The Macroeconomics of Medium-Term Aid Scaling-Up Scenarios

WP//6 The Macroeconomics of Medium-Term Aid Scaling-Up Scenarios Andrew Berg, Jan Goschalk, Rafael Porillo, and Luis-Felipe Zanna

2 Inernaional Moneary Fund WP//6 IMF Working Paper Research Deparmen The Macroeconomics of Medium-Term Aid Scaling-Up Scenarios Prepared by Andrew Berg, Jan Goschalk, Rafael Porillo, and Luis-Felipe Zanna * July 2 Absrac This Working Paper should no be repored as represening he views of he IMF. The views expressed in his Working Paper are hose of he auhor(s) and do no necessarily represen hose of he IMF or IMF policy. Working Papers describe research in progress by he auhor(s) and are published o elici commens and o furher debae. We develop a model o analyze he macroeconomic effecs of a scaling-up of aid and assess he implicaions of differen policy responses. The model feaures key srucural characerisics of low-income counries, including varying degrees of public invesmen efficiency and a learning-by-doing (LBD) exernaliy ha capures Duch disease effecs. On he policy fron, i disinguishes beween spending he aid, which is conrolled by he fiscal auhoriy, and absorbing he aid financing a higher curren accoun defici which is influenced by he cenral bank's reserve accumulaion policies. We calibrae he model o Uganda and run several experimens. We find ha a policy mix ha resuls in full spending and absorpion of aid can generae emporary demand and real exchange rae appreciaion pressures, bu also have a posiive effec on real GDP in he medium erm, hrough higher public capial. Full spending wih parial absorpion, on he oher hand, may sem appreciaion pressures bu can also induce adverse medium-erm real GDP effecs, hrough privae secor crowding ou. When aid is very inefficienly invesed and here are srong LBD exernaliies, aid can be harmful, and parial absorpion policies may be jusified. Bu in his case, a welfare improving soluion is o defer spending or even beer if possible raise is efficiency. JEL Classificaion Numbers: E2, E2, F3, O4 Keywords: Aid; Africa; Duch Disease; Fiscal Policy; Moneary Policy; Public Invesmen; Real Exchange Rae; Transfer problem. Mail Auhor s E-Addresses: aberg@imf.org; jgoschalk@imf.org; rporillo@imf.org; fzanna@imf.org * The auhors have benefied from commens and conversaions wih Chris Adam, Emanuele Baldacci, Benedice Chrisensen, Yasemin Bal Gunduzmany, Bre House, Enrique Mendoza, Tokhir Mirzoev, Sephen O'Connell, Chris Papageorgiou, Peer Pedroni, Kazuko Shirono and several colleagues in he Fund's African deparmen who firs applied he model, and UNDP colleagues who conribued o he join IMF-UNDP projec from which his model arose. All errors remain ours. The views expressed in his paper are solely he responsibiliy of he auhors and should no be inerpreed as reflecing he views of he Inernaional Moneary Fund.

2 Table of Conens Page I. Inroducion...4 II. The Model...7 A. Households...8 A.. Asse Holders...8 A.2. Hand-o-Mouh Consumers... B. Non-Traded Good Secor... C. Traded Good Secor...2 D. The Governmen...3 E. The Cenral Bank...4 F. Aggregaion and he Goods Marke Equilibrium Condiions... III. Calibraion...6 IV. Experimens...2 A. The Baseline Scenario...2 B. Parial Aid Absorpion Policies...22 B.. Reserve Accumulaion Rules under a Flexible Exchange Rae Regime...22 B.2. A Fixed Exchange Rae Regime wih Serilizaion...24 C. Learning-by-Doing Exernaliies, he Efficiency of Public Invesmen, and Parial Absorpion Policies...27 C.. The Efficiency of Public Invesmen...27 C.2. The Learning-by-Doing Exernaliies...28 C.3. Parial Absorpion Policies...3 V. Discussion...3 VI. Conclusions...36 Tables Table. Baseline Calibraion: Preference Parameers...7 Table 2. Baseline Calibraion: Technology Parameers...8 Table 3. Baseline Calibraion: Policy Parameers and Aid Process...9 Figures Figure. Baseline Scenario...2 Figure 2. Parial Absorpion under a Flexible Exchange Rae Regime: Accumulaing Some Aid Flows in Reserves...23 Figure 3. Full Absorpion: A Fixed Exchange Rae Regime wihou Serilizaion...2 Figure 4. Parial Absorpion Policy: A Fixed Exchange Rae Regime wih Serilizaion...26 Figure. The Efficiency of Public Invesmen and Real GDP...28

