Background

Inflation constitutes one of the first economic jobs in emerging market economic systems that requires pecuniary governments to lucubrate tools and policies to set a halt to high volatility in monetary values and long periods of rising prices.

In Tanzania, Inflation is one of the major macroeconomic jobs with overall norm of 16 % since the late 1966 to 2007, though the magnitude of this job continues to vary overtime. Immediately after independency, the rates of rising prices were low and in the individual figure bracket, averaging below 10 % in the period ( 1966 – 1980 ) . Although the rates were low, they were increasing bit by bit over-time and reached an mean close to 30 % in the period ( 1981-1994 ) nevertheless the rate declined to an norm of below 10 % from the period ( 1995-2007 ) .

The negative effects of rising prices to the economic system are good known. Inflation can ensue in a lessening in the buying power of the national currency taking to the exasperation of societal conditions and life criterions. High monetary values can besides take to uncertainness doing domestic and foreign investors reluctant to put in the economic system. Furthermore, inflated monetary values worsen the state ‘s footings of trade by doing domestic goods expensive on regional and universe markets.

To develop an effectual pecuniary policy, cardinal Bankss should possess information on the economic state of affairs in the state, the behaviour and interrelatednesss of major macroeconomic indexs. Such information would enable the cardinal bank to foretell future macroeconomic developments and to respond in a proper manner to floor the economic system is capable to. Therefore, an effectual pecuniary policy depends mostly on the ability of economic experts to develop a dependable theoretical account that could assist understand the on-going economic procedures and predict hereafter developments. When completed the consequences of the Research could be an of import measure frontward analyzing economic procedures in passage economic systems like that of Tanzania, and could function as a motive and a footing for farther probes by research workers, economic experts and policy shapers.

As the popularity of rising prices aiming has spread, rising prices prediction has come to play a cardinal component in many states ‘ economic policy-making. Numerous emerging market and developing economic systems have adopted rising prices aiming since the 1990s, e.g. South Africa in 2000.

The BoT is presently re-examining the pecuniary targeting model and developing capacity towards rising prices aiming as a hereafter option. In this respect, the BoT will go on to take deliberate steps to intensify fiscal markets, place the determiners for rising prices in Tanzania and develop proficient capacity in rising prices targeting, so as to increase the Bank ‘s flexibleness in pecuniary policy execution.

Inflation prognosiss are utile if they are accurate and include information about the factors finding them. Inflation prognosiss play an of import function to efficaciously implement an rising prices aiming government ( Svensson, 1997 ) . Furthermore, many economic determinations, whether made by policymakers, houses, investors, or consumers, are frequently based on rising prices prognosiss. The truth of these prognosiss can therefore hold of import reverberations in the economic system. Therefore the Research will construct the theoretical account upon which accurate prognosis of rising prices can be made.

Diagram 1: The tendency of Inflation in Tanzania from 1966 to 2007

Statement of the Problem

Harmonizing to the Bank of Tanzania Act 2006 Section 7 stipulates that the primary aim of the Bank shall be to explicate, define and implement pecuniary policy directed to the economic aim of keeping domestic monetary value stableness conducive to a balanced and sustainable growing of the national economic system. The concern with rising prices originates non merely from the demand to retain overall macroeconomic stableness but besides from the fact that rising prices hits the hapless peculiarly hard as they possess effectual rising prices hedges.

For the intent of spearheading the economic development of Tanzania, a better apprehension of the state ‘s inflationary experience is hence warranted to originate appropriate policy steps to incorporate the monetary value force per unit areas. This research will therefore construct an econometric theoretical account that adequately explains rising prices kineticss in Tanzania ; it will place the comparative importance of these factors that triggers rising prices in long run footing ; and to determine the demand to follow the rising prices aiming government in Tanzania.

