12 The Short-Run Macroeconomics of Aid Inflows

Andrew Berg, and Rafael Portillo
Published Date:
April 2018
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Andrew Berg, Tokhir Mirzoev, Rafael Portillo and Luis-Felipe Zanna 

1 Introduction

African countries are exposed to a variety of external shocks, which can generate large swings in output, inflation, and the balance of payments. The impact on the domestic economy is typically mediated by the broad policy response to these shocks, though the role of different types of policy is often not fully understood. This is the case for example with (unexpected) changes in aid flows. Much of the discussion typically assumes that the effects of aid depend mainly on the fiscal response. To the extent aid is used to finance higher government spending, then it is assumed that it must also help finance a higher current account deficit net of aid, i.e., higher absorption. The appreciation of the real exchange rate plays an important role in this process: it helps reallocate private demand away from non-traded goods (which is what the government typically spends on) and toward traded goods (which helps absorb the additional aid).

Little attention is paid to how the reserve policy of the central bank may affect the impact of aid, an important issue when analysing the experience of African countries. In the case of Uganda, aid inflows and aid-financed government spending increased considerably during the first half of the 2000s, yet the current account deficit net of aid did not increase (Table 12.1). Instead, the additional aid ended up accumulated as reserves. In addition, the real exchange rate depreciated and the country experienced a considerable increase in real interest rates—a variable that is often ignored in the analysis of aid. As documented in Berg et al. (2007), other African countries with large aid surges also experienced a fiscal expansion, a large accumulation of reserves, and a real depreciation.

Table 12.1.Selected Macroeconomic Variables, Uganda, 1998–2004
Average Pre-Aid Surge 1998–2000Average Aid-Surge 2000–04Difference
Fiscal Variables (in per cent of GDP)
Net Aid7.910.62.7
Expenditure (excluding external interest)
Balance of Payments (in per cent of GDP)
Net Aid7.710.83.1
Current account deficit net of aid11.512.10.6
Capital account surplus net of aid-3.6-3.50.1
Reserve accumulation-
Central Bank Balance Sheet (in per cent of GDP)
Reserve accumulation-
Changes in net domestic assets0.7-1.6-2.3
Base money growth0.40.70.3
Relative Prices
Real effective exchange rate (depreciation)9.16.3
Terms of trade (worsening)14.45.9
91-day real Treasury-bill rate5.68.42.8
Nominal Variables
Nominal effective exchange rate (depreciation)9.46.3
91-day Treasury-bill rate8.211.63.4
Source: IMF Staff Reports, IFS, Bank of Uganda.
Source: IMF Staff Reports, IFS, Bank of Uganda.

The above experience suggests that the distinction between the spending and the absorption of the aid can be an important factor in understanding its macro effects.1 While the former is determined by the fiscal policy response, the latter can be influenced by the reserve policy of the central bank. In the case of Uganda, aid was spent but not absorbed.

In practice, there is no institutional arrangement between the government and the central bank that ensures coordination of the two policy responses. In a canonical aid transaction, the foreign exchange (FX) from aid accrues to the government, which sells it to the central bank in exchange for a local currency deposit. The central bank in turn decides on its own whether to accumulate the FX as reserves, and whether such accumulation should be sterilized, as it was in Uganda. Depending on the policy mix, there can be several possible combinations of spending and absorption (Figure 12.1).

Figure 12.1.Possible Fiscal and Reserve Policy Combinations

In this chapter we provide a framework for thinking about the macroeconomics of aid flows, centred on the fiscal/reserve policy interaction. Given the surprising depreciation of the real exchange rate and the simultaneous increase in real interest rates in Uganda, we study whether certain combinations of fiscal and reserve policy can account for this joint behaviour.

We present our analysis in the context of a tractable two-sector dynamic general equilibrium model with nominal rigidities. Our model conforms with the New Keynesian paradigm but emphasizes important features of low-income countries: little market power in export markets, limited international capital mobility, and consumers’ limited participation in domestic financial markets. We also extend the policy set of the central bank to include two rules: the standard monetary policy rule and a separate rule determining the rate of reserve accumulation. Given the model’s tractability, we can represent the short-run equilibrium using a graphic representation of external and internal balance.2

With the help of our model we show that a policy combination that results in spending but not absorbing the aid can generate both an increase in real interest rates and, under certain conditions, a real exchange rate depreciation. The starting intuition for our results is that spending but not absorbing the aid is akin to a domestically financed fiscal expansion: public spending increases but the foreign exchange from the aid is not being used to increase the country’s external financing. The increase in spending must therefore come at the expense of the private sector, which is crowded out. Another way of restating the same idea is that aid is being ‘used’ twice: once to increase government spending, and once to increase the stock of reserves. Note that this intuition also justifies the choice of a New Keynesian framework with non-Ricardian features—in this case limited participation in domestic financial markets—to study the short run macroeconomics of aid flows.

