FACULTY OF BUSINESS MANAGEMENT

RESEARCH PROPOSAL

TITLE OF THE RESEARCH

EFFECTS OF INFLATION,INTEREST RATES AND MONEY SUPPLY ON

ECONOMIC GROWTH IN TANZANIA

1995 -2020

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 TABLE OF CONTENT

ABBREVIATIONS AND ACRONYMS...............................................................................................2

CHAPTER ONE....................................................................................................................................4
1.1 Background Information...............................................................................................................4
1.2 Research Problem statement.......................................................................................................12
1.3Research objectives.....................................................................................................................13
1.3.1 General objectives...............................................................................................................13
1.3.2 Specific objective................................................................................................................13
1.4 Research Questions:...................................................................................................................13
1.5 Research Hypotheses..................................................................................................................14
1.5 Justification of the study.............................................................................................................14
1.6 Scope of the study..........................................................................................................................15
CHAPTER TWO..................................................................................................................................16
LITERATURE REVIEW.....................................................................................................................16
2.1 Chapter Overview.................................................................................................................16
2.3Theoretical literature review........................................................................................................18
2.3.1 Neo-classical growth Theory........................................................................................19
2.3.2 Keynesian Theory.........................................................................................................19
2.4 Empirical literature review.........................................................................................................23
RESEARCH METHODOLOGY.....................................................................................................29
3.2Research design...........................................................................................................................29
3.4 Research design..........................................................................................................................29
3.6 Types and sources of data...........................................................................................................30
3.6Data analysis Methods.................................................................................................................33

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ABBREVIATIONS AND ACRONYMS

LCPI Log of Consumer Price Index

LM2 log of Money Supply

M1 Narrow Money Supply

M2 Broad Money

M3 Broad Money

GDP Gross Domestic Product

LRGDP Log of Real Gross Domestic Product

RGDP Real Gross Domestic Product

VECM Vector Error Correction Model

VAR Vector Auto Regression

QTM Quantity Theory of Money

ARDL Autoregressive Distributed Lag model

GARCH Generalized Autoregressive Conditional Heteroscedasticity model

SUR Seemingly Unrelated Regressions

ECM Error Correction Model

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 CHAPTER ONE

INTRODUCTION

1.1 Background Information

Price stability, favourable interest rate and increase in money supply contribute to a higher

economic growth of an economy. The primary target of macro-economic policies in Tanzania

is to advance economic growth and keep the inflation rate at a low rate or a solitary digit

(Makwandi, 2017).Since the enactment of BOT act in 1995 low inflation rate has been at the

heart of Tanzania monetary authority as price stability plays a big part in determining the

macroeconomic stability and sustainable economic growth. (Yabu, 2015)

Since the late 1970s, the Tanzanian economy has experienced numerous internal and external

shocks. All sectors of the economy have been affected by shocks, the manifestations of which

have been, among other things, large budget deficits and an imbalance between productive

and non-productive activities. Signs closely associated with these phenomena were high

inflation rates, large balance of payments (BOP) deficits, falling domestic savings, increasing

government spending, falling agricultural production, and reduced utilization of industrial

capacity which, in turn, hampered economic growth (Kilindo, 1997). Regarding the

Tanzanian economy, Ndyeshobola (1983) reported that between 1964 and 1969, inflation was

very low (0.3% and 3.2%) on average respectively for the national price index. consumption

(NCPI) and the National Food Price Index (NFPI). After 1972, the NCPI increased by an

average of 16% through 1975 (with peaks of 19% in 1974 and 25.9% in 1975). The NCPI of

1974 and 1975 appears to have been caused by the severe food problems that prevailed during

the second half of 1973. The NFPI reached up to 35.0% in 1974 and 30.6% in 1975.

Tanzania's economic growth has shown an erratic trend as it recorded an average GDP growth

rate of around 3% between 1991 and 2000, the rate of GDP growth in 1992 was only 0.584%,

while the rates in 1996 and 2000 were 4.6% and 5.1%, respectively (Odhiambo, 2011).

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Between 1952 and 1970, an economic growth rate of 5.2 percent was associated with official

single-digit inflation rates, excluding the period 1966-70 when the inflation rate was 11.7

percent. From 1965 to 1985, the rate of economic growth steadily declined while the rate of

inflation continually increased. Tanzania displayed stable price stability in the 1950s and

1960s. Average annual inflation rates were low, in the single digits, at around 4.5% and 9.3%

respectively during the 1950s and 1960s. But rates rose to 10.5% in 1973, before reaching

26.5% in 1975. Between 1980 and 1985, the highest average inflation rate, 27.3%, was

coupled with the rate of lowest economic growth of 0.9%. Furthermore, studies found that as

the economy recovered between 1986 and 1990, the average inflation rate fell to 23.9%, while

the average growth rate rose to 3.7 % (Shitundu and Luvanda, 2000).

Tanzania's economy depends largely on agriculture, which employs around 75% of its

population. An estimated 34% of Tanzanians currently live in poverty. The economy has been

in transition from a command to a market economy since 1985. Although total GDP has

increased since these reforms began, GDP per capita initially fell sharply and only exceeded

the level before transition figure towards 2007.

Significant steps have been taken to liberalize the Tanzanian economy along market lines and

encourage foreign and domestic private investment. Beginning in 1986, the Tanzanian

government embarked on an adjustment program aimed at dismantling socialist economic

controls (Ujamaa) and encouraging more active private sector participation in the economy.

