International Capital Flows and Exchange Rates, a Dynamic Analysis: The Case of Tanzania

This dissertation investigates the impact of international capital flows and other macroeconomic fundamentals on the real exchange rate for Tanzania. In this dissertation I use a cointegrated vector autoregression (CVAR) or Vector Error Correction (VECM) framework of the Johansen (1988) and Juselius (1992) maximum likelihood estimation technique to assess the dynamic relationships among the real exchange rate, international capital flows i.e. foreign direct investment, foreign aid, and other macroeconomic fundamentals. For analysis of the short run structural VAR, I follow Sims (1986). Cholesky identification restriction of the structural shocks (innovations) is employed to investigate the dynamic effects of international capital flows, foreign aid, and other macroeconomic fundamentals on the real exchange rate by analyzing the orthogonalized impulse response functions (OIRF) in the economy.;The econometric results from the cointegration model revealed two long-run cointegration equations, showing that foreign direct investment and foreign aid have a statistically significant impact on the real exchange rate. That is a 1 percent increase in foreign aid as a percent of GDP reduces the real effective exchange rate by 2.88 percent, while for foreign direct investment as a percent of GDP decreases real exchange rate by 5 percent—hence both appreciating the value of the currency in the economy. Analyzing the Vector Error Correction Model, the speed of adjustments are significant and have an increasing impact on the real exchange rate toward the equilibrium which are 27.76 percent and 29.19 percent, this indicates a rapid response of the real exchange rate to deviations from its fundamentals; depreciating towards its initial equilibrium. The same results are supported by the forecast from the model, indicating that there is less appreciation of the currency in the future. Analyzing the impulse response functions I found that shocks are permanent in the economy. This study also used the Structural VAR model to analyze sterilization of the Tanzanian economy. I recovered the structural coefficient and found a significant impact of sterilization of the international capital flows of about 94.2 percent showing an almost complete sterilization in the economy. Sterilization results were comprehended by the orthogonalized impulse response functions.