The results from the model can be summarized as follows:

  • A policy mix that results in spending and absorbing the aid leads to an appreciation of the natural real exchange rate and little movement in the natural rate of interest, where ‘natural’ denotes the flexible-price equilibrium values. In contrast, a policy that results in spending without absorption moderates the appreciation of the natural real exchange rate and increases the natural rate of interest. The appreciation is moderated because there is no increase in external financing, while the rise in the natural rate of interest reflects the crowding out of the private sector.
  • Once we introduce nominal rigidities in the non-traded sector, the increase in the natural rate of interest implies that spending but not absorbing the aid generates demand pressures, i.e., temporary increases in inflation and the aggregate output gap. This is a well-known result of the standard closed-economy New Keynesian model in which monetary policy is not optimal. Because our model is isomorphic to that setup (when the capital account is closed), the same result applies here.3
  • Demand pressures are associated with a more depreciated real exchange rate relative to the flexible-price case. They result in an increase in aggregate labour demand and therefore generate an increase in real wages. This requires a more depreciated real exchange rate—relative to its ‘natural’ value—to guarantee external balance.4

For the real exchange rate to depreciate in absolute terms, demand-related pressures must dominate the ‘natural’ real appreciation. We use this distinction to clarify how various features of the model affect the results. Limited participation in domestic financial markets increases the likelihood of a real depreciation because it amplifies demand pressures. The same holds if monetary policy is loosened as a result of incomplete sterilization of reserves, whereas a more aggressive monetary policy (a higher coefficient on inflation in the Taylor rule) will have the opposite effect. On the other hand, the natural appreciation becomes smaller if the share of government spending on traded goods increases.

When we calibrate the model to Uganda, simulate a temporary aid increase, and assume aid is spent but not absorbed, the model generates a temporary real depreciation and an increase in the real interest rate. However, once the capital account is open, the mapping between reserve accumulation and absorption is considerably weakened. As a result, aid invariably leads to a real appreciation, unless the accumulation of reserves is not fully sterilized. While this is an important caveat, the assumption of limited capital mobility is broadly consistent with the behaviour of the capital account in Uganda following the aid surge.5

Our chapter is organized as follows. Section 2 briefly discusses the experience of Uganda. Section 3 presents the model, while Section 4 focuses on the short-run equilibrium when prices are flexible. Section 5 adds nominal rigidities, and discusses the calibration and simulated results. Section 6 concludes.

2 The Aid Surge in Uganda

To provide some motivation and context for our approach, we briefly describe the experience of Uganda—summarized in Table 12.1. Starting in 2000, this country experienced a sustained increase in aid flows. Net aid, defined as the sum of gross aid flows and debt relief minus debt service and arrears clearance, increased by about 3 percentage points of GDP (on average) during 2000–04, with a subsequent fall below pre-surge levels after 2005. In present value terms, the surge represented 11 per cent of Uganda’s GDP in 2000–01; by way of historical comparison, the transfer associated with the Franco-Prussian war indemnity—the largest transfer in history—represented 25 per cent of the French economy in 1870 (Devereux and Smith, 2007). Most of the increase took the form of budget support rather than project aid (Berg et al., 2007).

The surge to Uganda coincided with a sharp increase in overall aid to sub-Saharan Africa over the same period, up 42 per cent in real terms from 1999 to 2004 (IMF, 2008a). This increase reflected renewed donor enthusiasm for aid in the context of the UN Millennium Development Goals campaign, the end of a post-Cold War decline in aid, and the implementation of the highly indebted poor countries (HIPC) debt relief initiative. Uganda benefited from this trend because of its successful track record in the 1990s, pre-existing strong policy regime, and good relationships with major donors, all of which made it an attractive target for additional assistance.6

Following the aid surge, fiscal authorities responded by increasing public spending (net of interest payments on foreign debt) by an average of 2.3 percentage points of GDP over the same period, with the difference being used to improve the fiscal balance.7 Most of the foreign exchange flow associated with the aid was accumulated as reserves by the central bank (2.3 per cent increase), with the difference financing a higher current account deficit before aid (of 0.6 per cent). Only a small fraction of the increase in reserves resulted in an increase in base money growth (0.3 per cent of GDP)—in other words almost all was sterilized.