The program included a comprehensive package of measures aimed at reducing the budget

deficit and improving monetary control, significantly depreciating the overvalued exchange

rate, liberalizing the trade regime, removing most price controls, easing restrictions on the

marketing of food crops, to free interest rates and to launch a restructuring of the financial

sector. (www.wikipedia.com)

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Tanzania's current GDP per capita increased by more than 40% between 1998 and 2007. In

May 2009, the International Monetary Fund approved an Exogenous Shock Facility (ESF) for

Tanzania to help the country cope to the global economic crisis. a Policy Support Instrument

(PSI) with the International Monetary Fund, which began in February 2007 after Tanzania

completed its second three-year Poverty Reduction and Growth Facility (PRGF), the first

having been completed in August 2003. The PRGF was its successor program. to the

Enhanced Structural Adjustment Facility (ESAF), in which Tanzania also participated from

1996 to 1999. The IMF's PSI program provides policy support and signaling to participating

low-income countries and is aimed at countries that have generally achieved reasonable

growth performance, low underlying inflation, an adequate level of official international

reserves and which have started to establish net external and domestic reserves. debt

sustainability (www.wikipedia.com)

Tanzania has also embarked on a major restructuring of state-owned enterprises. The program

has so far divested 335 of the approximately 425 parastatals. Overall, real economic growth

has averaged about 4 percent per year, much better than the previous 20 years, but not enough

to improve the lives of average Tanzanians. In addition, the economy remains extremely

dependent on donors. Additionally, Tanzania has an external debt of $7.9 billion. Servicing

this debt absorbs approximately 40% of total government spending. Tanzania has received

debt relief under the Enhanced Initiative for Heavily Indebted Poor Countries (HIPC). Debts

worth more than $6 billion were canceled following the implementation of the Paris 7 Club

agreement (www.wikipedia.com).

The economy of Tanzania has been growing at an average of 6.7 Percent since 2007 to 2016

and 7 percent from 2014 to 2016. The contributing factors to the outstanding growth records

include sound economic reforms initiated and policies undertaken by the government since

the mid 1980’s that supported various economic activities while some of the reforms and

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policies aimed at maintaining fiscal consolidation in order to increase efficiency and

effectiveness in utilization of resources. (Masenya, 2018).

Central banks can only control the rate of inflation, money supply, and interest rate through

monetary policy in order to increase economic growth, employment and price stability of an

economy (Sultana, 2018).

1.1.1 Inflation and economic growth in Tanzania

Over the years inflation rate and GDP in Tanzania have been observed to have a negative

relationship. This was illustrated in the year 1975 when the inflation rate was 27 percent and

the GDP was 8.26 percent. Such relationship has been much observed during 1980s when the

inflation rate was much higher compared to the GDP in year 1981 and 1983 when it declined

to -0.5 percent and -2.4 percent respectively (Makwandi, 2017). However, this relationshiphas

been debatable to economist and policy makers, whether inflation has a negative impact on

economic growth or whether it is important for economic growth.

1970s Tanzania experienced a decline in GDP growth and sharp increase in inflation. The

GDP decline from an average of 5.7 percent between 1965 and 1975 to an average of 1.8

percent between 1976 and 1979 and then 1.2 percent between 1980 and 1985, while inflation

increased from 7.3 to 30.6 percent in the same period. There was a precognitive

improvementhowever from 1996 to 2009 after adopting economic recovery and structural

adjustment (Yabu, 2015).

Overall, real GDP growth averaged 6.2% between 1996 and 2009, higher than the average

annual growth rate of less than 5% in the early 1990s. During the same period, inflation was

contained to single digits, averaging 6.8%, compared with 25% in the early 1990s (BoT,

2011). Between 1995 and 2000, inflation fell steadily while economic growth remained

essentially unchanged. The low and stable inflation experienced between 2001 and 2005 was
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rewarded by slow GDP growth. In 2012, economic growth was 6.9%, compared with 6.5% in

2010. The inflation rate increased from 7.2% in 2010 to 16.0% in 2012.

A central objective of Tanzania’s macroeconomic policies is to promote economic growth and

to keep inflation on a low level. However, in recent years there has been substantial debate on

the relationship between inflation and economic growth. Some scholars, mainly those in favor

of the Structural and Keynesian perspectives tend to believe that inflation is not harmful to

economic growth whereas other scholars particularly those in favor of monetarist views, argue

that inflation is harmful to economic growth. Through Motivation by this economic

controversial, this paper investigates the impact of inflation on economic growth in Tanzania.

Since the data used are recent ones covering 1995-2013 it was anticipated that it might bring

different result to contribute to answers of these controversial and serve as policy

recommendation.

Trend of inflation rate and GDP from 1995 to 2020.

Inflation in Tanzania has been fragile, with the highest recorded as 27.4 percent in 1995 but

falling steadily to single digit in 1999.Most part of inflation has been maintained at single

digit with the lowest recorded at 3.29 in 2020. From 2008 to 2012 there was a rise in the

inflation to a double digit for only a short period of time then in 2013 it was a single digit and

from 2015 to below 5 percent as presented by the graph below.

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 Trend of Inflation and GDP from 1995 to 2020
30.00

25.00

20.00

15.00
Axis Title
inflation rate
10.00
GDP
5.00

0.00
95 97 99 01 03 05 07 09 11 13 15 17 19
19 19 19 20 20 20 20 20 20 20 20 20 20
years

Trend of inflation rate and GDP from 1995 to 2020.

