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This paper has benefited from presentations at the University of Washington and the IMF. The constructive comments of Aleš Bulíř, Yu-chin Chen, and Leslie Lipschitz are gratefully acknowledged. Work on this project began when Turnovsky visited the IMF Institute in April 2006. He gratefully acknowledges the hospitality extended during that visit. This research is adapted from Chapter 1 of Tekin’s Ph.D. thesis written at the University of Washington under Turnovsky’s supervision. Substantial financial support for for this project has been provided by the Castor Endowment at the University of Washington
Valerie Cerra, IMF; Serpil Tekin, University of Washington; Stephen J. Turnovsky, University of Washington.
These include: (i) costs of installing the publicly provided capital, (ii) substitutability between public and private capital in production, (iii) access to the world financial market, (iv) opportunities for domestic co-financing of infrastructure projects (v) flexibility of labor supply; see Chatterjee and Turnovsky (2007). Adam and Bevan (2006) employ a simple static model and draw a similar conclusion that with sectoral spillovers, the relationship between aid, growth, and output is not necessarily straightforward. Dalgaard (2008) analyzes the effectiveness of foreign aid under different donor policy rules in a one-sector overlapping generations model, in many ways paralleling the work of Chatterjee and Turnovsky.
The original analysis of the Dutch disease by Corden and Neary (1982) and Corden (1984) employed a static framework. Early dynamic studies based on intertemporal optimization include Brock (1988) and van Wincoop (1993).
Issues concerning the volatility of aid flows are also important, but are not addressed here; see e.g. Isard, Lipschitz, Mourmouras, and Yontcheva (2006), Arellano, Bulíř, Lane, and Lipschitz (2008).
The independence of the long-run relative price to untied transfers (a pure demand shock) is an immediate consequence of a basic property of the two-factor two-sector production model, namely that with perfect sectoral factor mobility the long-run relative price depends solely upon supply conditions. A similar result is obtained by Devarajan, Go, Page, Robinson, and Thierfelder (2008). Arellano et al. (2008) generate long-run Dutch disease effects by introducing the imperfect substitutability of capital stocks across sectors. In contrast, untied transfers would continue to have no long-run relative price effects for the form of costly intrasectoral capital flows introduced by Morshed and Turnovsky (2004).
However, such an extension by involving at least four state variables and corresponding co-state variables would likely be intractable, even using numerical simulations.
The equilibrium and implications are also insensitive to variations in the specification of (3), that replace N/pK with expressions such as N/Y (output) or N W (wealth); see e.g. Chatterjee, Sakoulis, and Turnovsky (2003).
We are assuming that the foreign aid denominated in units of traded output can be costlessly converted to nontraded output. We also abstract from issues pertaining to the theft of aid by corrupt government officials.
The conditions ∂CT/∂μ < 0,∂CN/∂μ < 0 are a statement of the normality of the two consumption goods, while ∂CN/∂p < 0 follows from the concavity of utility. Also, sgn (∂CT/∂p) = −sgn (UTN).
In all cases the equilibrium possesses the saddlepoint structure necessary to yield a unique stable adjustment path.
The choice of parameters, particularly those relating to the sectoral aspects, are discussed in greater detail by Morshed and Turnovsky (2004). Our choice of elasticities on government expenditures in production, ν1 = 0.10,ν2 = 0.15 imply that government expenditure is more productive in producing nontraded than traded output, which includes services. While this is arbitrary, it is not implausible, and in any event our numerical results are insensitive to this assumption.
The World Bank Group, World Development Indicators Online reports the average external debt total (% of GNP), for the lower middle income Latin America and Caribbean countries, excluding Guyana and Nicaragua, to lie within the range of 60-65%. Our benchmark estimates of this ratio given by N/Z in Table 3 are very close to this range.
Further increases in a beyond a =10 have negligible effects except on the level of debt.
Adam and Bevan (p. 275, 2006) follow a similar strategy and assume that initial public infrastructure is 50% of its optimal value. We have also run the simulations reported in Section V-X starting from the initial optimal allocation of government spending. The time paths are virtually identical to those presented in Figs. 1-4.
These calibrations are consistent with the economic structures of developing countries summarized by Morshed and Turnovsky (2004).
This is close to average aid flows for Latin American countries. The World Bank Group, World Development Indicators Online reports the average Aid (% of GNP), for the lower middle income Latin America and Caribbean countries to be about 5%.
The speed of adjustment of the real exchange rate slows dramatically and the significance of the transitional path enhanced by introducing adjustment costs on sectoral capital movements; see Morshed and Turnovsky (2004).
We illustrate the capital intensity only in the traded sector, since both kN and kT move together.
The issue of the allocation of aid and the transfer problem is addressed by Yano and Nugent (1999). Using a purely static model they show that if the recipient country imposes a tariff it is possible for a transfer of capital applied to the nontraded sector to be welfare deteriorating. In the absence of such a tariff they find that the transfer unambiguously improves the recipient’s welfare (as we do here).