The contrast between the fiscal and the reserve response reflected the de facto separation of policy objectives between the government and the central bank. The increase in government spending was consistent with the authorities’ goal of providing public services and implementing investment projects, while also satisfying the donors demand that aid be used in the first place. On the other hand, the reserve policy response reflected the central bank’s concern with ‘external competitiveness’.

Against this backdrop, the real exchange rate depreciated considerably, most of it on account of a nominal depreciation. It is likely that some of the real depreciation reflected the worsening of the terms of trade, which started before the aid surge. However, back-of-the-envelope calculations in Berg et al. (2007) suggest the additional financing provided by the aid surge was much larger than the direct income effect of the terms of trade change. Finally, both nominal and (ex post) real Treasury-bill rates increased by about 200 basis points during the aid-surge period; while six-month and one-year rates increased by about 500 and 600 basis points, respectively.

We now proceed with the description and analysis of the model, before returning to simulations that capture some of these stylized facts.

3 The Model

In this section we present our small open economy model, where the only source of uncertainty is a shock to foreign aid. The economy has two goods, a traded good (T) and a non-traded good (N), and consists of the following agents: i) households; ii) firms; iii) a central bank in charge of monetary policy and reserve accumulation; and iv) a fiscal authority.

3.1 Households

There is a continuum of households [0, 1], all valuing consumption and hours worked. For any household j, consumption is given by a standard CES basket:

which implies the consumer price index (CPI) (CPI)Pt=(φ(PtN)1χ+(1φ)(PtT)1χ)11χ. PtTandPtN correspond to the prices of the goods, χ denotes the elasticity of substitution between traded and non-traded goods, and φ is the degree of home bias in consumption. Equation (1) implies the following demand functions for traded and non-traded goods:

Households differ in their access to financial markets. A fraction p trade in asset markets, which allows them to smooth consumption in a forward-looking manner. These asset holders are indexed by the superscript ‘a’. The remaining households—the fraction (1 – p)—have no assets and fully consume their current labour income. They are indexed by the superscript ‘h.’ We now describe the optimization problem faced by each type of agent.

Asset Holders The representative asset holder maximizes expected life time utility:

where lta is the amount of labour supplied and ψ is the inverse of the labour supply elasticity. His budget constraint, deflated by the domestic CPI, is given by:

where btac is the saver’s real holdings of domestic bonds issued by the government, which pay a ‘gross’ nominal interest rate it; and bta* denotes his holdings of foreign assets deflated by the foreign price index (Pt*), which pay a gross nominal international interest rate i* and are subject to portfolio adjustment costs Q(bta*). The variable st is the CPI-based real exchange rate (st=StPt*Pt), where St is the nominal exchange rate; πt is gross domestic inflation (πt=PtPt1) is the real wage; ΩtaN denotes asset holders’ profits from domestic firms in the non-traded sector; and τ is a real lump sum tax levied by the government.8 Utility maximization results in the following first-order conditions:

Portfolio adjustment costs are given by Q(bta*)=v2(bta*ba*)2, where ba* is the steady state value of the foreign assets. These costs ensure stationarity bta* and allow us to model various degrees of international capital mobility.9 When υ >>> 0, a sterilized foreign exchange rate intervention will influence the exchange rate: ceteris paribus, by reducing bta*, a purchase of foreign exchange with domestic bonds will increase expected returns on foreign assets—net of adjustment costs—and cause a nominal depreciation.10

Non-Asset Holders Households that do not have access to asset markets maximize the same lifetime utility function as in (3) but subject to a static budget constraint:

The optimization programme for these consumers reduces to a single first-order condition:

Aggregation We define aggregate consumer-related variables as:

3.2 Firms

Non-traded goods sector The non-traded good ytN is a composite good made from a continuum of varieties—indexed by i ∈ [0, 1]—satisfying ytN=(01yitNθ1θdi)θθ1, where θ is the elasticity of substitution between varieties. The demand for variety i is given by:

with PtN defined as PtN=(01PitN1θdi)11θ The non-traded sector features monopolistic competition, with each firm producing a variety. Production by firm i is given by:

where litN is the amount of of labour employed, α is the labour share, and zN is a productivity parameter. The monopolist also faces price adjustment costs that are similar to Rotemberg (1982): F(ptN,ytN,πitN)=ptNζ2(τitN1)2, where

The monopolist chooses pitN to maximize its real discounted flow of profits:

where Jt=βctact+1a. Each firm receives a subsidy ι, which is financed with a tax common to the entire sector.11 Focusing on a symmetric equilibrium, the first order condition is the following:

