external balance, given specific values of relevant macroeconomic variables that influence internal and external balance (Montiel 1999, Edwards 1989). Internal balance is when the nontradables market clears in the current and futures periods. External equilibrium is attained when the current account balance is compatible with long-run sustainable capital flows. Concretely, an equilibrium REER is an unobservable variable that would prevail from real macroeconomic factors acting upon foreign exchange markets without interruption. Because an equilibrium REER is unobservable it must estimated by identifying fundamental macroeconomic factors that are theoretically expected to act upon foreign exchange markets.

Estimating the equilibrium REER as a function of macroeconomic variables that vary over time implies that the equilibrium REER changes <u>over time. But, the function</u> between the REER and the **Figure 3. Tanzania Real Effective Exchange Rate** fundamentals is fixed over the **Long-term Trend** time period of analysis. This approach is well supported 360 320 theoretically (Edwards (1989), Montiel (1997) and 280 Elbadawi (1990), (1994)) and 240 is particularly relevant in a 200 case where the REER is 160 found to be nonstationary. 120 Figure 3 displays the long-run 80 component of Tanzania’s 40 REER, which shows 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 significant changes over the REER (WPI-based) long-term trend (HP filtered) sample period. The aim of the ’ Calculations <u>Source: Authors’ Calculations Calculations</u> next section is to identify the <!-- Start of picture text --> Figure 3. Tanzania Real Effective Exchange Rate<br>Long-term Trend<br>360<br>320<br>280<br>240<br>200<br>160<br>120<br>80<br>40<br>1969 1973 1977 1981 1985 1989 1993 1997 2001 2005<br>REER (WPI-based) long-term trend (HP filtered)<br>Source: Authors’ Calculations<br>REER (2000=100)<br><!-- End of picture text --> macroeconomic variables that explain these long-term movements. This reduced-form equilibrium real exchange rate approach is one of a number of complementary approaches that can be used to assess real exchange rates. Others include the macroeconomic balance approach, the external sustainability approach and in the LIC context, the PPP approach.<sup>6</sup> IMF (2006) and Hinkle and Nsengiyumva (1999) compare and contrast the various methods for real exchange rate assessments.

# **ii) Recent macroeconomic developments**

The recent macroeconomic history of Tanzania can be broadly grouped into three periods – 1970-1986, 1987-1995 and 1996-2005. The first period was marked by an increasing role of the state in the domestic economy and the pursuit of an importsubstituting strategy aimed at creating a new brand of African socialism. Donors were

> 6 This approach is common in LICs when data availability is an issue. It involves identifying a base year for which the economy under consideration is judged to be in both external and internal balance and choosing the REER that prevailed in that year as the estimate of the equilibrium REER. This approach implies that the equilibrium REER does not change over time and assumes that the values of fundamental macroeconomic variables that influence internal and external balance do not change over time.

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