3 Figure 6. The Effecs of Low Efficiency and Srong Exernaliies...29 Figure 7. Parial Absorpion Policies under Low Efficiency and Srong Exernaliies...3 Figure 8. Parial Absorpion Policies under High Efficiency and Srong Exernaliies...32 Figure 9. Parial Absorpion and Parial Spending Policies...33 Figure. Welfare Gains and Absorpion Policies...34 Appendix A. Wriing he Model in Saionary Terms...38 B. The Equaions of he Model...39 B.. The Firs Order Condiions of he Households Problem...39 B.2. The Firs Order Condiions of he Firms Problem...4 B.3. Demand Funcions, Aggregaion, Marke Clearing Condiions, and Oher Equaions...4 B.4. Definiion of Equilibrium...4 C. The Efficiency of Public Invesmen and GDP...42 References...43

4 I. Inroducion Aid surges o er boh challenges and opporuniies o recipien counries. Some argue ha hese surges may hur growh by inducing real exchange rae appreciaion pressures, o he derimen of growh-promoing exporing indusries; while ohers believe hey may spur growh by nancing muchneeded public invesmen in infrasrucure. 2 Concerns abou he poenial negaive e ecs of aid surges may rigger policy responses aimed a dampening hese e ecs. For insance, Berg e al. (27) documens how, during aid surges, concerns abou real appreciaion induced several African economies o accumulae much of he addiional aidrelaed foreign currency in reserves. This response may have helped conain he appreciaion pressures. Bu when combined wih a scal policy ha enailed he full spending of he local currency counerpar o he aid, his response urned ou o be problemaic. I led o an increase in he money supply, and di eren serilizaion policies posed new challenges o hese economies: hose ha did no serilize faced high in aion; whereas hose ha did serilize experienced high ineres raes. These di ering views and concerns abou aid surges have creaed he need for a common framework o analyze he shor and medium erm macroeconomic e ecs of aid surges, as well as he appropriae policy responses. This paper proposes such a framework, by developing a dynamic quaniaive model ha can be useful for Fund sa eams and policy-makers in recipien counries. The model has already been used o help formulae counry-speci c aid scaling up scenarios. As par of he Unied Naions Millennium Developmen Goals (MDG) Africa Seering and Working Groups, he IMF was requesed o provide macroeconomic assessmens of Gleneagles aid scaling-up scenarios for several African counries. IMF (28a) and IMF (28b) presen he rs six counry scenarios, ve of which used he model presened here. 3 The novely of our model sems from is srucure, which capures he main mechanisms and policy issues of ineres in low-income counries (LICs). The model feaures a learning-by-doing mechanism (LBD) ha creaes an exernaliy associaed wih he producion of raded goods and capures he noion ha real exchange rae appreciaion may harm produciviy growh in he raded secor; a role for public capial in producion, so ha governmen spending can raise oupu direcly and poenially crowd in privae invesmen; and less-han-full conversion of public invesmen ino useful public capial. 4 The model also allows for separae and possibly uncoordinaed scal spending and reserve accumulaion responses o aid surges, permiing a variey of policy combinaions. By assumpion, he scal See Rajan and Subramanian (2), among ohers. 2 See, for insance, Collier (26). 3 IMF and UNDP (2) describes he full join projec. The assessmens have been developed for Benin, Cenral African Republic, Ghana, Liberia, Niger, Rwanda, Sierra Leone, Togo, Tanzania, and Zambia. The model used for Niger is described in Farah e al. (29). 4 The model also feaures hand-o-mouh consumers o capure nancial marke imperfecions ha can give scal policy larger real e ecs in he shor run; limied access o inernaional capial markes ha gives serilized inervenion an imporan role; and imperfec mobiliy of producive facors across raded and non-raded secors, which a ecs he degree of real exchange rae appreciaion.