Traded goods sector The traded goods sector features perfect competition and flexible prices. We assume the law of one price holds: PtT=StPtT*, where PtT* is the foreign price of traded goods. Production by firm j is the following:

The representative firm chooses litT to maximize real profits: E0t=0Jt[stzT(litT)αwtTlitT], which leads to the following first-order condition:

3.3 The Government

The government spends on a basket of traded and non-traded goods:

which implies the following government price index, measured in real terms:

and the following demand functions:12

The government budget constraint is given by:

The government finances spending with taxes τ, aid proceeds stAt* (of which it is the direct recipient), changes in deposits held at the central bank (dtdt1πt), or domestic debt issuance (btbt1πt). It pays interest on government debt held by the private sector btc, which is the difference between total debt and debt help by the central bank btcb:

We assume foreign aid At* follows the process:

where A* is the steady state level of aid and εt is an i.i.d. shock. Fiscal policy is determined by rules for deposits and gross debt. Deposits are determined as follows:

where d is a deposit target. When aid increases, the government initially spends a fraction γ. In this regard, γ measures the degree of short-term aid spending. Aid-related deposits are drawn down at rate ρd. Debt accumulation follows a simple rule:

where ς is small but positive. This ensures that open market operations—which affect government interest payments—do not influence the steady state fiscal position.

3.4 The Central Bank

We initially assume the economy is cashless, which implies the central bank balance sheet does not contain any monetary liabilities. Changes in its balance sheet are given by:

where Rt* is the level of foreign reserves. Central bank policy is given by a Taylor rule:

which implicitly defines the inflation objective πN = 1, and a reserve policy rule:

where R* is a long-run target.13 The central bank initially accumulates a fraction (1 – ω) of the increase in aid as reserves, which will eventually be drawn down at rate ρR. When the capital account is closed, ω is a direct measure of short-term aid absorption.

3.5 Equilibrium Conditions

The labour market equilibrium (LL) is given by the following equation:

Then there is the equilibrium in the non-traded goods market:

The balance of payments (BOP) is derived by adding all budget constraints:

Equation (28) summarizes the possible uses of aid: it can finance a higher current account deficit (net of aid), a capital account surplus, or an accumulation of reserves.

Finally, it is useful to introduce real GDP, which is defined as the sum of production in both sectors, valued at their normalized steady-state prices pN and s:

We define an equilibrium in this economy as follows:

Definition: Given {b1,b1c,b1*,R1*,d1g} the targets and policies {bc,ba*,R*,dg,πN,τ,ι,} and the stochastic process for aid {A*}t=0, a symmetric equilibrium is a set of stochastic process {cta,ctaN,ctaT,cth,cthN,lta,lth,ltN,ltT,ytN,ytT,gt,gtT,gtN,bt,btc,btac,btcb,bta*,bt*,Rt*,dtg}(t=0) and {wt,st,ptN,ptg,πt,πtN,it}t=0 satisfying (i) the demand functions and price indices (2), (12), (16), and (17); (ii) the optimal conditions for consumers (5)-(7) and (8)-(9); (iii) the optimal conditions for firms (11), (13)-(15); (iv) the government rules and constraint (18)-(22); (v) the central bank rules and constraint (23)-(25); (vi) the aggregation and equilibrium market conditions for labour, non-traded goods and the BOP (26)-(28).

This concludes the presentation of the model. We use a log-linearized version of the above equations (around the model’s deterministic steady state) to generate impulse response functions to an increase in aid following various fiscal and central bank policy responses; the complete system of log-linear equations is presented in Berg et al. (2010). A hat (x^) indicates log-deviations from steady state, except for stocks, for which it indicates changes in per cent of steady state GDP.

3.6 Graphic Representation of the Model Solution

We show in Berg et al. (2010) that the equilibrium dynamics of the model can be simplified to a system of two equations and two variables, private consumption and the real exchange rate, c^tands^t, shown in Figure 12.2. Here we provide a non-technical description of the economics behind these two curves; for a full derivation see Berg et al. (2010).

Figure 12.2.External and Internal Balance

The first equation captures internal balance: the equilibrium in the non-traded goods market and in the labour market in that sector. The relation between c^tands^t is negative: an increase in aggregate private consumption (c^t) increases demand for non-traded goods and reduces the overall supply of labour (via the labour supply equation). A real appreciation (s^t) helps reduce demand and increases supply of non-traded goods (by reducing real product wages in the sector). The increase in government spending (in response to a positive aid shock) shifts the internal balance curve to the left, with the magnitude of the shift given by the coefficient of short-term aid spending (γ) and the share of government spending spent on non-traded goods (φg).14 In addition, deviations in non-traded firms’ mark-ups μ^tN, which stem from the presence of nominal rigidities, also shift the internal balance curve: a decrease in mark-ups μ^tN<0 results in greater production of non-traded goods for any given real exchange rate, which implies the internal balance curve shifts right.