Aims of the Study

Models have become a standard tool in pecuniary policy determination devising and communications. Policymakers have usage theoretical accounts to assist measure the deductions of different strategic options, and alternate responses to dazes. These theoretical accounts are non mechanical ushers to determination devising, but tools to promote consistent believing based on standard economic theory. The wide aim of this survey is to develop rising prices calculating theoretical account of Tanzania. This wide aim will besides be accompanied by the following specific aims.

This Research will analyse in item the behaviour of headline rising prices, its subcomponents, and nucleus rising prices during the 1966-2007 period so as to cast some visible radiation on the kineticss of rising prices in Tanzania.

The survey will besides find the major determiners of rising prices in Tanzania. Base on this it will be possible to cognize whether rising prices is a existent sector issue or a pecuniary issue.

Finally, the Study will propose an Inflation calculating theoretical account in Tanzania ; this will move as a base for the authorities to take on rising prices aiming ( IT ) as the best policy bundle in order to incorporate rising prices.

Significance of the survey

Forecasting rising prices rate is of significance to everyone. Economic policy shapers forecast rising prices rate as a usher to policy doing. Firms use rising prices prognosiss as one of the key inputs in fiscal projections. Workers impute rising prices prognosiss in finding rewards that they ask from their employers.

In this respect, this survey is of import since it is aimed at look intoing the inflationary procedures in Tanzania, Developing an Inflation Forecasting theoretical account every bit good as proposing the move of the state into Inflation Targeting Regime.

On extension of frontier of cognition, this survey will add to the bing literature on the comparative part of the domestic every bit good as foreign determiners of rising prices in Tanzania in footings of specificity, variables used and coverage. This will be achieved by extension of the sample period from 1967-2007 and besides the employment Box-Jenkins methodological analysis in calculating Inflation.

On policy evidences, the theoretical account adopted in this thesis should supply an iterative device for pecuniary policymaking. This will connote pertinence of rising prices aiming in Tanzania like many other state as a pick for grounding rising prices outlooks.

Section TWO

LITERATURE REVIEW

Introduction

This subdivision focuses on the thought on the theoretical every bit good as empirical surveies on the rising prices prediction theoretical accounts. Section 3.2 discusses theoretical statements behind the construct of Inflation. The theoretical underpinnings of rising prices prediction are outlined in Section 3.3. Section 3.4 introduces some basicss of Inflation Targeting. Section 3.5 nowadayss some overview of empirical surveies on Inflation carried out in Tanzania. Last, the sum-up of the subdivision will be given in Section 3.6.

Conceptualization of Inflation

Inflation can be defined as a sustained or uninterrupted rise in the general monetary value degree or, instead, as a sustained or uninterrupted autumn in the value of money. This rise in the general degree of monetary values, the kernel of rising prices, is measured by utilizing a monetary value index. Ideally, the monetary value index used should be wide based and one in which the person monetary values are weighted to bespeak their importance to the economic system.

There has been virtually no period in Tanzanian history in which a important alteration in the monetary value degree has occurred that was non at the same time accompanied by a corresponding alteration in the supply of money. This originates from the Monetarists view that “ rising prices is ever and everyplace a pecuniary phenomenon ensuing from and accompanied by a rise in the measure of money relation to end product. ” ( Friedman, 1970 ) .

Keynesian Economists have in common a belief that the major upward force per unit area on monetary values comes from activities which would bring forth a autumn in existent end product. Harmonizing to Keynesians the inflationary spread come from supply side job and hapless demand direction.

Other accounts of rising prices come from structural constrictions in the economic system. These constrictions include the monopolistic pricing behaviour of OPEC that lead to imported rising prices due to lifting monetary value of rough oil, major harvest failures due to mismatch between supply and demand of agro-products or alterations in the footings of international trade produced by a diminution in the foreign exchange value of the Tanzanian shilling and besides mismatch between public disbursement and grosss.

Since, Inflation enforce a existent cost on society in footings of the efficiency with which the exchange mechanism plants, by falsifying the inducements to salvage, put, and work, and by supplying wrong signals that needlessly alter production and work attempt. Because of this, policymakers should be concerned with the on-going rate of rising prices and any inclination for it to speed up.

