Do Remittances Help Stabilize Macroeconomic Fluctuations? How Much of Shocks Are Absorbed by Remittances?

In responding to the first question, our working paper follows the existing work in assessing the correlation between business cycle volatility and remittances by estimating the semi-elasticity of volatility (measured by the standard deviation of GDP or consumption) on cross-section data. The sample comprises 27 African countries with yearly data covering 1980–2005 all from the African Development Indicators (2011) from the World Bank. Data are averaged over this period. The model controls for other relevant determinants of volatility identified in the literature such as per capita income, financial development, government size, development aid, and terms of trade volatility. Standard endogeneity tests (Correlation and Nakamura and Nakamura tests) rule out the endogeneity of remittances in the model. The model is estimated using generalized least squares method to account for potential heteroskedasticity in the residuals. The empirical results show that remittances reduce both output and consumption fluctuations. Specifically, an increase in workers’ remittances-to-GDP of one percentage point reduces the log of the standard deviation of per real capita GDP growth by 3.2 percent while the volatility of real per capita consumption decreases by two percent. This small stabilizing effect on consumption seems rather counterintuitive, but at least two arguments can be put forward to explain it. First, households’ consumption in developing economies encompasses both consumption of durables and non-durables. It might be that remittances actually reduce the consumption instability, but only of the non-durable component of aggregate consumption. If this is the case, the inability to disentangle these two components makes it harder to observe a significant effect on aggregate consumption fluctuations. Second, surveys at microeconomic levels in some African countries have brought evidence that more than half of households receiving remittances from outside Africa are in the top two consumption quintiles (Mohapatra and Ratha 2011), minimizing the consumption smoothing effect of remittances may, since these households have access to alternative means (e.g., credit markets), help to smooth out consumption shocks.

Our analysis also quantifies how much of GDP shocks are absorbed by remittances, that is the risk-sharing through migration using a very simple econometric panel framework designed by Asdrubali, Sorensen, and Yosha (1996). The results suggest that around 4 to 22 percent of GDP shocks are smoothed through remittances channel. In a context where remittances data are severely underestimated due to informal channels, misreporting or misclassification in other revenues (e.g., non resident’s deposits), the stabilizing virtues of remittances are potentially underestimated as well.

How Do Remittances Affect Macroeconomic Volatility? A DSGE Model Approach

We present a small open economy dynamic stochastic general equilibrium (DSGE) model to provide a theory consistent with the preceding empirical results. In particular, we probe into the channels through which remittances affect macroeconomic fluctuations. For this purpose we used a small open economy a la Schmitt-Grohe and Uribe (2003) enriched with financial frictions which play a significant role in driving aggregate fluctuations, in particular, the excess volatility of consumption with respect to output. The model is calibrated to replicate the average economy formed in the sample of the economies. The quantitative experiments suggest that the stabilization benefits of remittances depend on two key factors: (i) the size of the wealth effect of remittances on labor supply and (ii) the ability of remittances to promote financial development. The first mechanism is highlighted by comparing the predictions of the model with two types of utility specifications: Greenwood, Hercovitz, and Huffman (1988), or GHH, which induce a zero wealth effect and King, Ploser and Rebelo (1988), or KPR, with a negative wealth effect on labor supply. This channel implies that the impact of remittances on macroeconomic fluctuations is higher in countries where the labor supply does not decrease following an increase in response to an increase in remittances (no wealth effect). In this case, the elasticity of labor supply is constant and irresponsive to changes in households’ income, implying a moderate response of output and consumption in response to shocks. However, in an environment where migrants’ transfers induce a negative wealth effect on the recipients’ labor supply, an increase in remittances deepens the business cycle as macroeconomic variables respond strongly to exogenous shocks. In order to highlight the second channel, we assume that remittances could reduce households’ borrowing costs through a lower risk-premium. This mechanism suggests remittances are more stabilizing in countries with a shallow financial sector while remittances are channeled through this sector. The reason is that remittances help credit-rationed borrowers to access financial services as they build physical assets which they can use as collateral. This finding underscores the need for recipient countries to promote financial development so as to channel remittances through the financial system and to help the poor have greater access to credit.