The second equation captures external balance: the combination of private consumption and the real exchange rate that helps clear the balance of payments and the labour market in the traded sector. The relation is positive. An increase in consumption (c^t) increases demand for traded goods and reduces overall labour supply; a real depreciation (s^t) helps reduce demand and increases supply for traded goods (by reducing real product wages in the sector). Increases in aid shift the external balance curve to the right, with the magnitude of the shift depending on whether international reserves increase (given by (1 – ω)). Fiscal policy may also affect external balance if some of the government spending goes to traded goods (φg < 1). Finally, note that increases in net foreign asset holding by the private sector also shift the external balance curve (in this case to the left).

4 Fiscal and Reserve Policy Interaction Under Flexible Prices, Closed Capita Account, and φg = 1

To develop some intuition for our results below, we first focus on a simplified version of the model. In particular, we study the interaction of spending and reserve policy response to an increase in aid—the pair (γ,ω)—under: (i) flexible prices, ζ = 0 and μ^tN=0, (ii) a closed capital account, υb = +∞, and (iii) no government spending on traded goods φg = 1. We relax these assumptions later. We will use a (*)n‘ superscript for equilibrium variables under flexible prices.

Note that, when φg = 1, the government’s spending of the additional aid (γ > 0) affects internal balance only (the IB curve shifts to the left), while the central bank’s sale of the aid-related FX (ω > 0) affects external balance (the EB curve shifts downward). We look at four policy combinations (see Figure 12.3); point a refers to steady state.

Figure 12.3.Alternative Spend and Absorb Scenarios

4.1 Complete Spending and Absorption-Point b

If aid is spent and the central bank sells all the aid-related FX (γ = 1, ω = 1), the short run equilibrium moves from point a to b. The real exchange rate appreciates and consumption increases slightly.15

Complete spending but no absorption-pointc. If aid is spent but the central bank uses all of the FX to accumulate reserves (γ = 1, ω = 0), there is a smaller real appreciation and private consumption is crowded out.

Complete absorption but no spending-pointd. If the central bank sells the FX but government spending does not increase (γ = 0, ω = 1), there is also a smaller real appreciation but with higher consumption.

No absorption and no spending—pointe. Finally, if aid is not spent but the FX is accumulated as reserves (γ = 0, ω = 0), there is no initial impact on the real exchange rate or consumption.

4.2 Reserves Policy, the Real Exchange Rate, and the Natural Rate of Interest

Much of the policy debate about the short-term response to aid takes spending as given and focuses on the central bank response; we will set (γ = 1) for the remainder of the chapter and analyse the role of ω.

It is helpful to derive the implications of aid on the natural rate of interest, i.e., the real interest rate under flexible prices r^tN.16 For a given increase in aid, Figure 12.4 displays the pair (r^tN,s^tN), in the short term, as w goes from one (complete absorption, shown as point b in the figure) to zero (no absorption, shown as point a). As reserve accumulation increases (ω ↓), the size of the ‘natural’ real appreciation (represented on the y axis) is reduced while the natural rate of interest (represented on the x axis) increases—consistent with the crowding out of the private sector. We also show how the result changes when the share of spending on traded goods by the government increases (φg ↓). As φg ↓, the range of real exchange rate movements shifts up—there is less appreciation—while the range of real interest rates remains the same.

Figure 12.4.Alternative Reserve Policy Responses: Impact on s^tNandr^tN

To summarize, the experiments presented here have shown that, when capital mobility is limited, the short-run impact of aid on the real exchange rate and other real variables depends crucially on the combination of fiscal and reserve policy responses, as well as the composition of spending. The differences become starker once we introduce nominal rigidities, which we discuss in the next section.

5 Policy Interactions Under Sticky Prices

We now analyse how nominal rigidities (ζ > 0) affect the short-run effects of aid. It is no longer possible to fully characterize the short-run equilibrium with the system of external and internal balance, although we will use it to clarify the role of nominal rigidities. Instead, we simulate the model calibrated to the Ugandan economy.

5.1 Calibration

The calibration is shown in Table 12.2. β is set so the equilibrium annual real interest rate is 4 per cent. The non-traded share of employment and GDP (δ), and the ratios of government spending and aid to GDP (κg and κA) are based on Uganda’s national income and fiscal accounts prior to the aid surge.17 We set φg = 0.8 based on data from the Bank of Uganda; the share of consumption in GDP (κc) and the share of non-traded goods in consumption (φ) follow from the country’s resource constraints.18 Our baseline maintains υb = +∞ (closed capital account).