auhoriy evenually spends all he incremenal aid; he quesion here is abou he e ecs of doing so as he aid comes in, which we de ne as full spending of aid. The moneary auhoriy, on he oher hand, in uences aid absorpion, which we de ne as he use of he foreign currency proceeds from aid o nance higher curren accoun de cis (ne of aid). I does so by accumulaing par of he aid ows in inernaional reserves. In previous work we have shown, using a smaller model wihou privae or public invesmen, ha policies ha are frequenly implemened in response o aid ows can have sriking implicaions for he shor-run behavior of macro variables such as he real exchange and he real ineres rae. Here, we demonsrae ha he same policy responses can someime have adverse medium-erm e ecs as well, depending on he e ciency of public invesmen and he exen of learning by doing exernaliies in he economy. We show hese resuls by calibraing our model o he Ugandan economy and running several experimens. To x ideas, we sar wih a baseline scenario of a exible exchange rae regime, somewha e cien public invesmen, mild LBD exernaliies, and scal and reserve accumulaion rules ha imply he full spending and absorpion of aid. As he governmen spends he aid, demand pressures emerge. These combine wih nominal price rigidiies in he non-raded secor o creae a shor-lived spike in real gross domesic produc (GDP). The real exchange rae subsanially appreciaes and he raded secor su ers a conracion bu recovers in he medium erm. Over ime, price rigidiies dissipae and he demand impulse fades ou, bu GDP coninues o grow on he srengh of higher public capial and he resuling higher privae capial accumulaion. The subsanial shor-erm real appreciaion pressures of he baseline scenario may concern policymakers who are commied o mainaining compeiiveness in he raded secor. We herefore invesigae he consequences of parial absorpion policies ha may help counerac hese pressures: (i) accumulaing some of he aid ows in reserves in he conex of a (managed) oa, and (ii) operaing a xed exchange rae regime. Accumulaing reserves succeeds in miigaing appreciaion pressures bu crowds ou privae consumpion and invesmen in he shor run, hus lowering real GDP over he medium erm relaive o he full-absorpion baseline. The underlying cause of he crowding ou is he aemp o use he same aid resources wice: he cenral bank uses aid in ows o build up reserves, while he scal auhoriy uses he domesic currency counerpar of hese in ows o increase spending. Aid resources can be used eiher by he governmen for increased spending or by he cenral bank for reserve buildup, bu no for boh wihou crowding ou he privae secor. A xed exchange rae regime may also sem appreciaion pressures, depending on he associaed moneary policy. This regime induces he auhoriies o accumulae reserves in resising nominal appreciaion. If he auhoriies do no serilize he associaed moneary emission, he resuling in aion induces a real appreciaion and produces roughly a full-absorpion scenario ha closely resembles he baseline in real erms. E ors o resis he in aion by serilizing he moneary emission will again succeed in narrow erms bu a a cos of parial aid absorpion, higher real raes, and privae secor See Berg, Mirzoev, Porillo, and Zanna (2).