Inflation Forecasting

A great trade of the inspiration behind seeking to give the accurately descriptive rising prices theoretical account, seeking to find parametric quantity values that most closely represent the behaviour of rising prices over clip, and uniting these with the best accessible outside information emanate from the desire to fabricate precise prognosiss about rising prices in Tanzania.

In calculating macroeconomic variables like rising prices one has many possible types of theoretical accounts to take from: mistake rectification theoretical accounts, vector mistake rectification theoretical accounts, autoregressive conditional heteroskedasticity ( ARCH ) -based theoretical accounts, full econometric systems, nonlinear theoretical accounts, or assorted possible combinations. But, as most predictors know, it ‘s hard to calculate the macro economic system and, despite decennaries of attempt, research workers find it surprisingly difficult to happen new theoretical accounts that outperform the simple Box Jenkins type autoregressive ( AR ) theoretical accounts.

A clip series of rising prices consists of observations generated in turn over clip. These clip series informations are ordered with regard to clip and consecutive observations may be dependent. The ascertained clip series is by and large referred to as clip series realisation of an implicit in procedure. The information may bespeak that there is a tendency over clip, i.e. there is a long term behaviour underlying the information. The tendency, if observed over a long clip, may be increasing, diminishing, or may stay unchanged. There may be cyclical fluctuations, i.e. a form of ups and downs over clip. In add-on, the informations may demo that the underlying procedure has periodic fluctuations of changeless length, i.e. seasonally. The intent of mold is to capture this implicit in procedure utilizing the ascertained clip series so that one can foretell what would be the likely realisation at a clip point in future.

Inflation Targeting

Since the early 1990s, an intensifying figure of cardinal Bankss have adopted rising prices aiming as their favourite model for pecuniary policy. This has replaced models refering utilizing marks for the exchange rate or pecuniary sums. Although in the beginning rising prices targeters were developed states, in recent times an increasing figure of emerging-market economic systems have besides adopted this model, motivated in portion by the success of inflation-targeting states in accomplishing and prolonging low degrees of rising prices.

Under rising prices targeting, the cardinal end of pecuniary policy is monetary value stableness. However, as mentioned, this besides contributes to more stable economic activity and employment, and reduces the spread between existent and full-employment end product, conditional to maintaining rising prices near to aim over a medium-term skyline. Given that future rising prices is unknown, it must be projected over the policy skyline.

Diagram 1: Conceptualization of the Research Agenda

Forecasting Model

Monetary Policy

Future Inflation

Empirical Surveies on Inflation in Tanzania

There have been some few surveies on Inflation in Tanzania. Minungu ( 2004 ) investigated whether rising prices in Tanzania during the period 1966-2002 is a Monetary Phenomenon. He used VAR Model and Cointergration to gauge the secondary one-year clip series informations of money supply, nominal exchange rate, gross domestic merchandise growing rate, shortage funding and nutrient rising prices on rising prices rate. The consequences in the impulse response maps indicated that nutrient supply and GDP growing contributed significantly towards motion in rising prices over clip. The discrepancy decomposition of the VAR Model suggests that 71 per centum fluctuation in rising prices is due to its ain inventions with the staying per centum being to other variables. He concluded that pecuniary enlargement is driven chiefly by enlargement pecuniary policies which explain to a big grade the rising prices procedure in Tanzania.

Ottaru ( 2001 ) studied the behaviour of Monetary values in Tanzania during 1966-200 by utilizing Error rectification theoretical account. Analysis from the theoretical account appraisal showed that, in the long tally rising prices emanates from the motions in money growing, involvement rates, exchange rates and gross domestic merchandise. He besides discovered that the kineticss of rising prices is influenced by external dazes such as war, drouth and oil crises.