Table 12.2.Benchmark: Calibrated Parameters

The labour share α is calibrated to the employment compensation share in Uganda’s 2002 input-output table, and χ is calibrated to the estimate of import demand elasticity for Uganda from Tokarick (2008). We do not have estimates of labour supply elasticity (ψ-1); we set ψ = 2. We set ζ= 10, which is consistent with firms changing prices every 3.5 quarters.

The share of asset holders p is set to 40 per cent, based on a comprehensive survey of financial access in Uganda.19 The coefficient ρA is chosen so that the increase in aid has a half-life of about a year and half; the choice of ρR ensures reserve accumulation is persistent. Finally, Uganda, like many African countries, does not set operational targets on interest rates; we choose a Taylor rule for simplicity and our value for ϕπ (1.5) is standard. We experiment with an alternative monetary policy rule below.

5.2 Simulation Results

We examine the dynamics of the model following a 50 per cent increase in At* (about 3 percentage points of GDP), similar to what Uganda experienced during the aid surge. Impulse response functions are computed under both sticky and flexible prices.20

5.2.1 Complete Spending and Absorption (Figure 12.5)

Figure 12.5.Spend and Absorb Scenario (Per cent Deviations from Steady State)

In this case, there is an equivalent increase in government spending and the current account deficit (net of aid).21 The real exchange rate appreciates and the impact on real GDP is close to zero: the expansion of the non-traded sector is almost fully offset by the contraction in the traded sector. Real wages increase. There is a small increase in non-traded inflation (shown in annualized terms), which is consistent with a small decline in markups. Headline inflation falls while nominal and real interest rates remain unchanged. Note that the simulation under sticky prices is very similar to its flexible price counterpart.

5.2.2 Complete Spending, Zero Absorption (Figure 12.6)

Figure 12.6.Spend, No Absorption Scenario (Per cent Deviations from Steady State)

This case matches the policy response observed in Uganda (Table 12.1). Government spending increases but the current account deficit net of aid stays flat. The real exchange rate now displays a depreciation, there is a large decline in markups, consistent with aggregate demand pressures, and inflation increases considerably. The monetary policy response results in a large increase in real interest rates, while output expands for two reasons: an increase in labour supply—related to the crowding out of consumption—and higher demand pressures. Note that the performance of the model with sticky prices is very different from the flexible-price version: we observe higher output and inflation, lower mark-ups, higher real wages, and a more depreciated real exchange rate.

5.3 Discussion

The simulations raise two related questions: why are there demand pressures when aid is spent but not absorbed, and how can these pressures generate a temporary real depreciation?

5.3.1 Why are There Demand Pressures When Aid is Spent but not Absorbed?

To understand this question, it is helpful to look at one-sector closed economy New Keynesian models. These models typically feature three equations: an IS curve that relates the output gap to the difference between the actual real interest rate and the natural rate of interest; a New Keynesian Phillips curve; and a monetary policy rule.22 It is a well-known property of these models that real shocks affect inflation through their implication for r^tn. In particular, increases in r^tn will generate a positive output gap, provided monetary policy is not optimal, i.e., ϕπ << ∞. When the capital account is closed, our model admits the same representation after some additional derivation, i.e., it is isomorphous to the closed economy model.23 So the same logic applies here: since spending but not absorbing the aid raises r^tn, it generates demand pressures. This is not the case when aid is both spent and absorbed, as can be seen in Figure 12.3. In that case the increase in aggregate demand stemming from higher government spending is offset by an increase in the trade deficit (the current account deficit net of aid).

5.3.2 How Can Demand Pressures Generate a Temporary Real Depreciation?

Under sticky prices, the real exchange rate following an aid shock is the combination of the real exchange rate under flexible prices and an additional effect stemming from aggregate demand and the presence of nominal rigidities, which we denote s^gapt:

We know that s^tn<0 (the ‘natural’ real exchange rate appreciates somewhat) when aid is spent but not absorbed (see Figure 12.3)). For the actual real exchange rate s^t to depreciate when aid is spent but not absorbed, a necessary condition is that s^gaptn>0, which is indeed the case.