Source of Data: Bank of Tanzania

GDP has been steady for the most part compared to the Inflation rate with the highest

recording of 7.67 in 2011 and lowest at 2.00 percent in 2020.The GDP has been rising in

years were a single digit for inflation were maintained and falling in years with double digit

figure for inflation. However, in 2020 other factors that affects GDP rather than inflation

came into view due to the great fall in GPD in spite of Inflation rate been at the lowest. The

pandemic of Covid -19 said to be the causative.

1.1.2 Money supply and economic growth

Monetary policies have been used to control the inflation by monitoring the supply of money

to stabilize the economy (Stanslaus, 2017).The quantity of money in circulation plays a great

part in influencing the economic activities by stimulating the increase in output, creating

employment and thus spurs the economic growth. In monetarism growth rate of money may

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increase inflation rate with unchanged economic growth in long run (sultana, 2018). This is

the case when much money is chasing after limited goods and services.

In Tanzania money supply as broadly defined grew at the rate of 18.8% between 1965 and

1970, reaching 26.3% between 1976 to 1980. The highest recorded at 47% in 1978/79. The

increase was mainly due to rise in domestic bank credit to the government and parastatals.

Government faced with the social and economic responsibilities, turned to domestic lending

to cater for recurrent expenditures leading to the rise of money supply in the system (fiscal

operation).

Trend of Money supply in Tanzania from 1995 to 2020

MONEY SUPPLY (BILLION OF TZS)

35000.00

30000.00

25000.00
BILLIONS OF TZS

20000.00

15000.00

10000.00

5000.00

0.00
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20
19 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20
YEARS

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Source of Data: Bank of Tanzania

From 1995 to 2020 as seen from the graph money supply in Tanzania has been increasing

with slightly fall in 1996. However, the economic growth has been rising and falling

irrespective of the gradual increase of money supply. These phenomena imply that money

supply may not be the only factor affecting the economic growth but lather other factors need

to be in place for it to have greater impact in the economy.

1.1.3 Interest rate and economic growth in Tanzania

Capital formation and interest rate have been found to have slightly significance on economic

growth, however if managed well can indeed promote the economic growth by increasing

investment and lower the cost of borrowing. Other studies have shown that there is a negative

relationship between interest rate and economic growth in Tanzania, while others still suggest

that the effects of high interest rate on financial development, savings and economic growth is

at best inconclusive, Odhiambo 2018 et al.

Through expansionary monetary policy by lowering the interest rate may lead to increase in

economic activities but may destabilize the price because people will demand more money

while the tight monetary policy may have adverse effect on the economic growth. Therefore,

Interest rate may be said to have both positive and negative effects on the economic growth.

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Trend of interest rate and economic growth of Tanzania from 1995 - 2020

interest rate and economic growth from 1999 to 2020

40.00
35.00
30.00
25.00
20.00 interest rate
Axis Title GDP
15.00
10.00
5.00
0.00
95 97 99 01 03 05 007 009 011 013 015 017 019
19 19 19 20 20 20 2 2 2 2 2 2 2
years

Source of Data: Bank of Tanzania and World bank

1.2 Research Problem statement

Economic growth is affected by several factors among which include capital accumulation,

technology, labor input and knowledge advancement. These are considered to be primary

factors that are also affected with other factors like monetary policy (Odhiambo, 2018).

There is empirical consensus on the significant effect of the monetary policy on the economic

growth in short run lather than in the long run. Basing on that we cannot rule out the need to

study and understand the effects of interest rate, money supply and inflation on economic

growth. Bearing in mind that if interest rate is not well monitored may affect the capital

accumulation and hence investment while unstable price level may redirect the proper

allocation of productive resources harming the economy in the long-term Fisher, 1993 et al.

In Tanzania few studies have been made on the effects of the three factors namely interest

rate, money supply and inflation on how they affect the economic growth. Other studies have

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just examined one factor and its effects on the economic growth. Above all the subject matter

is still open for more insight and knowledge to reach the consensus. Therefore, it is important

to do more research to see how our economic growth is affected by the policies we implement

in our nation.

1.3Research objectives

The research has both the general and the specific objectives and specifically the study aims at

achieving the following;

1.3.1 General objectives

 To establish the effects of inflation, interest rates and money supply on the economic

growth of Tanzania from 1995 – 2020.

1.3.2 Specific objective

 To assess the effect of inflation, money supply and interest rate on economic growth

of Tanzania from1995-2020.

 To establish the relationship between inflation, interest rate and money supply on

economic growth in Tanzania.

 To provide policy recommendation for country on economic growth.

1.4 Research Questions:

Based on the afore-mentioned objectives, the following research questions will be answered:

 Do inflation, money supply and interest rate affect economic growth?

 Does economic growth respond to inflation, money supply and interest rate?

 What is the causal linkage between economic growth, interest rate, inflation and
money supply?

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1.5 Research Hypotheses

i. : Inflation does not affect the economic growth of Tanzania.

: Inflation affect the economic growth of Tanzania

ii. : Interest rate does not affect the economic growth of Tanzania.

: Interest rate affect the economic growth in Tanzania

iii. : Money supply does not affect the economic growth of Tanzania.