6 crowding ou. 6 As before, his implies lower real GDP in he medium erm. Why migh governmens noneheless consider parial absorpion policies? Maybe because, in conras o our baseline assumpions, he e ciency of public invesmen is low, while very srong LBD exernaliies imply a signi can loss in produciviy of he raded secor when oupu in his secor conracs. In his conex, accumulaing some addiional aid in reserves may relieve some of he shor-erm appreciaions pressures wihou inducing adverse medium-erm e ecs on real GDP. To fully undersand his resul, i is necessary o invesigae he roles of he e ciency of public invesmen and he LBD exernaliies and heir ineracion in he model. Consider he role of e ciency, i.e., he exen o which public invesmen is acually convered ino useful capial. In our model, here is a disincion beween he e ciency of seady-sae invesmen and ha of he invesmen nanced by he scaling-up of aid. Wha maers for he e ecs of aid on real GDP (in percen changes) is he e ciency of he aid-surge invesmen spending relaive o seady-sae e ciency. Our focus in his paper is on his relaive e ciency concep. In our model, counries ha are less e cien in his sense enjoy lower medium-erm bene s in real GDP erms, as less public capial is accumulaed and he crowding in e ec on privae invesmen is smaller. Srong LBD exernaliies, on he oher hand, raise he sakes: hey may amplify posiive e ecs of aid on raded oupu and real GDP which we refer o as Duch vigor bu he may also make aid harmful causing Duch Disease. Wheher he srong exernaliies amplify he posiive or negaive e ecs of aid depends on he e ciency of public invesmen, as his will deermine if he shrinkage in he raded secor is emporary or proraced. When e ciency is low and exernaliies are srong, Duch-disease ype e ecs can dominae under full absorpion policies so ha aid reduces real GDP. By limiing he conracion in raded secor oupu, parial absorpion policies can help miigae hese e ecs, even if hey sill crowd ou privae invesmen in he shor run. In hese circumsances, however, here are beer ways o respond o aid surges, while miigaing appreciaion pressures, han parial absorpion policies. Firs, if governmen spending is ine cien and here are srong exernaliies, hen he reserve accumulaion policy could be accompanied by parial spending of aid. Second, if aid were o be used more e cienly, hen he GDP e ec of scaled-up aid would always be posiive, and more so wih full absorpion. 7 We suppor hese ndings wih some simple welfare analysis. Wih low e ciency and srong exernaliies, accumulaing some of he addiional aid in ows in reserves may generae small welfare gains if aid is fully spen, alhough parial spending is preferable. However, wih high e ciency, his resul is overurned, as here are large gains from fully spending and absorbing he aid. 6 The model feaures limied inernaional capial mobiliy making serilizaion policies e ecive in a small-openeconomy se-up, even when he exchange rae is xed. 7 Spending more aid on invesmen raher han consumpion or allocaing more public invesmen owards he raded goods secor are policies ha are no explored in his paper bu ha would like achieving higher e ciency yield beer growh oucomes han parial absorpion in he face of srong LBD exernaliies.

7 Our work disinguishes iself from he lieraure by simulaneously analyzing boh shor-erm (demand) and he medium-erm (supply) e ecs, in a conex where scal and cenral bank policies shape he spending and absorpion of aid and maer for medium-erm oucomes. Adam e al. (29), our previous work Berg e al. (2), Bu e e al. (28), and Prai and Tressel (26), among ohers, also focus on he e ecs of various policy responses o aid in ows, bu hey do so in models where secoral oupu is exogenous or capial accumulaion is absen. The absence of capial accumulaion is a noable simpli caion, given ha all he way from he work of Keynes (936) and Hicks (939) o ha of Kydland and Presco (982), macroeconomic heories have underscored invesmen dynamics as an imporan channel for he ransmission of aggregae shocks. By inroducing boh public and privae capial, our work shows ha invesmen spending plays a key role in shaping he e ecs of moneary and scal policies under aid surges. Our work also di ers from papers ha presen real models wih capial, including Adam and Bevan (26), Agenor e al. (28), Agenor and Yilmaz (28), Arellano e al. (29), Cerra e al. (28), and Chaerjee and Turnovsky (27), among ohers. Despie heir imporan conribuion, hey do no model scal and moneary policies and, herefore, do no permi a rich discussion of he ineracion of hese policies and heir implicaions for he shor-o-long run e ecs of aid. In addiion, hese works have no underscored he role of he e ciency of public invesmen, as our work does. 8 These invesmen ine ciencies may have imporan implicaions for he empirical calculaions of capial as well as for growh analysis. 9 Finally, our parial absorpion resuls are reminiscen of hose in Calvo e al. (99), which are derived in a small sylized model: absen inernaional capial mobiliy, prevening he real exchange rae from appreciaing leads o some combinaion of emporary higher in aion and higher domesic real ineres raes. The remainder of his paper is organized as follows. Secion II presens he srucure of he model. Secion III discusses he calibraion o Uganda. Secion IV presens and elaboraes on he resuls of he experimens, saring by he baseline scenario. A discussion of he scope of our resuls, including some welfare analysis, is presened in secion V. Finally, secion VI concludes. II. The Model Consider an in nie-horizon small open economy. The economy has wo goods, a raded good (T ) and a non-raded good (N), and consiss of he following agens: i) wo ypes of households, some paricipaing in asse markes and ohers no; ii) wo secors wih rms producing raded and nonraded goods using labor, privae capial, and public capial; iii) a cenral bank in charge of exchange rae policy and moneary policy, including reserve accumulaion policy; and iv) a scal auhoriy ha is he direc recipien of aid and decides how much of his aid o spend as par of is scal policy. 8 Agenor e al. (28) is a parial excepion using a srucural model ha is no fully microfounded. 9 See Hulen (996) and Priche (2).

