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The author would like to thank Messrs. Basu, Carstens, Clement, Georgiou and Pujol for insightful comments and useful discussions, participants at an informal IMF seminar for helpful remarks and Mrs. Bungay for many editorial improvements. The author is responsible for the remaining errors. The views expressed are those of the author and do not necessarily represent those of the IMF.
Note that in the International Financial Statistics, country-owned counterpart funds are usually recorded as government deposits and foreign-owned counterpart funds as foreign liabilities (IMF 1984). Data regarding counterpart funds quoted in Bruton and Hill (1991) and based on the IFS reflect only mutually owned counterpart funds and underestimate the total amount of counterpart funds considerably. This underestimation must be kept in mind. For example because one of the main conclusion of Bruton and Hill (1991), that counterpart funds have a limited inflationary impact, is based to a large extent on the small size they think counterpart funds have.
The model is not easily solved analytically, however, because it contains an arbitrary lag. The budgetary impact of counterpart funds and foreign aid is not modelled, while the import equation cannot be derived consistently with the underlying budget constraints.
The replacement of imports leads through higher foreign reserves to an increased money supply.
That is a money supply equation c.q. budget constraint of the financial sector plus a flow of reserves equation c.q. balance of payments definition.
It can be inferred from the implicit derivation of the money supply equation from the adding up of the budget constraints c.q. balance sheets of the Central Bank and the private banking sector, that it is immaterial for this money supply equation whether counterpart funds are a liability of the Central Bank or the commercial banks. What is relevant is that they constitute a liability of the combined money creating financial sector and that they are not counted as part of the money supply.
A different matter is how the money supply target is achieved. This could be influenced by the division of counterpart funds between Central Bank and commercial bank accounts if indirect instruments of money supply control such as reserve requirements are used instead of direct credit control. Clement (1989) and Bruton and Hill (1991) conclude that the division matters, but they implicitly assume that the government indirectly controls money supply and does not change the instruments as it should.
This is a harmless fiction. If aid does not generate counterpart funds this is in this set-up equivalent to immediate spending of those counterpart funds.
For the macroeconomic budgetary and monetary consequences of counterpart funds it is therefore immaterial whether the government or the donor or both of them own the counterpart funds.
IMF balance of payments support is not included since it is directly offset by an increase in foreign liabilities.
Imports of commodity aid are not included as a separate item in the equation for the foreign reserves, as they are not included in imports either and the effects cancel out.
Capital flows are assumed to be zero. Fg in the model is the net stream of aid, i.e., after paying interest and principal on previous aid, insofar as given in the form of soft loans. As long as foreign currency aid has only a monetary or budgetary impact on the economy, it does not make a principle difference whether the aid is in the form of a grant or a loan. It is the cash flow that counts for the monetary and budgetary impact.
Foreign currency aid used for imports of specific goods for projects has no effect on the economy apart from a supply-side effect (the project undertaken could enhance the productive capacity in the economy, at the same time that it reduces the availability of real resources such as labor for the rest of the economy). The aid cancels out against imports. Both foreign currency and imports are hence defined excluding imports for projects.
If the commodity aid is sold abroad for foreign currency it is in effect equivalent to foreign currency aid in the amount of the proceeds of the sale.
Instead of just commodity aid imports, all imports could be assumed to effect money demand. This does not result in much additional insight.
Foreign currency aid is assumed to effect the production frontier only with a lag. Together with the second and further period effects of commodity aid and a host of other elements, these effects are implicitly assumed to be embedded in the production frontier.
Commodity aid could even reduce inflows of foreign currency. For example, about 30 percent of U.S. PL480 aid is used for U.S. uses such as embassy expenditure.
Unless n=1, b=a=0, in which exceptional case commodity aid is equivalent to foreign currency aid.
In the accounting frameworks underlying the programs all counterpart funds are generally treated as government deposits in affect calculating a number for Cgf. According to the results in this paper, this is a correct procedure. It is the policy rules using the correctly derived numbers, which gives rise to several observations.
In as far aid is to be repaid this could be less desirable, in particular if there is little evidence of a contribution of the aid to the repayment capacity.
Policy rule (14) closely resembles (11). The difference is that (14) allows for a non zero unexpected change in the reserve level. Note that (14) is a rewritten version of the money demand equation. It can be inferred from (14) and the way it is derived that it implies an inflation rate below the program target.
Roemer (1989) restates this conclusion, which is echoed by Bruton and Hill (1991) and Maxwell (1991) as the consensus view. Note however the subtle situation in which there are excess foreign reserves. Counterpart funds can then be perceived as a title to these resources, which may be used to further development.
Of course if counterpart funds can be used for otherwise undertaken expenditure such as paying for embassy procurement or tourism of foreign nationals real effects may occur as well.