: Money supply affect the economic growth in Tanzania

1.5 Justification of the study

The need for understanding these macroeconomics variables and their effects on the economic

growth is very important to the policy makers like central bank officials, financial analyst and

to academicians as well. The knowledge will shed light onto proper policies to be adopted

while solving these macroeconomics problems to enhance the economic growth.

Several studies have been conducted on the same issue, however mainly on the effect of

inflation on economic growth or rather the effect of money supply on the inflation. Very few

studies have been conducted to involve the three variables that are inflation, money supply

and interest rates to access their relationship and effects on the economic growth. Tanzania

has been through different phases of economic growth and the analysis of these variables in

relation to economic growth in the specified period of time will show which policies have

better results.

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1.6 Scope of the study

1.6.1 Time Scope

The study will consider values of inflation rate, interest rate, money supply and economic
growth from 1995-2020.

1.6.2 Subject Scope

The study will focus on four variables i.e inflation rate, interest rate, money supply and
economic growth,

1.6.3 Geographical Scope

The study will be carried out in Tanzania.

1.7 The organization of the work

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 CHAPTER TWO

LITERATURE REVIEW

2.1 Chapter Overview

This chapter starts by building the theoretical foundation of the study for a better

understanding of other part while reviewing other’s literature and processing of data. Here we

look into the conceptual definition of key terms used and different theories that depict the

effects of the said macroeconomic variables on economic growth. The empirical review will

be the second in this section reviewing different studies that relate to this study in Tanzania

and in other diverse countries and in different time frame meaning short run and long run.

2.2Conceptual definition

2.2.1 Economic growth

Economic growth refers to the increase in the production of goods and services over specific

period of time. There are several factors that contribute to the economic growth, capital

goods, human capital, labor force and high technology (Stanislaus 2017). Economic growth is

measured by the increase in the country’s total output or real Gross Domestic Product (GDP).

The assessment of economic growth is done by comparing the real GDP rate from one year to

another. The positive change that refers to economic recession is the one that is mostly

desired especially in developing countries. However, the target of each nation is to increase

the standard of living of people, referred to as the GDP per capital (Majid Salum 2017).

2.2.2Inflation

Inflation is said to be the persistence rise in the price level of goods and services over a period

of time mainly a year. The rise in prices has always affects the businesses, government and

individuals as purchasing power becomes low. There are several methods that are used to

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determine the rate of inflation and the most common one is Consumer price index (CPI). The

change in the price index (CPI) tells how the prices have gone up or down. (Makwandi, 2017)

There are two main causes of inflation; one the demand-pull inflation this is when demand

outpaces supply of goods and services. The second which is also rarely is cost push inflation,

this occur when supply of goods and services is restricted but not demand leading to rise in

price level. Others have said “Inflation is always and everywhere a monetary phenomenon” in

other words when money supply in the economy increases at a higher speed than the increase

in production of goods and services, it attracts rise in price level resulting in inflation.

(Mishkin, 2012)

2.2.3 Money supply

Money supply can be referred to as the total amount of money injected in the economy at any
given period of time. It may include cash, coins and bank deposits in other words any assets
that can be used to make payments or held as short-term
investment .https://www.federalreserve.gov/faqs/money_12845.htm

There are several measures of money supply M1, M2, and M3. M1 consist of currency in
circulation, checkable deposit and travels checks. M2 is broader than M1 it includes M1 plus
small savings accounts, money market funds, small time deposits and overnight repurchase
agreements. M3 is even broader it includesM2 and all large denomination deposits, money
market fund, shares and other financial instruments like long term purchase agreements.
Therefore, the definition of money supply depends on the measure that is used, meaning
narrow or broader definition (Mishkin, 2012).

Money supply plays a big role while making monetary policies because it exhibited a close
relationship with GDP and inflation. For this study we are going to use M3 when referring to
money supply.

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2.2.4 Interest rate

Interest rate is the amount of interest paid by a borrower to a lender and is by the central bank

of a country. The interest rate which is set by the central bank is called the base rate. The base

rate affects the aggregate output.

Interest rate affects both private and firm’s economic decisions, particularly on how much to

borrow and lend and what equipment or new plant to invest depending on the cost of

financing it (gylych, 2016).Interest rate plays a role on proper allocation of resources that may

facilitate growth and development of an economy through deposit mobilization and credit

creation.

Interest rate is always expressed in percentage, low interest rate means the loans are cheap

thus more people can afford, more investment and discourages people to save. However, the

low interest rate may spur inflation rate due to increase in money supply in the circulation as

demand for money increases. Loans are costly when interest rates are high therefore people

will borrow less and save more slowing down the economic growth due to fall in

investment(Williamson, 2018). Interest rates affect economic growth since the reduction of

interest rates increase economic growth, if the interest rate is good, it keeps output growth

high. Low interest rates increases help the economy grow since people can get more money to

make purchases and invest in businesses thus spurring economic growth.

2.3Theoretical literature review

In this section different theories have been discussed to explain the economic growth and how

it does relate with other economic variables namely inflation, interest rate and money supply.

These theories include Neo-classical growth theory, the new Keynesian theory, the quantity

theory of money and the Investment saving and Liquidity preference money supply (ISLM)

model.

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2.3.1 Neo-classical growth Theory

The Neo-classical growth theory was developed by Robert Solow in 1800’s also known as

Solow model. Different from the classical growth theory here the economic growth is

independent of population growth. However, in the long run the economy will continue to

grow as long as there is technological progress that improves labor productivity.

