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The authors would like to thank Chris Adam, Olivier Blanchard, Mai Dao, Peter Montiel, Steve O’Connell, Chris Papageorgiou, Mauro Roca, David Romer, and Antonio Spilimbergo for helpful comments and suggestions, as well as seminar participants at the Banque de France and the IMF Workshop on Frameworks for Policy Analysis in Low-Income Countries. All errors remain ours.
The modern literature on the topic started with the famous Keynes-Ohlin (1929) controversy. Brakman and Van Marrewjik (1998) thoroughly review the (mostly static) literature; Devereux and Smith (2007) provide a dynamic treatment.
Ohlin (1929) is the first to emphasize the role of the non-traded sector. See also McDougall (1965) and Brock (1996). Most of the literature focuses on the (endogenous) response of the terms of trade rather than the real exchange rate. Because terms of trade tend to be exogenous in low-income countries, which typically have little market power in their export markets, we abstract from this channel in our analysis.
The exception to this claim is the analysis of transfers under the gold standard, where it is well understood that some accumulation of reserves is necessary to accommodate the required increase in the domestic price level.
The distinction between spending and absorption is reminiscent of the separation between the “budgetary” and the “transfer” problem in Keynes (1929).
The framework presented here—the distinction between spending and absorption of aid—has been used for policy analysis in Berg, and others (2007) and a number of subsequent IMF (and non-IMF) policy papers. Buffie, and others (2010) critique some of these analyses.
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 chapter 2 in Agenor and Montiel (2008)). 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.
An exception is Peiris and Saaxegard (2007), who estimate a DSGE model for Mozambique. We believe a systematic, careful, application of these models to low income countries is long overdue.
The relation between real interest rates and the real exchange rate in our model is also reminiscent of the work by Calvo, Reinhart, and Vegh (1995).
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 3.0 percent figure 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 channeling 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
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.
We use the equation for government spending to solve for ĝt.
The opposite holds for lagged outstanding government debt
Note that participation in financial markets does not affect the flexible price equilibrium values for (
The increase in consumption happens because vA > εA, which reflects the fact that the private sector—being more intensive in the production of non-traded goods than in their consumption (ϕ > 0)—benefits when relative demand for non-traded goods goes up.
Note that the equilibrium is not given by the interaction of curves IBa′ and EBa′, as their position assumes consumption has not increased, in which case labor supply exceeds labor demand.
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 percent 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 this data.
The survey, titled “Financial Access Survey for Financial Sector Deepening” (2009), was conducted by the Steadman group; it surveyed 3000 Ugandans and covered access to both the formal and informal financial sector. Information available at http://www.finscope.co.za/uganda.html.
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. We leave an examination of real rigidities for future work.
This additional derivation is available upon request.
This follows the specification in Bouakez, and others (2005).
See Monacelli and Perotti (2008) for an application of a more general specification–which encompasses both specifications used here–to the modeling of fiscal policy. See also Burstein, Eichenbaum, and Rebelo (2007) for an application to episodes of large nominal devaluations.
The utility derived from holding real money balances does not enter separately, which implies the linearized Euler equation also depends on linearized real money balances. It can be shown that, since the share of real money balances is very small, these complications can be safely ignored. See McCallum (2001).
This result does not imply money targeting is superior to an interest rate rule. The anchoring role of lagged interest rate is not specific to money targeting but is instead a general property of optimal rules (see Woodford 1999). In addition, money targeting is subject to the (well-known) instability and volatility of money demand. See Berg, Portillo, and Unsal (2010) for a comparative analysis of money and interest rate rules in low-income countries.
See Dagher, and others (2010) for an application of a closely-related model to the expected oil windfall in Ghana.
Unlike the benchmark case, we assume that non-asset holders maximize instantaneous utility rather than lifetime utility. This simplifies their money demand equation without qualitatively affecting the results.