanism.
Specifically, it aims to examine the exchange rate channel of the monetary
transmission mechanism; and examines the exchange rate pass-through to prices. The
study applies the Bayesian Vector Autoregression and also incorporates the Markov
switching processes to account for the structural breaks in the data. The results
indicate that positive shocks on interest rates contract money supply, which leads to
lower output growth and inflation, while exchange rates appreciate. Also, the degree
of dollarization has a negative impact on the monetary supply of the local currency, as
the central bank seeks to maintain a relatively constant rate of total money supply.
This has the effect of lowering inflation and interest rates; and is also associated with
further depreciation of the exchange rate. The positive shock on the exchange rate is
associated with an increase in dollarization. The exchange rate pass-through to prices
is not significant. The findings suggest the possibility of other factors that affect the
exchange rate, which may be beyond the direct control of the central bank, such as the
amount of foreign currency in circulation.