Laryea and Sumaila ( 2001 ) used Ordinary Least Squares to gauge the determiners of rising prices in Tanzania. In the short tally, end product and pecuniary factors are the chief determiners of rising prices. However, in the long tally, the parallel exchange rate besides plays a cardinal function, in add-on to end product and money. The findings besides suggest that in the long tally, pecuniary factors have a bigger impact on the rate of rising prices in Tanzania, compared to end product effects. This is because the long tally snap of money and end product were 0.77 and -0.085 severally. This determination besides supports the monetarist statement on the power of pecuniary factors in the long tally inflationary procedure. The positive coefficients on the exchange rate variable reflect the consequence on rising prices via trade in goods, chiefly through imports in the informal sector.

A survey by Rutasitara ( 2004 ) used Ordinary least squares to analyse Exchange rate governments and rising prices in Tanzania, over clip, founded that rising prices has been driven by pecuniary and financial factors, on the one manus, and by structural restraints on the other. Therefore, although the theoretical account does non corroborate the relationship between money supply and rising prices, an indirect association of these can be found in evident Co- motion of rising prices and authorities bank adoption over the old ages.

Summary and combined synthesis

The empirical groundss indicate that causes of rising prices are legion ; most researches confirm the strong influence of money supply on monetary values, this is a widely held belief among macroeconomic experts that there exists a long-term relationship between the growing rate of the money supply and the growing rate of monetary values ( i.e. , rising prices ) . This survey differs from others by using both OLS and Box-Jenkins AR ( autoregressive ) Models to analyze the behaviour of rising prices in Tanzania over a considerable clip skyline of 31 old ages ( 1966-2007 ) and to develop an rising prices calculating theoretical account of Tanzania. So, for this theoretical account to “ execute better ” than other, we will go through on to the standard public presentation standards: holding the minimal prognosis mistakes which are calculated by root mean prognosis mistakes ( RMSEs ) in calculating out-of-sample periods.

Diagram 2: A convenient Matrix for of import Articles Reviewed

Writers

Minungu ( 2004 )

Ottaru ( 2001 )

Rutasitara ( 2004 )

Laryea ( 2004 )

Model Used

Vector Error Correction Model.

Error Correction Model.

Application of OLS to incorporate clip series.

Ordinary Least Squares.

Database

Secondary Time series informations 1966-2002 from BoT, Bureau of Statistics.

Annual clip series Data runing from 1966-2000.

Quarterly informations for 1967-1995.

Quarterly informations for the period 1992:1 – 1998:4, a sum of 28 possible observations.

Test Consequence

Growths in Real money, expected exchange rate depreciation have short tally effects on rising prices while growing in GDP and shortage funding has a long tally effects.

Growth in existent GDP has negative and important consequence on rising prices. Growth in money supply, nutrient deficit and exchange rate depreciation have a positive consequence on rising prices.

In long tally rising prices emanates from the motions in money supply and exchange rate, involvement rate and gross domestic merchandise. In the long tally rising prices is positively related to both money supply and exchange rate and negatively related to income. Inflation is besides influenced by external dazes like war, drouth and oil crises.

All consequences show that current rising prices is significantly related to its 4th slowdown, ( in a few instances the 3rd slowdown ) of rising prices, besides lagged foreign monetary values ( due to imports dependance ) and growing rate of GDP

The consequences suggest that in the long tally, pecuniary factors have a bigger impact on the rate of rising prices in Tanzania, compared to end product effects. This is because the long tally snap of money and end product were found to be 0.77 and -0.085 severally. This determination besides supports the monetarist statement on the power of pecuniary factors in the long tally inflationary procedure.

Decision Made

Monetary enlargement is driven chiefly by expansionary pecuniary policies which explain to a big extent the rising prices procedure in Tanzania.

Motions in exchange rates, money supply, involvement rate, GDP and external dazes are major determiners of rising prices in Tanzania

Over clip, nevertheless, it is true that rising prices has been driven by pecuniary and financial factors, on the one manus, and by structural restraints on the other. Therefore, although the theoretical account does non corroborate the relationship between money supply and rising prices, an indirect association of these can be found in evident co-movement of rising prices and authorities bank adoption over the old ages.