To understand why this is the case, it is useful to recall that aggregate demand pressures shift the internal balance curve to the right, as these pressures generate a decrease in non-traded goods mark-ups and firms in that sector produce more goods (for a given real exchange rate). The shift in the internal balance curve stemming from lower mark-ups results, all else equal, in a relatively more depreciated real exchange rate (and a relatively higher level of private consumption). This is because, as non-traded firms increase their demand for labour, real wages increase. Since higher real wages tend to reduce the supply of traded goods—relative to the flexible price case—a more depreciated real exchange rate is necessary to re-establish external balance, by increasing product wages in the sector and switching expenditure away from traded goods.

Finally, for s^t>0 it must be the case that s^gapt>s^tn. This clarifies what makes a real depreciation more likely when aid is spent and not absorbed: factors that decrease the natural appreciation of the real exchange rate (s^tn) and factors that amplify demand pressures (and increase s^gapt). Two features are worth mentioning here. First, in the model calibration for Uganda we have φg < 1, which reduces the natural appreciation. Second, we have rule-of-thumb consumers (p < 1) which, as we show below, tend to amplify the aggregate demand effects from a domestically financed fiscal expansion. The combination of these two features, together with the rest of the calibration, is sufficient to generate a small depreciation when aid increases.

5.4 Sensitivity Analysis

We now analyse how several features of the model affect the macro impact of aid and how these effects vary with the reserves policy response. We limit ourselves to three cases: (i) excluding rule-of-thumb consumers (p = 1), (ii) a perfectly open capital account, and (iii) incomplete sterilization of reserve accumulation.24 The results from these alternative specifications are presented in Table 12.3.

Table 12.3.Sensitivity Analysis
BenchmarkFlex P. ζ = 0Asset holders p = 1Open K. Acc. υb = 0.0125Inc. Sterilization f=0.9
No Res. Accumul. (Per cent dev. from SS)
Full Res. Accumul. (Per cent dev. from SS)

5.4.1 Excluding Non-Asset Holders

When the share of non-asset holders falls from 60 per cent (p = 0.4) to zero (p = 1), the response of the economy varies depending on whether aid is absorbed or not. When aid is absorbed results are similar to the benchmark. When aid is not absorbed, demand pressures are now smaller and the real exchange rate no longer depreciates. This result confirms the fact that non-asset holders amplify demand pressures. A related point is that the increase in equilibrium real interest rates is larger when there are rule-of-thumb agents.

5.4.2 Opening the Capital Account

We now assume that the capital account is open with changes in private foreign asset holdings subject to small portfolio adjustment costs. We set υb = 0.0125, which implies that, ceteris paribus, a decrease in private NFA by 5 per cent of annual GDP leads to an increase in annualized domestic interest rates of 100 basis points. In addition to (s^t,y^t,π^t,r^tπ^t+1) we also study the impact on the BOP categories (see Table 12.3).

In this case, reserve accumulation has a smaller impact on real variables, including the current account deficit which is now determined in part by inter-temporal considerations. When all aid-related foreign exchange is sold to the private sector, there is both a higher current account deficit net of aid and a capital account surplus. Since absorption is now smaller, real exchange rate pressures are smaller. When the central bank accumulates reserves, the private sector borrows from the rest of the world to maintain a broadly similar—although smaller—current account deficit, resulting in large capital inflows.

Relative to the previous discussion, the sterilized accumulation of reserves—during an aid-financed fiscal expansion—cannot generate a short-term real depreciation when the capital account is perfectly open. More generally, the (sterilized) reserve policy of the central bank has a limited impact on the macroeconomy. Note, however, that an unsterilized reserve accumulation will lead to a real depreciation, regardless of the degree of capital mobility. We discuss the role of sterilization next.

5.4.3 Incomplete Reserve Sterilization

As discussed in Berg et al. (2007), in contrast with Uganda, some of the countries that accumulated reserves during scaling-up episodes did not fully sterilize. To analyse this scenario, we introduce (real) money balances in the representative agent’s utility function and in the central bank balance sheet (see Berg et al., 2010 for a derivation). Unlike in the cashless case, an increase in reserves need not lead to an increase in government bonds outstanding but can be financed instead with an increase in the money stock. Such lack of sterilization would result in a loosening of policy, which suggests the following variant of the Taylor rule:

where κm measures the ratio of reserve money to GDP, f measures sterilization, and η is the aggregate interest semi-elasticity of money demand. The impact of incomplete sterilization (f < 1) on the policy stance depends on κm and η. The parameter κm is calibrated to the share of reserve money in Uganda and the choice of η is based on an OLS regression of nominal money balances on nominal interest rates and nominal output. We set f = 0.9.

When sterilization is incomplete, reserve accumulation results, not surprisingly, in a large depreciation of the real exchange rate, a large increase in output and a spike in inflation. In this case, the fiscal expansion is financed by the inflationary tax, which is expansionary in the short run.