8 There is exogenous deerminisic growh of he labor-augmening ype, which is he same across secors. The labor produciviy level T grows a he consan facor n so ha T = nt. To faciliae he descripion of he model, we will presen is srucure in saionary erms. This involves rescaling variables by T when required, such ha all he variables are consan in he long run (seady sae). We assume ha he law of one price holds for he raded good. Therefore P T = S P T ; where P T is he price of raded goods, S corresponds o he nominal exchange rae, and P T is he foreign price of raded goods. By denoing he domesic (foreign) Consumer Price Index (CPI) as P (P ), we can express he CPI-based real exchange rae as s = SP P and he relaive price of non-raded goods as p N = P N P : We also de ne real gross domesic produc (GDP) as: y = p N y N + sy T ; () i.e., he sum of he producion of he non-raded good, y N, and he raded good, y T, valued a heir seady-sae relaive prices p N and s. Nex, we describe he objecives and consrains of he di eren agens of his economy. A. Households There is a coninuum of households on he inerval [; ]. A fracion p is represened by households who are forward-looking and smooh consumpion by being able o rade in asse markes. These are asse holders or savers and will be indexed by he superscrip a. The res of he households p have no asses and canno smooh consumpion. They will be indexed by he superscrip h and behave in a hand-o-mouh fashion, fully consuming heir curren labor income. A.. Asse Holders Savers mus decide how o allocae consumpion expendiures among di eren goods. Consumpion of he raded good and he non-raded good, denoed by c at and c an, respecively, are combined ino a CES baske c a = ' + ( ') ; (2) c jn h wih he associaed CPI P = ' P N i + ( ')(P T ) ; where denoes he inraemporal elasiciy of subsiuion, and ' is he degree of home bias in consumpion. This CES aggregaor implies he following demand funcions for raded and non-raded goods: c an = ' p N c a and c at = ( ')s c a : The non-raded good is in urn a composie good wih a coninuum of varieies indexed R by i 2 [; ] saisfying c an = c an i di ; wih measuring he elasiciy of subsiuion of The rs par of he Appendix discusses in more deail how o ransform he model in saionary erms. A recen survey conduced in Uganda nds ha almos 62 percen of he sample does no access formal or informal nancial markes. See Seadman Group (29). c jt

9 hese varieies. The demand for variey i is given by: h where p N i P i N R P and P N = Pi N i di : p c an N i = i p N c an ; (3) The represenaive saver maximizes his life-ime uiliy: 2 X ( a ) u a (c a ; m a ) = { a + (la ) + ; (4) wih h i u a (c a ; m a ) log # a (c a ) + ( # a ) (m a ) ; () where c a Ca T refers o a consumpion baske of he ype described in (2), m a M a P T are he holdings of real money balances, and l a is he amoun of labor supplied o rms for he producion of he non-raded and raded goods. The parameer a 2 (; ) corresponds o he subjecive discoun facor of he asse holders, # a 2 (; ) is he share of consumpion in he uiliy u a (:); > measures he elasiciy of subsiuion beween c a and m a, { a is a scale parameer, and > is he inverse of he labor supply elasiciy. We wan o capure he noion ha labor mobiliy is limied across secors and ha inersecoral wage di erenials are possible. Supplied labor is hen de ned as in Bouakez e al. (29): l a = % l an +% % + ( ) % l at +% % +% % ; (6) where 2 (; ) is he share of labor supplied o he non-raded secor, l an, in oal employmen, and % > is he elasiciy of subsiuion beween labor services provided o he wo secors. The index of real wages associaed wih he aggregaor (6) corresponds o: w = h w N +% + ( ) w T +% i +% : (7) The budge consrain of he represenaive agen, de aed by he domesic CPI and expressed in saionary erms, is given by: c a + m a + b ac where b ac Bac P T + s b a + s P a = ( )w l a + ma b ac + i n n + s i b a n + a + s rm + a ; (8) is he saver s real holdings of domesic bonds issued by he governmen, which pay a gross nominal ineres rae i + r and b a Ba P denoes his real holdings of foreign asses ha T pay a gross nominal inernaional ineres rae i and are subjec o porfolio adjusmen coss P a. 2 Because we are wriing he problem of he agen in saionary erms, he objecive funcion should also include he erm ( a ) log(t ): We can omi his erm, since T is exogenous and does no represen a conrol variable.