Technological change has a major influence on an economy, and economic growth can’t

continue without technological advances. Labor, capital and technology are the necessary

factors for economic growth. Therefore savings, population may affect GDP growth in the

short run but not GDP per capita in the long run. Solow and other growth theorists did not

show how the growth is affected by inflation or money supply (Salim, 2017).

Mundell (1963) was the first to show the mechanism that relate inflation and output growth.

Increase in inflation or an expectation of inflation reduces peoples' wealth. This works in a

way that the rate of return on individual’s real money balances falls. Therefore, to accumulate

the desired wealth people save more by switching to assets, increasing their price and bringing

down the interest rate. Greater savings means greater capital accumulation and thus faster

output growth.

2.3.2 Keynesian Theory

The tradition Keynesian theory uses the aggregate demand (AD) and aggregate supply (AS)

curves to explain the inflation – growth relationship. AS curve slope upward responding to the

change in price level in the short run due to various factors like labor force, fiscal and

monetary policy and pricing of other factors of production. The AD curve slope downward

with one factor causing it to shift and that is change in money supply due to government

spending, taxes and business willingness to spend. This changes in AD and AS will affect the

price and output level (Nathan, 2015).

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Keynesian theory is the theory that links inflation, interest rate and money supply with

economic growth. It advocates aggregate demand to be the key factor in boosting economic

growth during recession when the government spends more on infrastructure, education and

unemployment benefit to enables people to spend more. (Stanislaus, 2017)

Output and money supply will change until full employment with fixed price level is reached.

Meanwhile price will change in the same proportion as the quantity of money in the full

employment. (Sultana, 2018)

The theory can be illustrated by the graph below

AS2

P2 AS1

P0
AD2
P1

AD1

Y0 Y1

At the initial price Po, the output level is Y1, when the money supply is increased through

government spending the AD will increase in the short run from AD 1 to AD2. Point B will be

the new equilibrium point with output Y2 and Price P2. Prices tend to be flexible in the long

run rising the cost of production due to increase in wages. Therefore, the supply curve will

shift leftward to the potential level because money supply can change the level of output in

20
the short run but not in the long run. The graph shows the initial positive relationship between

inflation and growth that will later turn negative. (Mishkin, 2012)

2.3.3 Quantity theory of money

Quantity theory of money links the inflation and the economic growth by simply equating the

total amount spent on final goods and services produced in the economy to the total amount of

money in existence. Generally the quantity theory of money explains the increase in the

quantity of money tends to creates inflation.

Friedmanand Schawarts (1982) proposed that inflation is the result of the increase in the

supply of money in the economy at a rate greater than economic growth. The theory was

developed by the classical economist Irving Fisher and it suggests that interest rate have no

effect on the demand for money. The quantity theory of money is also known as Fisher

equation of exchange presented as follows;

MV =PY

Where: M is quantity of Money, V velocity of circulation of money, P average price level and

Y is the approximation level of income.

In this module velocity is constant in the short run; therefore any change in the money supply

by central bank will cause a change in the nominal value of output PY (GDP). In the long run

however V and Y are constant. Therefore

Y =MV / P

with logarithm the equation can be represented as;

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 LogY =LogM + LogV −LogP

by differencing the equation for growth

gy=gm+ gv −gp

From the equation it is evident that output is positively affected by the increase in money

supply and negatively with the inflation. As long as the money supply kept on increasing in

the long run it will have no effect on the level of output thus leading to rise in the price level.

(Sultana, 2018)

2.3.4 The Investment saving and Liquidity preference money supply (ISLM) model.

The model is called Hicks-Hansen model and was developed by John Hicks in 1937 later it

was developed by Alvin Hasen in 1953.The model explains how the interest rates and total

output level produced in the economy can be determined given a fixed price level. The

intersection of these two equilibrium markets in other words IS and LM curve revels the

equilibrium level of output and interest rate giving a complete analysis on determination of

aggregate output for which monetary policy plays an important role. (Mishkin, 2012)

The IS function represent goods market equilibrium such that each point on the IS curve

represent the equilibrium between savings and investment. LM function describes the

relationship between different levels of income and equilibrium rate of interest. LM relate

with the money market equilibrium such that each point on the LM represents equality money

supplied and money demanded and the equilibrium rate of interest is determine the

combination of interest rate and aggregate output for which quantity for money demanded

equals quantity of money supplied.

r
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 LM- Curve

r*

IS -Curve

Y* Y

At point Equilibrium point the quantity of money demanded equals the quantity of money

supplied (LM) and the aggregate output equals aggregate demand (IS). In other words the

market for goods and the finance market are at equilibrium.

Mention what theory will be used to guide this study

2.4 Empirical literature review

This part will review other studies that were conducted on the same subject or related, to

examine their findings and the methodology adopted while analyzing the data.

2.4.1 Effects of inflation on economic growth

Teshome, (2011) studies the source of inflation and economic growth in Ethiopia using

Statistical analysis between year 2004 and 2008, he stated that the desire to spend and higher

import price with slow growth of aggregate supply contributed to inflation in the country. He

went on saying inflation is not a monetary phenomenon otherwise controlling money to

reduce inflation will hinder economic growth. When there is a high velocity of money as a

result of financial institutions growth and economic transactions it is difficult to stop inflation

by simply stopping the injection of money. Therefore, it is importance to study the structure

23
of government spending and the nature of economic growth to establish the relationship

between inflation and economic growth.

