The Macroeconomics of Delayed Exchange-Rate Unification: Theory and Evidence from Tanzania
Natural Resource Governance Institute (NRGI); The Brookings Institution
Stephen A. O'Connell
Swarthmore College - Economics Department; University of Oxford - Centre for Study of African Economics
World Bank Policy Research Working Paper No. 2060
A more aggressive move toward exchange-rate unification in Tanzania would have delivered a fiscal bonus by the mid-1980s' and unification of the exchange rate would have reduced monetary growth and inflationary pressures. From a fiscal viewpoint there was no economic rationale for gradualism in exchange-rate unification and delay of a move toward convertibility.
Parallel exchange-rate markets have often been dismissed by authorities as a nuisance or as the domain of a small group of economic saboteurs. Using Tanzania as a case study, Kaufmann and O'Connell argue instead that these markets played a central macroeconomic role in the 1970s and 1980s. They provide a rigorous macroeconomic analysis of the parallel foreign-exchange market and its fiscal implications.
First, they investigate the evolution of that market in Tanzania from the mid-1960s to 1990. That period stretched from the adoption of exchange controls to macroeconomic collapse and then to subsequent reforms in the mid- to late 1980s. A reduced-form econometric equation (of a Dornbusch stock-flow model type) indicates that both trade and financial portfolio factors were important in determining the parallel premium, with trade determinants dominating in the long run, as theory suggests.
Then they investigate the fiscal impact of the parallel exchange-rate premium, an issue emphasized in the literature on exchange-rate unification. They construct a counterfactual simulation of fiscal and balance-of-payments flows under alternative assumptions about the indexing of those flows to the parallel and official exchange rate. They find that a more aggressive move toward exchange-rate unification would have already delivered a fiscal bonus by the mid-1980s. Accordingly, unification of the exchange rate would have reduced monetary growth and inflationary pressures.
So, contrary to conventional advice often given in Africa and elsewhere, the case of Tanzania suggests that from a fiscal viewpoint there was no economic rationale for gradualism in exchange-rate unification and delay of a move toward convertibility.
This paper - a product of the Development Research Group and the Regulatory Reform and Private Enterprise Division, Economic Development Institute - is part of a larger effort by the Bank to investigate exchange rate regimes. The study was funded by the Bank's Research Support Budget under research project The Macroeconomic Implications of Foreign Exchange Markets in Developing Countries (RPO 675-30). The paper also appears in M. Kiguel, J. Lizondo, and S. O'Connell, Parallel Exchange Rates in Developing Countries [London and New York, MacMillan and A. Martin].
Number of Pages in PDF File: 38
Date posted: April 20, 2016