Toal labor income sais es w l a = w N l an + w T l at wih w k W k P T denoing he real wage in secor k = N; T. Moreover, = P P denoes gross domesic in aion, while is foreign in aion; which is assumed o be consan; a denoes real pro s from domesic rms; is an income ax rae se by he governmen; rm are remiances received from abroad and assumed o be consan; and a is a ransfer from asse holders o hand-o-mouh consumers. 3 This budge consrain implies ha spending (lef-hand side) mus equal income (righ-hand side). The porfolio adjusmen coss are given by P a 2 (ba b a ) 2 ; where b a is he seady-sae value of he real foreign asses. These coss serve wo purposes. Firs, hey ensure saionariy of b a. 4 Second, hey allow us o model di eren degrees of inernaional capial mobiliy. When! +; he capial accoun is pracically closed; whereas when < << ; i is parially open. The problem of he asse holders reduces o maximizing (4) wih respec o consumpion, real money balances, labor supply in boh secors, and domesic and foreign asses, subjec o he consrain (8) and a ransversaliy condiion associaed wih all asse holdings. The rs-order condiions of his problem are presened in he Appendix. A.2. Hand-o-Mouh Consumers Households ha do no have access o asse markes rely on labor income, remiances, and ransfers as heir only source of income. The represenaive agen from his group maximizes uiliy as in (4) and (), where c h and l h ake he same form as in (2) and (6). The agen is subjec o a ransversaliy condiion associaed wih money holdings and he budge consrain: c h + m h = ( )w l h + mh n + s rm + h ; (9) wih w l h = w N l hn + w T l ht and h p = p a. Noe ha in principle hand-o-mouh consumers could smooh consumpion by changing heir money holdings. To preven his, we can assume ha heir subjecive discoun facor h is se o zero. In his regard, heir problem becomes saic. The rs-order condiions of his problem are lised in he Appendix. B. Non-Traded Good Secor This secor faces monopolisic compeiion and nominal price rigidiies. Each monopolis produces a variey i of he non-raded good. The echnology of he represenaive producer i is given by: y N i = z N h k N i N (q ) N i N l N i N ; () 3 This ransfer simpli es he analysis of he model by avoiding he need o keep rack of he di eren consumers. They ensure ha consumpion a he seady sae is he same for he wo ypes of households. See Galí e al. (27). 4 See Schmi-Grohé and Uribe (23) for alernaive mehods o ensure saionariy of ne foreign asses. The share of consumpion in he uiliy for hese consumers, # h ; can be di eren from ha of asse holders. In his way we ensure ha real money balances are he same across boh ypes of households, a he seady sae, given ha he demand funcions are no he same for boh ypes, as shown in he rs-order condiions saed in he Appendix.

where z N is a consan produciviy parameer; li N is he amoun of labor employed, ki N is privae capial, which is rm-speci c, and q is public capial. The coe cien N indicaes he producion share of labor, while N denoes he share of privae capial in oal capial used in producion. Privae capial is subjec o a depreciaion rae N : I is accumulaed via invesmen x N i, which is a composie 2 of raded and non-raded goods like in (2), and subjec o adjusmen coss Fi N N x N i 2 ; as in Chrisiano e al. (2). Then: x N i nki N = ( N )ki N + Fi N x N i : () The monopolis is subjec o a demand consrain of he Dixi-Sigliz ype described in (3) y N i = p N i p N y N ; (2) where y N is he overall demand for he non-raded good. She also faces price adjusmen coss 2 G i 2 p N y N, where N is he non-raded goods in aion wih he seady-sae p N i p N i N value represened by N. These coss are a varian of hose proposed by Roemberg (982), as hey allow for indexaion o pas values of in aion. The maximizaion problem of he monopolis corresponds o choosing he price level p N i, he amoun of labor, capial, and invesmen in order o maximize he discouned pro s X J ( $)( + N ) p N i yi N G i = w N l N i x N i + ($ N )(p N y N G ) ; subjec o equaions ()-(2), where G corresponds o G i wih p N i = pn. 6 The rs-order condiions are presened in he Appendix. There is a ax disorion $ ha reduces he value of rms sales ne of price adjusmen coss for any given level of producion. This disorion is o se in he aggregae, as he amoun $(p N y N G ) is resiued o each rm, bu i a ecs rms incenive o hire labor and inves in new capial. I is mean o capure a broad se of insiuional feaures ha keep poor counries from invesing a he high raes ha migh oherwise be jusi ed by he very low socks of privae capial. In his way, we mach he observed low invesmen shares in many low-income counries. In addiion, each rm receives a subsidy N per uni produced and ne of price adjusmen coss, which is nanced wih a ax common o he enire secor. This simpli es he seady-sae analysis by ensuring ha disorions arising from monopolisic compeiion are zero a seady sae. 6 The discoun facor J of he pro s is sochasic and relaed o he asse holders marginal uiliy of consumpion, since hey own he rms.

