External aid inflows and real exchange rate in Tanzania

This study estimates an empirical model for Tanzania’s real exchange rate with special focus on foreign aid. The study examined the trends of real exchange rate in Tanzania and explored the impact of foreign aid inflows on real exchange rate under the period of study. The study used annual time series secondary data for the period 1970-2003 in conducting estimations on the variables included in the model. Analysis of the data was done by using Ordinary Least Square (OLS) in the linear model. Analysis of the data was done by using Ordinary Least Square (OLS) in the linear model.Examination of the time series characteristics of the data was undertaken and testing for stationarity and co integration was considered. The model of the real exchange rate determination is adopted and foreign aid proxied the amount of Overseas Development Assistance (ODA) as percentage of GDP incorporated as one of the fundamentals of the real exchange rate. The main hypothesis of the study is that external aid inflows to Tanzania result in real exchange rate appreciation. This is consisted with the theory which postulates that aid inflowa result into increased real incomes and consequently increased demand for non-traded goods thereby precipitating appreciation of real exchange rate.The results show that foreign aid has resulted into depreciation of the real exchange rate for the period under study. This finding does not concur with the theoretical expectation which predicts that aid inflows will lead to real appreciation. This could probably happen due to some offsetting capital flows (capital flight)