# **i) Cointegration results**

The following model is estimated by OLS and Phillips and Hansen’s (1990) FMOLS over the period 1970-2005: REER is the real effective exchange rate as measured as the nominal effective exchange rate multiplied by the ratio of foreign wholesale prices to Tanzanian CPI. A variety of measures of the REER (see Section II) including a measure that incorporates the parallel exchange rate will be used to test the robustness of the results. TOT is the terms of trade measured as Tanzania’s real commodity price index. AID is net aid inflows taken from the OECD’s DAC database.<sup>11</sup> We also include net private capital flows in the measure to capture total public and private capital inflows. Trade is a measure of trade liberalization and is proxied by the ratio of exports plus imports to GDP. PROD is a relative productivity measure aiming to capture Balassa-Samuelson effects and is measured as the ratio of real GDP per capita in Tanzania relative to its major trading partners. INV is government investment expressed as a percentage of GDP.

ADF tests indicate that the error term in our OLS regressions is stationary, indicating that there is a long-run cointegrating relationship between the REER and the fundamental macroeconomic variables chosen (Table 1). The preliminary results suggest that the terms of trade, aid and trade liberalization are strongly significant determinants of Tanzania’s long-run equilibrium exchange rate (Table 1, column (1)). The sign of the parameter estimate on the government investment variable is not as expected, although it is insignificant at conventional levels. The coefficient on the relative productivity measure is also insignificant, but this is likely the result of measurement error. It is also the case that the relative productivity measure is highly correlated with the terms of trade measure. We ran the specification alternately excluding the relative productively measure and the terms of trade measure and found that by excluding the ToT measure the relative productivity measure remained insignificant. On the basis of this result we dropped the relative productivity measure from the specification.<sup>12</sup> Dropping both the investment and the relative productivity measures from the original specification does not significantly alter the parameter estimates on the remaining variables or the overall goodness of fit of the model. Column 2 reports the results of the more parsimonious specification. This specification was re-run using the parallel nominal exchange rate in the REER index.<sup>13</sup> The signs and the significance of

> 11 The debt relief component of this measure is adjusted to better reflect the annual cash flow of HIPC debt relief which purges the DAC’s measure of the possible over recording of debt relief in a single year due to the practice of some DAC reporting creditors to record debt relief as stock of debt reduction operation rather than a flow of debt service reduction.

> 12 Better proxies for relative productivity differentials in the tradable and nontradables sectors are required before further testing on this variable can be undertaken.

> 13 The parallel nominal exchange rate is incorporated into the REER by taking a weighted average of the official and parallel rates by assuming that the share of transactions in the parallel market is 80 percent when parallel premium is highest and the share of parallel market trade decline proportionally with (square

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