Calls for the scaling up of aid flows to sub-Saharan Africa—notably at the Gleneagles Group of Eight Summit in 2005—underscored the need for a better understanding of the macroeconomic effects of aid and of the policies that are typically implemented by recipient countries in response to such flows. This article summarizes recent research on this topic. As aid has failed to surge, the article also discusses extensions to the related topics of resource booms and debt-led scaling up.

Aid flows offer both opportunities and challenges to recipient countries. They may alleviate poverty and spur growth by financing much-needed public investment in infrastructure. But they may also hurt growth by inducing real exchange rate appreciation pressures, to the detriment of growth-promoting export industries (‘Dutch disease”). This ambivalence is reflected in the empirical results found in the literature (Clemens, Radelet, and Bhavnani, 2004; Rajan and Subramanian, 2007).

Against this backdrop, researchers have studied actual policy responses implemented by recipient countries to address their concerns about aid, and how those policies can shape its macroeconomic effects. Berg and others (2007) document how, during episodes of aid surges, concerns about real appreciation induced several African economies to accumulate much of the additional aid-related foreign currency in reserves, even as fiscal policy entailed the full spending of the local currency counterpart to the aid. This response turned out to be problematic, as it led to either higher inflation in countries that did not sterilize or high real interest rates in countries that did.

The analysis of actual aid surges revealed two important insights. First, it is important to distinguish between the spending and the absorption of the aid, with absorption referring to the increase in the current account deficit net of aid. While spending is determined by the fiscal policy response, absorption is influenced by the reserve policy of the central bank, especially when access to international capital markets is limited. In practice, there is no institutional arrangement between the government and the central bank to ensure coordination between these two policies, and several policy mixes are equally possible. Aiyar and Ruthbah (2008) find that spending out of aid differs from absorption in a panel of aid-recipient countries.

Second, short-term responses aimed at offsetting potentially negative effects of aid can have unintended macroeconomic consequences, both in the short and medium term. Given the complex interrelationship between the structure of the economy, macroeconomic policies, and private sector decisions, IMF researchers have recently been building dynamic stochastic general equilibrium (DSGE) models to better understand these consequences and contribute to policy analysis. For example, Berg and others (2010a) build an open economy, new-Keynesian model with two sectors and no capital accumulation to analyze the short-term effects of aid in Uganda, conditional on the fiscal-reserves policy interaction. Contrary to the predictions of the literature on the transfer problem (dating to Ohlin, 1929), which implicitly assumes spending equals absorption, they find that an increase in aid that is spent but not absorbed—the typical policy mix during aid surges in Africa—can result in a temporary real exchange rate depreciation, even when the accumulation of reserves is fully sterilized, a phenomenon that is also observed during these surges.

The intuition for why a real depreciation can occur 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 increasing the country’s external financing. The increase in spending must therefore come at the expense of the private sector, which is crowded out. But the resulting demand pressures, which are amplified when aid is not absorbed, can threaten external balance and require a real depreciation. This reversal of the real exchange rate response is facilitated by the fact that central banks typically receive all of the aid-related foreign exchange initially, so that a “passive” reserve policy implies the full accumulation of aid (no absorption).

The above result is highly sensitive to the degree of de facto capital account openness. As capital mobility increases, reserves policy becomes less effective—its effect on absorption is offset by capital flows—and the likelihood of a real depreciation is reduced. Moreover, Buffie, Adam, and O’Connell (2010) show that capital flows can either amplify or dampen appreciation pressures, depending on whether aid is used to reduce seignoriage revenues and on the credibility of fiscal policy.

Berg and others (2010b) study the medium-term implications of several spending and absorption policies. They do so in a DSGE model with traded and nontraded goods that captures two mechanisms for the medium-term effects of aid. First, the model features a learning-by-doing externality associated with the production of traded goods that captures the notion that real exchange rate appreciation may harm productivity growth. Second, it features a role for public capital in production, so that government can raise output directly and potentially crowd in private investment, as well as less-than-full conversion of public investment into useful public capital.

They find that, when learning-by-doing externalities are small, a policy mix that results in full spending and absorption of aid can have a positive effect on real GDP in the medium term through higher public capital. Full spending with partial absorption, on the other hand, may stem appreciation pressures but can also induce adverse medium-term effects on output through the crowding out of private investment.

Berg and others (2010b) also study how the presence of learning-by-doing affects the impact of aid and of various policy responses. Learning by doing raises the stakes: it may amplify the positive effects of aid on traded output and real GDP—which they refer to as “Dutch vigor”—but they may also make aid harmful, causing “Dutch disease.” Whether the externalities amplify the positive or negative effects of aid depends on the efficiency of public investment.

When efficiency is low and learning-by-doing externalities are strong, accumulating some of the additional aid inflows in reserves may be preferable even if aid is fully spent, although partial spending is preferred (see also Prati and Tressel, 2006). However, with high efficiency of public investment, the result is overturned, as there are large gains from fully spending and absorbing the aid as it accrues. More generally, coordination of fiscal and reserves policies improves the macroeconomic effects of aid.

Research on spending and absorption has contributed to the operational work of the IMF. The model in Berg and others (2010b) has recently been used to construct specific aid scaling-up scenarios in 10 African countries, in collaboration with the UNDP. Three of those scenarios are presented in Berg and others (2011).

Recent research has also focused on aid volatility and its macroeconomic implications (Arellano and others, 2005). But more work is needed to understand how macroeconomic policies may help counteract the adverse effects of aid volatility. In this regard, Portillo and Zanna (2011) analyze optimal (welfare-maximizing) and implementable fiscal and reserve accumulation rules in response to volatile aid flows.

Additional empirical work is needed to complement the case studies on aid surges. While the return to further aid-growth panel regressions may be low, more structured analyses would be useful, with an emphasis on how the policy responses to aid—differentiated across countries—have affected its macroeconomic impact. Kang, Prati, and Rebucci (2010) provide a useful starting point. Insights from the above literature can also be extended beyond aid flows: Dagher, Gottschalk, and Portillo (2010) apply the model in Berg and others (2010b) to the analysis of oil windfalls in Ghana, and emphasize the risk of uncoordinated fiscal and reserve policy.

It has become clear that the doubling of aid to sub-Saharan Africa pledged at the G-8 summit at Gleneagles in 2005 did not materialize. Countries are therefore exploring alternative sources of financing for their public infrastructure needs. Work by Buffie and others (2010) focuses on the macroeconomics of debt-financed-investment scaling-up scenarios.

Finally, from a methodological point of view, the research described above has shown the usefulness of building low-income-country-specific DSGE models to analyze relevant policy issues in these countries, both fiscal and monetary.