1. 1 The Macroeconomic Dynamics of Scaling –up Foreign Aid Shantayanan Devarajan, Delfin S. Go John Page, Sherman Robinson, Karen Thierfelder PREM-DEC Workshop – The Delivery of Scaled Up Aid: Does Predictability Matter? December 17, 2007

2. 2 Motivation:Aid is about the future  If agents respond to aid in the same way they make inter- temporal choices, what will be the impact on the economy? Real exchange rate (Dutch disease) Consumption Investment Growth  Will the results differ critically from what a static model will predict?  Re scaling up of foreign aid – Are the optimists right in some pure economic arguments? Does aid predictability matter?

3. 3 Recent Literature  Empirical estimates generally reliable  Recursive dynamics in a computable general equilibrium (CGE) model. Van Winjbergen (1984), Gelb et al. (1988), Benjamin, Devarajan,and Weiner (1989), Adam (2005), Bourguignon et al. (forthcoming).  Inter-temporal dynamic models don’t focus on aid and the price of tradables to non- tradables (the real exchange rate). Devarajan and Go (1998), Turnovsky and Chatterjjee (2004), Mirzoev (2007).

4. 4 Our contribution to the debate  Compare the static and dynamic effects of exogenous aid flows.  Demonstrate the implications of inter- temporal choices.  Generalize the results of the “standard” 1-2-3 Salter-Swan model on the real exchange rate.

5. 5 Key Findings  A model with choice and inter- temporal optimality eliminates the Dutch disease problem. No additional links between trade and total factor productivity (TFP) needed. No assumptions about the complementarity between public and private capital.

6. 6 1-2-3 Aid Model  Producer and consumer decisions are both intra- and inter-temporally consistent.  An upward sloping supply curve for external debt.  A risk premium that rises with external debt.

7. 7 1-2-3 Aid Model  Flexible Dynamic Country Forward looking investment and consumption. External borrowing (subject to an upward sloping supply of debt) is an integral part of optimal decision making; adjusts to bridge the gap between investment and savings.

8. 8 1-2-3 Aid Model  Credit constrained country Severe constraints in savings and external borrowing. Investment each period is not forward looking; it adjusts to available savings. External savings are exogenous. If foreign aid is predictable and stable, consumption is forward-looking and dynamic. If foreign aid is unpredictable and volatile, consumers are myopic and optimize in each time period.

9. 9 Simulations: Foreign aid in a flexible dynamic economy  Permanent increase in foreign aid (2 percent of GDP).  Temporary increase in foreign aid (2 percent of GDP for 10 years).

10. 10 Simulations: Foreign aid in a credit constrained economy  Permanent increase in foreign aid (2 percent of GDP). Consumers make optimal inter-temporal choices. Investment decisions are not based on a comparison of the marginal returns of additional capital to its replacement costs; instead investment is completely driven by the inter- temporal decision to consume or save.  Temporary increase in foreign aid (2 percent of GDP for 10 years). All aid goes to government spending. All aid goes to investment spending.

11. 11 Real Exchange Rate, Flexible Dynamic Economy

12. 12 Investment, Flexible Dynamic Economy

13. 13 Consumption, Flexible Dynamic Economy

14. 14 Debt, Flexible Dynamic Economy

15. 15 Real Exchange Rate, Credit Constrained Economy

16. 16 Investment, Credit Constrained Economy

17. 17 Consumption, Credit Constrained Economy

18. 18 Real Exchange Rate, Permanent Aid, with and without Credit Constraints

19. 19 Investment, Permanent Aid, with and without Credit Constraints

20. 20 Consumption, Permanent Aid, with and without Credit Constraints

21. 21 Conclusions  When aid recipients can plan consumption and investment decisions optimally over time, aid induced appreciation of the real exchange rate (Dutch disease) does not appear.  Aid should be predictable for intertemporal smoothing to take place. If aid volatility forces recipients to be constrained and myopic, Dutch disease problems become an issue.