Nathan, (2015) using the time series analysis integration test, VAR and Granger causality

analysis to explore the relationship between inflation and economic growth in Tanzania found

that; there is no stable long run equilibrium relationship between inflation and economic

growth neither between inflation and capital accumulation. However, the analysis reveal that

there is a significant negative relationship between inflation and economic growth in the short

run as found also by Fisher in 1993.Further effort to check on the direction of causality have

shown that there is a directional causality from inflation to economic growth and economic

growth to inflation implying that inflation has indeed impact on economic growth.

Nicas. Nicholas, (2015) on the study of appropriate threshold level of Inflation a case study of

East African countries using a panel data from 1970 to 2013 and a nonlinear quadratic model

and Seemingly Unrelated Regressions(SUR) for estimating the optional levels of inflation

suggest that the average inflation beyond 8.46 percent has a statistically negative impact on

economic growth. The findings pointed out an optimal level of 8.8 percent for Tanzania

beyond which the inflation will start to have a negative impact on economic growth.

Therefore, it is important for the government to make sure they maintain a single digit level of

inflation to support economic growth.

Chuan- Yeh, (2012) examined the causal relationship between economic growth and inflation

using data from over 140 counties from 1970-2005 and the results indicate that, inflation

retards growth whereas the effect from growth to inflation is beneficial. He also found that the

negative impact of inflation on developing countries is greater than that of the developed

countries. The effects of economic growth on inflation in different income level countries

differs, higher economic growth cannot improve the inflation rate for both high- and low-

24
income countries. Conversely rapid economic growth induces higher inflation rate in low-

income countries.

2.4.2 Effects of money supply on economic growth

Vincent, (2017) Assessed the causal effects of macroeconomic factors on economic growth in

Tanzania. Using Vector Auto regressive (VAR) model to analyze the variables in a multiple

cassation namely inflation, money supply and government spending. The findings were such

that inflation had negative effect to the economic growth, government spending had inversely

proportional relationship with economic growth. Money supply was seen to have a direct

effect on the economic growth, as it increases so is the economic growth. The researcher

found each variable is statistically significant and thus its effects and causes must be well

monitored.

Amin, (2011) in the study of Quantity theory of money and its applicability in the case of

Bangladesh using Johansen integration method, the empirical findings indicate that in the long

run there is a relationship between money supply and inflation. the granger causality test

revealed unidirectional causal relationship between inflation and economic growth supporting

the findings of Ahmed and Mortaza (2005) who did the same study in Bangladesh using

annual data of CPI and GDP for the period of 25 years 1980-2005 and the co-integration and

error correlation model. In their study they found there is a negative correlation between CPI

and GDP in the long run.

Johannes M, (2017) Examined the impact of government expenditure, money supply and

inflation on economic growth in Tanzania from 1970 – 2011, using Augmented dickey fuller

(ADF) to test the stationary of data and its co integration was tested by ARDL bond tests. The

results show negative impact of inflation on economic growth while money supply and
25
government expenditure have significant impact to economic growth both in short run and

long run though itdiffers in intensity.

Fitsum (2016), trying to establish the relationship between inflation, money supply and the

economic growth in Ethiopia employ tri-variety Granger causality with VECM method of

analysis. The test shows that price, real GDP and the money supply have long run equilibrium

relationship. There is a bidirectional causal relationship between inflation and money supply

and unidirectional granger causal relationship from economic growth to inflation in the long

run. Inshort run monetary expansion that is not accompanied with the expansion of production

sector will have a direct effect to the inflation. And there is no reverse causality from inflation

to money growth.

2.4.3 Effects of interest rate on economic growth

Sultana Nahida (2018) conducts a study on the impact of money supply, inflation rate and

interest rate on economic growth, a case study for Bangladesh. Auto regressive Lag (ARDL)

model and ECM (Error Correction Model) were used to process the data from 1981 – 2016.

The finding shows that broad money supplies have a significant and positive relationship with

the economic growth whereas insignificant relation is found between inflation and economic

growth in the long run. Interest rate relate negatively with economic growth because of the

fall in investment in the economy. In short run there is no significant relationship between the

variables that was seen but money supply and inflation affect the economic growth

negatively.

Harswari, M (2017) examined the impact of interest rate on economic development in Asian

countries. The data collected were from 20 different countries from the period of 2006 to

2015. He employed descriptive analysis, correlation analysis and regression analysis using E-

26
view software. The outcome revealed interest rate has negative significant impact on

economic growth and insignificant impact on direct foreign investment.

Arhin, E, W.A, F.L, (2017) Who studied the effect of interest rate fluctuation on economic

growth of Ghana for the year 1988 to 2014 using ordinary least square multiple regression

technique in a form of log-log module to analyze data. Came with the results that show there

is a negative relationship between interest rate and economic growth, implying any increase in

interest rate may lead to decrease in economic growth while the fall in interest rate increases

the economic growth. Therefore government was recommended to formulate rules and

regulations that can enhance increase in aggregate savings to lower the interest rate on capital

and money market for sustainable increase in economic growth due to lower cost of funding

real economic sector.

2.5 Research gap

Through the extensive literature review, some of the studies have shown inflation rate affects

economic growth negatively but in the long run, the effect of money supply is positive on the

economic growth in the short run while interest rate has a negative effect on economic

growth. The same results were obtained despite the vastness of data used, different time

frame, methods of analyzing such data and the economic conditions of the said nation.

