Given these broad features of Tanzania’s economic history we focus on aid, trade and the terms-of-trade as the key explanations of the long-run behavior of real effective exchange rate. These three factors are standard among the macroeconomic economic fundamentals cited in the literature as determinants of REERs in LICs. The next section explains the relationship between each of these factors, among others, and Tanzania’s real effective exchange rate.

# **iii) Possible factors affecting the long –run equilibrium REER**

# _Terms of trade_

Tanzania’s export revenues are heavily dependant on international commodity prices. On average, well over half of its export earnings over the last thirty years have been comprised of primary commodities – coffee, tobacco and cotton being the most important. While the principal commodity exports have changed over time, it remains a primary commodity exporter. Revenues from Tanzania’s top three commodity exports – fish, coffee, and cashew nuts, - accounted for 31% of non-gold exports in 2005. International commodity prices are volatile and when they change relative to Tanzanian import prices the equilibrium path of the REER will be affected. An increase in the international price for Tanzania’s commodity exports will increase real incomes in the export sector, resulting in an increase in the demand for nontraded goods. An appreciation of the REER will follow unless there is a substitution effect from domestic goods to foreign goods, in which case the REER may depreciate.

Following Cashin et al (2002) we use a measure of Tanzania’s real commodity prices as a proxy for its terms of **Figure 4. Term of Trade and Real Effective** trade. The index is a geometric **Exchange rate** weighted average of Tanzania’s nine largest commodity export 300 300 prices deflated by the World 250 250 Bank’s index of manufactured 200 200 exports (MUV).<sup>7</sup> In principal, 150 150 the price of all exports rather than simply commodity exports, 100 100 over the price of all imports, 50 50 rather than a generic industrial 0 0 1970 1975 1980 1985 1990 1995 2000 2005 country export deflator, should be used to measure terms of WPI-based REER Real Commodity Price (2000=100) trade. However, concerns about <u>Source: Authors’ calculation rce: Authors’ calculation ce: Authors’ calculation Authors’ calculation uthors’ calculation hors’ calculation ors’ calculation rs’ calculation s’ calculation ’ calculation calculation lculation culation lation ation ion on n</u> the data quality and the <!-- Start of picture text --> Figure 4. Term of Trade and Real Effective<br>Exchange rate<br>300 300<br>250 250<br>200 200<br>150 150<br>100 100<br>50 50<br>0 0<br>1970 1975 1980 1985 1990 1995 2000 2005<br>WPI-based REER Real Commodity Price (2000=100)<br>Source: Authors’ calculation rce: Authors’ calculation ce: Authors’ calculation Authors’ calculation uthors’ calculation hors’ calculation ors’ calculation rs’ calculation s’ calculation ’ calculation calculation lculation culation lation ation ion on n<br>REER (2000=100)<br>Real Commodity Price (2000=100)<br><!-- End of picture text --> 7 The index is a weighted average of export prices of manufactured goods for the G-5 economies (the United States, Japan, Germany, France, and the United Kingdom), which is generally accepted as proxy of price index of developing country manufacture imports.We augment the measure to incorporate oil prices in the measure, as oil imports make up about 17% of Tanzanian imports in 2000s on average.

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