In the short tally, end product and pecuniary factors are the chief determiners of rising prices. However, in the long tally, the parallel exchange rate besides plays a cardinal function, in add-on to end product and money. The positive coefficients on the exchange rate variable reflect the consequence on rising prices via trade in goods, chiefly through imports in the informal sector.

Recommendations Made

In the short tally the pecuniary governments ‘ anti inflationary policy should aim high growing rate of GDP, Sustained decrease in money supply and stable exchange rate. Policies that encourage high production of nutrient should be pursued in the long tally

The pattern of restrictive pecuniary policy taking into history some innovative effects that may originate from other macroeconomic variables. Production of end product should be raised to convey down the lifting domestic monetary values.

Improved macroeconomic public presentation ( financial and pecuniary subject ) , growing of existent GDP, continued attempts for more efficient aggregation of domestic gross and prudent disbursement ( guided by the poorness decrease scheme since 2000 ) .

Inflation in Tanzania is a pecuniary phenomenon. Therefore to command rising prices the authorities will hold to prosecute a contractionary pecuniary and financial policy. The significance of the end product variable in our analysis, particularly in the long tally, besides suggest that the authorities can cut down rising prices by increasing end product, particularly agricultural end product. This is because nutrient histories for approximately 65 % of the weight used in the consumer monetary value index.

Section THREE

DYNAMICS OF INFLATION IN TANZANIA, HYPOTHESISES AND MODELS

This subdivision will hold the undermentioned subdivisions. Section 3.1 will brief shadow some visible radiations on the kineticss of rising prices in Tanzania. Section 3.2 will concentrate on the Hypotheses ( to be ) tested, while Section 3.3 will analyse the Applicable Models ( in drumhead signifier ) .

The Dynamics of Inflation in Tanzania

The Economic history of Tanzania is normally divided into three stages, that is, Growth Phase, Shocks Phase and Stabilization Phase. The growing stage covers the period instantly from independency 1961 to 1973. The Shocks Phase started from 1974 to 1985 and the last stage is the Adjustment-Stabilization Phase that runs from 1985 to 2005.

Growth Phase 1961-1973

With the Arusha declaration of January 1967, cardinal planning and authorities control became the cardinal economic attack with the ultimate aspiration of accomplishing autonomy for its people. This scheme of centralised economic planning proved successful ab initio until the early 1970 ‘s when terrible drouth hit the state with the growing rate averaged 4.4 per centum.

.

Table: Performance of selective Macroeconomic indexs in Tanzania 1967-1973

During this period rising prices averaged 4.4 per centum while the growing rate of wide money was reasonably low at an norm of 20 per centum. For the whole period the currency remained strong with an official exchange rate standing at an norm of 7.1 Tanzanian Shillings per unit of US $ .

Dazes Phase 1974-1985

In the economic history of Tanzania this period is marked by terrible macro-economic instabilities as a consequence of First oil monetary value dazes in 1973-1974, Severe Drought 1973-1974, followed by trade good roar in 1976-1977, a 2nd oil monetary value daze in 1979, the war with Uganda under Idd Amin in 1979. All these events led to economic pandemonium and uncertainnesss.

Table: Performance of selective Macroeconomic indexs in Tanzania 1974-1985

During the Period, Inflation moved in the upward tendency from 19.2 per centum in 1974 to 32.3 per centum doing an norm of 22.1 per centum higher than that during the growing government. The economic system continued to see low rate of growing averaging to 2.4 per centum. However The wide money ( M2 ) and Official exchange rate remained reasonably stable at 22.1 per centum and 9.7 Tanzanian Shillings per Unit of a US $ .