However, for the case of Tanzania many studies have been done on the relationship of

inflation, money supply, interest rate, and economic growth but most only two variables were

involved. However, the same study was conducted by Sultana (2018) the case study for

Bangladesh from 1981-2017 thereafter oblige this study to be done in Tanzania. To analyze

how the changes that have been made since 1995 on inflation, interest rate and money supply

have affected the economic growth of Tanzania.

27
2.6 Conceptual framework.

Conceptual framework concerns with how different concepts fit and relate to one another. In

this study inflation, money supply and interest rate are considered as independent variables

while economic growth is the dependent variable as presented here under.

Independend variable Dependent variable

Inflation

Money supply Economic growth

Interest Rate

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 CHAPTER THREE

RESEARCH METHODOLOGY

3.1Chapter Overview

This part will introduce the methodology and the model specification of the study. The

chapter will indicate the type of study, the area of study, types and source of data to be used

along with the techniques of analyzing the data.

3.2Research design

Refers to the conceptual structure within which research is conducted, it constitutes the

collection, measurement and analysis of data (Kothari). It is the process that can be used to

answer research question and solve research problem.

Because the study mainly focused on time series data of inflation, interest rate, money supply

and economic growth therefore, quantitative kind of data will be used.

3.3 Study area

The study area will be Tanzania main land as the title suggests the look of the macroeconomic

factors, of inflation, interest rate and money supply in a way they affect the economic growth

of Tanzania.

3.4 Research design

The study will adopt both descriptive and explanatory research designs. As the former allows

for description of a given phenomenon, the latter will allow test of relationships. Together

with that, an explanatory study enables the study to formally seek answers to problems by

answering the question “why” as opposed to questions such as “what”, “where”, “when”

29
which are answered by a descriptive approach. Finally, this combination of designs will

enable the study to describe relationship(s) among variables (Singleton and Strants, 2005;

Babbie, 2010). Further, the study will incorporate both quantitative and qualitative research

by collecting data for both. See a section on data collection techniques for further details.

3.4 Study Population

Since the inflation, interest rate, money supply and economic growth are macroeconomic

indicators therefore the population to be studied will be the whole of economy of Tanzania.

3.5 Sample Size

The study will use a sample of data of Tanzania economic growth from 1995-2020

3.6 Types and sources of data

This study will use secondary data sourced entirely from BOT (Bank of Tanzania) and World

Bank. The data to be used include Consumer price index (CPI), Real Gross Domestic Product

(RGDP), Interest rate and the Money supply covering the period from 1995 -2020.

Real Gross Domestic Product (RGDP) is an aggregate measure of the economy adjusted as

price changes. It represents the value of all goods and services produced in a country for a

given period of time measures in local currency. It is used to measure the overall economic

activities; the actual quantity of goods and services produced is what is known as GDP.

30
3.7. Methods/ Techniques

3.5.1 Inflation

A chief measure of inflation rate is the general price index (normally the consumer price

index) over time.

3.5.2 Interest rate

The most accurate measure of interest rates is yield to maturity (YTM). YTM is the total

expected return of a bond if it is held until the end of its lifetime.

3.5.3 Money supply

The alternative measures of money supply are labeled M1, M2, M3 and M4. The

measurement of the supply begins with the M0 or monetary base. It denotes the amount of

currency in circulation.

3.5.4 Economic growth

The size of an economy is typically measured by the total production of goods and services in

the in the economy which is called Gross Domestic Product (GDP).

3.8 Data processing and Analysis.

The research first will carry out a descriptive study on the variables and test for whether they
were trended or volatile. I will further carry out a normality test and conclude using the jaque
31
Bera probability, this aimed to see whether the variables were normally distributed. The
correlation analysis will also carried on under the null hypothesis to see if there is correlation
between the variables.

Because time series data will be used, to avoid having spurious results there is always need to
first test for stationarity therefore the researcher will ahead to test for unit root using Phillips
peron and Augmented Dickey-Fuller test (ADF).

3.9 Model specification.

The model below will be fit to test the long run and short run effect of inflation, interest rate
and money supply on economic growth of Tanzania.

GDPt= a + ∑biINFLt-i + ∑biIRt-i + ∑biMSt-i + et

The models below will be fit to test the causal relationship between inflation, interest rate,
money supply and GDP.

RGDPt= ∑biRGDPt-i + ∑biINFLt-i + ∑biIRt-i + ∑biMSt-i + et

INFLt = ∑biINFLt-i + ∑biRGDPt-i + et

IRt=∑biIRt-i + ∑biRGDPt-i + et

MSt=∑biMSt-i + ∑biRGDPt-i + et

Where

RGDPt = real gross domestic product in the current year

RGDPt-i = lagged value of real gross domestic product.

INFLt = inflation in the current year

INFLt-i = lagged values of inflation

IRt=Interest rate in the current year

IRt-i= lagged value of interest rate

32
MSt=Money supply in the current year

MSt-i=lagged value of money supply

et = the error term.

REFERENCE

1. Inflation as measured by the Consumer Price index (CPI) reflects the price level of a

market basket of a variety of goods and services that are purchased by a household.

