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 dollarizationand trace whether it has impacted the country ' s monetary transmission mechanism.Specifically, it aims to examine the exchange rate channel of the monetarytransmission mechanism; and examines the exchange rate pass-through to prices. Thestudy applies the Bayesian Vector Autoregression and also incorporates the Markovswitching processes to account for the structural breaks in the data. The resultsindicate that positive shocks on interest rates contract money supply, which leads to lower output growth and inflation, while exchange rates appreciate. Also, the degreeof dollarization has a negative impact on the monetary supply of the local currency, asthe 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 withfurther depreciation of the exchange rate. The positive shock on the exchange rate isassociated with an increase in dollarization. The exchange rate pass-through to pricesis not significant. The findings suggest the possibility of other factors that affect theexchange rate, which may be beyond the direct control of the central bank, such as theamount of foreign currency in circulation.