Adjustment-Stabilization Phase

The reform period is noteworthy for the economic recovery programmes supported by international fiscal establishments ( IFIs ) and givers taking at raising end product growing, conveying down the rate of rising prices, reconstructing external balance and bettering societal services. Together with these were trade and exchange rate liberalisation. These bit by bit led to a rapid depreciation of the Tanzanian shilling to an norm of 983.3 in the last stage of 2000-2005. Despite some betterment in the growing rate averaging 3.9 per centum in 1985-1989, 4.2 per centum in 1990-19994, 4.3 per centum in 1995-1999 and 5.9 per centum in 2000-2005 whole the general rate of rising prices in Tanzania shows a downward tendency between 1985-2005 from an norm of 32.4 per centum to an norm of 5 per centum. Broad Money supply continued to worsen from growing rate norm of 31 per centum in 1985-1989 to 19.7 in 200-2005.

Table: Performance of selective Macroeconomic indexs in Tanzania 1974-1985

The tendency of major Macroeconomic variables in Tanzania can be clearly shown by the assistance of the undermentioned graph.

Figure: Growth rate of cardinal determiners of Inflation in Tanzania 1967-2005

Hypothesiss

The major concern of the empirical work will be to develop an Inflation Forecasting theoretical account of Tanzania by utilizing Box-Jenkins Methodology. The undermentioned hypotheses will be tested

Development of Monetary Aggregates, exchange rate and Gross Domestic Product contains best information about future Inflation Rate in Tanzania.

Inflation, Broad Money Supply, Gross Domestic Product and exchange rate tend to travel together in the long tally.

External Shocks contain best information about future rising prices in Tanzania

Applicable Model

From a simple theoretical account of Price finding, Price degree ( Pt ) is a leaden norm of the Tradable Monetary values, PtT, and not tradable monetary values PtN.

Pt= a?zPtN + ( 1-a?z ) PtT

Where a?z is the weight on nontradable monetary values in the monetary value index. The monetary value of tradable goods is determined in the universe market, with their monetary value in the domestic economic system being a map of foreign currency monetary value, PtF, and exchange Rate, Et, with an addition stand foring the depreciation of Tanzania Shilling. The monetary value of Non tradable is determined in the domestic market:

LogPtN= I? ( LogMt-LogMtd )

Where Mt is the outstanding stock of money, Mtd is the demand for existent money balances, and I? is a scale factor stand foring the relationship between economic system broad demand and demand for non tradable goods. The demand for existent money balance is assumed to be determined by the degree of existent income, Yt, and the chance cost of keeping money vis s viz other assets ( existent or fiscal ) , it. Consequently the monetary value of non tradable can be written as

LogPtN= I? ( logMt- I?1LogYt+ I?2it )

An addition in the outstanding money stock is expected to ensue into higher monetary values, an addition in existent income is expected to spread out the demand for money for minutess and, in bend, lead to worsen in monetary values, and an addition in the chance cost of keeping money, by cut downing the demand for money balances, will ensue in an addition in monetary values.

So the uncapitalized letters stand foring logs, monetary values, Pt, can be written as:

Pt= I?a?z ( mt- I?1yt+ I?2it ) + ( 1-a?z ) ( et+ptf )

And the dynamic specification of this long tally relationship can be written for rising prices, Iˆt, as:

I t=bo+b1 ( L ) Iˆt+b2 ( L ) a?†mt-b3 ( L ) a?†yt +b4 ( L ) a?†it+b5 ( L ) a?†et+b6 ( L ) a?†ptf-b7ECMt-1+Ut

Where Iˆt=a?†pt, a?† is the first difference operator, L is the slowdown operator, and ECM is the divergence of Actual monetary values from their estimated long run equilibrium.

From the end product Gap theoretical account, with the monetary values of imported goods determined in the universe market, imported rising prices is a map of alteration in foreign monetary values and exchange rate. Inflation in the non tradable goods is assumed to be determined by an outlooks augmented Phillips curve of the signifier:

IˆtN= Iˆte+I¬ ( yt-yte ) /yte

So that, Iˆt=co+c1 ( L ) Iˆt+c2 ( L ) ( yt-yte ) /yte+c3 ( L ) a?†et+c4 ( L ) Iˆtf+Wt

Where, the slowdown of existent rising prices are used as a placeholder for rising prices outlooks in the absence of any study steps of rising prices outlooks.