What price Index measures is the variation of prices between goods and services by

reflecting their broad money movement (macroeconomics Jackson maclver)

2. Money supply in narrow definition money is a measure of money stock intended

primarily for use in transaction. It consists of currency held by public,

traveler’schecks, demand deposits and other checkable deposits. Broad money M2 is a

measure of the domestic money supply that includes M1 plus Quasi money (savings

and time deposits), overnight repurchase agreements and personal balances in money

market accounts. M3 is even broader it includes M2 and all large deposits, money

market funds and other financial instruments. Our study will adopt the broader

definition of money (M3) as money supply.

REFERENCES

Before data analyses insert model formulation

This study is a typical empirical study that uses econometric techniques to assess the effects

of inflation, interest rate and Money supply on economic growth.

33
3.6Data analysis Methods

The data analysis methodchoice is based on the specific objective of this study. Annual time

series data from different sources from year 1995 – 2020 will be used to establish the effect of

money supply, interest rate and inflation on economic growth. Therefore, the rudimentary

model will be as follows.

Y = β1 + β 2 i 1 + β 3 ms 2+ β 4 r 3 +u t … … ..(1)

33Where: Yis GDP growth rate, i1 is Inflation, ms2 is Money supply, r3 is interest rate and ut is

error term.

The AugmentedDickeys –fuller test (ADF) will be used to test the stationary of the data. This

process is essential to solve the problem of unit root (non- stationary) on the variables before

processing them. The test will be based on 5 percent level of significance therefore the null

hypothesis will be accepted if the p value is more than 5 percent and rejected if the p-value is

less than 5 percent.

3.6.1 Lag length selection number

Lagselection is determined by the use of Akaike information criteria (AIC), Schwarz

information criterion (SC), Hannan-Quinn information criterion (HQ). The lowest value of the

three criteria will be selected for the model(Sultana, 2018).Auto regressive distributed Lag

(ARDL) model test will be used to determine the lag variable. ARDL bound test will test the

existence of long run relationship between the variables where Y is dependent variable and

give the estimation of short-run and long-run coefficients. The basic model for the ARDL is

as follows;

∆ y t =β 1 + β 2 ∆ y t −1+ β3 ∆ i t −1 + β 4 ∆ lr t −1 + β 5 ∆ lmst −1+ β6 y t −1 + β 7 it −1+ β8 lr t−1 + β 9 lms t−1 +e t … … … …(2)

Where:∆ first difference operator and e t is the white noise residuals

34
3.6.2 Wald test

The Wald test will be used to test if there is long run and short run relationship between the

variables. The upper critical value will be compared with the f-statics; if f-static is greater

than upper critical value it implies there is a short run and long run relationship between

variables. But if the f value is lower than the critical value then there is no long

runrelationship between the variables namely, Inflation, interest rate, money supply on

economicgrowth.

3.6.3 ECM (Error Correction Model)

ECM is useful for estimation of both short run and long run relationship of variables showing

the speed of adjusting back to the long run equilibrium when and if they deviate from the

short run. The basic equation for ECM is as follows.

∆ y =β 1+ β 2 ∆ y t −1 + β 3 ∆ i t−1 + β 4 ∆ lr t−1 + β 5 ∆ lms t−1 + β 6 etct −1+u t … … … … ..(3)

The next step in establishing the existence of relationship between the variables will be to run

the residual diagnostic and stability tests of the ARDL model. The serial correlation,

functional forms, normality test and heteroscedasticity test will be found in residual diagnostic

(sultana, 2018).

35
 REFERENCES

Asimwe B, D.K (2019) “Assessment of monetary policy transmission mechanism in

Tanzania”, BOT, WP 19

Charles M, W.R (2018) “Drivers of economic growth in Tanzania”, BOT, WP 14

Joseph L, M.J (2015), “The interaction between finance, financial stability and economic

growth” BOT, WP 2

Wilfred .E.M, (2015) “Monetary policy rate pass through to retail bank interest rates in

Tanzania”, BOT, WP 4

Mundell, Y.A., (2005), Inflationand growth: an estimate of the threshold levell of inflation in

Pakistan, SBP-Research Bulletin, Volume 1,Number 1, 2005,PP. 35-43

Teshome, A. (2011) "source of inflation Always a monetary Phenomenon in Malaysia?",

Universitty of Sains Malaysia.

Nathan. S.(2015) " an assessment on relationship between inflation and the economic

growthof Tanzania, Mzumbe university.

Fitsum S. D, Yilkal W.A & Teshome A.R, (2016) " the relationship between Inflation ,money

market and economic growth in Ethiopia, Adis Ababa Ethiopia.

Faraji, K. Impactof Inflation on Economic growth; a case study of Tanzania, Asia journal of

empirical Ressearch

Mortaza, G. (2005), "Inflation and Economic growth in Bangladesh:19881-2005", Bank of

Bangladesh working paper Series, WP.0604

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Nicas Y, Nicholaus K,(2015) " AppropriateThreshold Level of inflation for Economic

Growth; evidence from the three EAC Founding Member countries, BOT, WP. 07

Chuan-Yen, c.(2012), "The Inflation Growth Nexus across countries under

simultaneousequation model" Academic research International Vol 2,pp. 18-32.

Odhiambo, M.(2011), InflationDynamics and economic Growth in Tanzania:

MultivariateTime series Model" university of south Africa.

Harswari, M (2017), “the impact of interest rate on economic development a study on Asian

countries”,

Arhin.E, W.A, (2017), “the effect of interest rate fluctuation on the economic growth of

Ghana”. Kwame Nkrumah Univesitr of science and Technology.

Mishikin F.S The economics of money, banking and financial market, 7th Ed

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