6 Conclusion

We have focused on the macroeconomic implications of different responses to aid surges. In particular, and following recent episodes of aid surges in low-income countries, we emphasize the interaction of fiscal policy and reserve management. We find that this interaction matters for the short-run effects of aid.

When calibrated to Uganda, the model is able to capture some of the main features of the aid inflow episode, notably the response of the real exchange rate and the real interest rate.

Our analysis has focused on the short term. The interaction of reserve and fiscal policy also has implications for the medium-term effects of aid, since the (potentially) positive effects from higher aid-financed public investment can be offset by the crowding out of private investment induced by reserve accumulation. The analysis is further complicated by Dutch Disease-type effects. We address these issues in Berg et al. (2010).

We believe our approach is applicable to issues besides aid. The macroeconomics of natural resource booms in low-income countries are closely related to those of aid surges.25 More broadly, the fiscal monetary policy interactions involved here are of general importance in low-income countries. For example, a spend-and-absorb response resembles a domestically financed fiscal expansion, combined with a sterilized intervention (financed by the aid). An in-depth discussion of sterilized interventions is provided in Chapter 13.


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The distinction between spending and absorption is reminiscent of the separation between the ‘budgetary’ and the ‘transfer’ problem in Keynes (1929).


This is in the tradition of work by Salter (1959) and Swann (1960) on the ‘dependent economy’ model. See Dornbusch (1974).


As discussed in Woodford (2003: chapter 4), this result stems from monetary policy—the interest rate rule—not responding directly to changes in the natural rate of interest. In Woodford’s terms, there is no positive shift in the intercept term of the interest rate feedback rule.


This result is reminiscent of the Mundell-Fleming model with limited capital mobility (see Agenor and Montiel, 2008: chapter 2). In that model, a domestically financed fiscal expansion requires a real depreciation if the increase in the demand for imports—as a result of the effects of the fiscal expansion on consumption—threatens external balance. In our model, the fiscal expansion results in an increase in real wages, and the pressures on external balance come mainly from the impact of higher wages on the supply of exports.


In Berg et al. (2010), on which we draw the material for this chapter, we provide an extensive review of the related (i) aid and (ii) open economy New Keynesian literature.


According to informal discussions with government officials, donors were so enthusiastic that in 2005 the Ugandan authorities deliberately turned down some grants for fear of the macroeconomic impact.


The 3.1 per cent number for the increase in net aid in the third row of Table 12.1 is calculated using Uganda’s balance of payments data. Instead, net aid derived from the fiscal accounts increased by 2.7 percentage points. The difference results from the channelling of some flows directly to the private sector.


We assume foreign inflation π* is constant and equal to one.


See Schmitt-Grohe and Uribe (2003) for alternative methods to ensure stationarity of net foreign assets.


Sterilized interventions affect the exchange rate because private foreign assets enter the portfolio adjustment cost function Q(bta*)


This ensures that distortions arising from monopolistic competition are zero at steady state.


We have assumed for simplicity that the government demand for traded and non-traded goods is not sensitive to changes in the real exchange rate.


As an extension, we introduce a role for money and consider money growth rate rules.


Lagged government deposits and the stock of government debt also shift the internal balance curve as they affect the level of government spending.


The increase in consumption happens because the private sector—being more intensive in the production of non-traded goods than in their consumption—benefits when relative demand for non-traded goods goes up.


See Berg et al. (2010) for an analytical derivation of the natural rate of interest.


NIA data is available at Fiscal accounts data was compiled from IMF staff reports, available at


The Bank of Uganda compiles data on direct imports of goods and services by the general government financed with aid—both budget support and project aid. This statistic (16 per cent of total government spending in 1999) provides a lower bound on total government spending on traded goods. We thank Kenneth Egesa for providing us with these data.


The survey, titled ‘Financial Access Survey for Financial Sector Deepening’ (Steadman Group, 2009) surveyed 3,000 Ugandans and covered access to both the formal and informal financial sectors. Information available at


While the aid surge in Uganda lasted four years, our focus is mainly on the first year. Since most of the features in our model that can generate a real depreciation are related to the presence of nominal rigidities, and there are few real rigidities, we cannot generate a persistent real depreciation that lasts beyond the first few quarters.


The log-linearized current account deficit net of aid (in per cent of GDP) is given by: ca^t=κA((1+φ)s^t+At*y^t)R^t*R^t1*.


This additional derivation is available upon request.


A more thorough sensitivity analysis is presented in Berg et al. (2010).


See Dagher et al. (2010) for an application of a closely related model to the expected oil windfall in Ghana.

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