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The Macroeconomic Dynamicsof Scaling –up Foreign Aid

Shantayanan Devarajan, Delfin S. GoJohn Page, Sherman Robinson, Karen Thierfelder

PREM-DEC Workshop – The Delivery of Scaled Up Aid: Does Predictability Matter?

December 17, 2007

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Motivation:Aid is about the future If agents respond to aid in the same way they make inter-

temporal choices, what will be the impact on the economy? Real exchange rate (Dutch disease) Consumption Investment Growth

Will the results differ critically from what a static model will predict?

Re scaling up of foreign aid – Are the optimists right in some pure economic arguments? Does aid predictability matter?

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Recent Literature Empirical estimates generally reliable Recursive dynamics in a computable

general equilibrium (CGE) model. Van Winjbergen (1984), Gelb et al. (1988),

Benjamin, Devarajan,and Weiner (1989), Adam (2005), Bourguignon et al. (forthcoming).

Inter-temporal dynamic models don’t focus on aid and the price of tradables to non-tradables (the real exchange rate). Devarajan and Go (1998), Turnovsky and

Chatterjjee (2004), Mirzoev (2007).

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Our contribution to the debate Compare the static and dynamic

effects of exogenous aid flows. Demonstrate the implications of inter-

temporal choices. Generalize the results of the

“standard” 1-2-3 Salter-Swan model on the real exchange rate.

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Key Findings A model with choice and inter-

temporal optimality eliminates the Dutch disease problem. No additional links between trade and

total factor productivity (TFP) needed. No assumptions about the

complementarity between public and private capital.

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1-2-3 Aid Model Producer and consumer decisions are

both intra- and inter-temporally consistent.

An upward sloping supply curve for external debt.

A risk premium that rises with external debt.

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1-2-3 Aid Model Flexible Dynamic Country

Forward looking investment and consumption.

External borrowing (subject to an upward sloping supply of debt) is an integral part of optimal decision making; adjusts to bridge the gap between investment and savings.

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1-2-3 Aid Model Credit constrained country

Severe constraints in savings and external borrowing.

Investment each period is not forward looking; it adjusts to available savings.

External savings are exogenous. If foreign aid is predictable and stable,

consumption is forward-looking and dynamic . If foreign aid is unpredictable and volatile,

consumers are myopic and optimize in each time period.

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Simulations: Foreign aid in a flexible dynamic economy Permanent increase in foreign aid (2

percent of GDP). Temporary increase in foreign aid (2

percent of GDP for 10 years).

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Simulations: Foreign aid in a credit constrained economy Permanent increase in foreign aid (2

percent of GDP). Consumers make optimal inter-temporal choices. Investment decisions are not based on a

comparison of the marginal returns of additional capital to its replacement costs; instead investment is completely driven by the inter-temporal decision to consume or save.

Temporary increase in foreign aid (2 percent of GDP for 10 years). All aid goes to government spending. All aid goes to investment spending.

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Real Exchange Rate, Flexible Dynamic Economy

0.991

1.011.021.031.041.051.061.071.08

1 4 7 10 13 16 19 22 25 28 31 34 37 40time periods

real

exc

hang

e ra

te

AID-P AID-P & trade AID-T10 AID-T10 & trade

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Investment, Flexible Dynamic Economy

11.051.1

1.151.2

1.251.3

1.351.4

1.45

1 4 7 10 13 16 19 22 25 28 31 34 37 40

time periods

inve

stm

ent r

atio

AID-P AID-P & trade AID-T10 AID-T10 & trade

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Consumption, Flexible Dynamic Economy

0.9

0.95

1

1.05

1.1

1.15

1.2

1 4 7 10 13 16 19 22 25 28 31 34 37 40

time periods

cons

umpt

ion

ratio

AID-P AID-P & trade AID-T10 AID-T10 & trade

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Debt, Flexible Dynamic Economy

0

0.2

0.4

0.6

0.8

1

1.2

1 4 7 10 13 16 19 22 25 28 31 34 37 40time period

debt

ratio

AID-P AID-P & trade AID-T10 AID-T10 & trade

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Real Exchange Rate, Credit Constrained Economy

0.920.930.940.950.960.970.980.99

11.01

1 4 7 10 13 16 19 22 25 28 31 34 37 40time periods

real

exc

hang

e ra

te

AID-P & I adj AID-P & I adj & trade AID-P & G adj

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Investment, Credit Constrained Economy

11.051.1

1.151.2

1.251.3

1.351.4

1.45

1 4 7 10 13 16 19 22 25 28 31 34 37 40

time periods

inve

stm

ent r

atio

AID-P & I adj AID-P & I adj & trade AID-P & G adj

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Consumption, Credit Constrained Economy

0.9

0.95

1

1.05

1.1

1.15

1 4 7 10 13 16 19 22 25 28 31 34 37 40

time periods

cons

umpt

ion

ratio

AID-P & I adj AID-P & I adj & trade AID-P & G adj

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Real Exchange Rate, Permanent Aid, with and without Credit Constraints

0.86

0.88

0.9

0.92

0.94

0.96

0.98

1

1.02

1.04

1.06

1.08

1 4 7 10 13 16 19 22 25 28 31 34 37 40time periods

real

exc

hang

e ra

te

AID-P AID-P & G adj

AID-P & G adj & myopic AID-P & I adj & myopic

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Investment, Permanent Aid, with and without Credit Constraints

1

1.05

1.1

1.15

1.2

1.25

1.3

1.35

1 4 7 10 13 16 19 22 25 28 31 34 37 40time periods

inve

stm

ent r

atio

AID-P AID-P & G adj AID-P & G adj & myopic AID-P & I adj & myopic

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Consumption, Permanent Aid, with and without Credit Constraints

0.9

0.95

1

1.05

1.1

1.15

1.2

1 4 7 10 13 16 19 22 25 28 31 34 37 40

time periods

cons

umpt

ion

ratio

AID-P AID-P & G adj AID-P & G adj & myopic AID-P & I adj & myopic

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Conclusions When aid recipients can plan consumption

and investment decisions optimally over time, aid induced appreciation of the real exchange rate (Dutch disease) does not appear.

Aid should be predictable for intertemporal smoothing to take place. If aid volatility forces recipients to be

constrained and myopic, Dutch disease problems become an issue.