2 C. Traded Good Secor The raded secor feaures perfec compeiion and exible prices. The represenaive rm j is endowed wih a similar echnology o ha of he non-raded secor: y T i = z T h k T i T (q ) T i T l T i T : (3) The represenaive rm also accumulaes capial k i T hrough invesmen xt i 2 adjusmen coss Fi T T x T i 2 : Accumulaion is dicaed by x T i which is subjec o nk T i = ( T )k T i + F T i x T i : (4) The rm picks he amoun of capial, labor and invesmen in order o maximize he discouned pro s X J ( $)s yi T w T li T x T i + $s y T ; = subjec o equaions (3) and (4). As in he non-raded secor, sales in his secor are also subjec o he ax rae $: The Appendix liss he rs order condiions. One of he chief concerns wih a scaling up of aid is he possibiliy of Duch disease e ecs. Frequenly, he real appreciaion and shrinkage of he raded secor are inerpreed as evidence of hese e ecs. However boh e ecs may no consiue a disease, as hey are an indispensable par of he ransmission mechanism o shif resources from he raded o he non-raded secor in order o mee higher governmen demand for non-raded goods. Raher, o capure he idea of a disease, we inroduce learning-by-doing (LBD) e ecs ino he raded secor: a decline in he raded secor will impose an economic cos hrough los oal-facor produciviy (TFP) in his secor. 7 More formally, we assume ha he produciviy in he raded secor depends on he hisory of he deviaions of he previous secoral oupus from he seady sae, as can be inferred from! z T z z T = zt y T z T y T! v ; () where z T is he seady-sae value of he produciviy in he raded secor, and z 2 (; ) and v > : This speci caion is a variaion of he one in Masuyama (992) and Krugman (987). 8 I implies ha here are no permanen e ecs of learning by doing on oupu or produciviy. Bu deviaions of raded secor oupu from rend do imply persisen produciviy e ecs. 7 Rodrik (28) models LBD as one of wo broadly equivalen for our purposes reasons why real appreciaion could lower produciviy growh, he oher being ha he raded secor is inensive in public goods such as srong conracing insiuions ha are scarce in many low-income counries. 8 See also Adam and Bevan (26) and Torvik (2), among ohers.

3 D. The Governmen Governmens face poenially good opporuniies for public invesmen bu have limied access o exernal capial and nd raising axes very cosly. 9 The governmen is he direc recipien of foreign aid A ; which follows he process A = A + A (A A ) + A ; (6) where A is he seady sae level of aid, A corresponds o an exogenous increase in aid a ime, and A 2 (; ) is a parameer ha measures he degree of persisence of he increase in aid. Governmen consumpion g is a CES baske ha includes raded and non-raded goods and is de ned by g = g N + ( ) g T ; (7) which implies he following governmen price index p g h = p N i + ( )(s ) ; expressed in erms of he CPI. In his speci caion, is he degree of home bias in governmen consumpion, which may di er from is privae counerpar. Using he aggregaor (7), we can derive he following demand funcions: g N = p N g ; and g T = ( )s g : (8) The governmen can nance is spending p g g hrough a variey of sources: axes on labor income w l, using he domesic currency value of aid proceeds, s A, drawing down on deposis held a he cenral bank, d g d g b n, or issuing domesic deb ne of amorizaion b n. This domesic deb (b ) is held by households ha can save (b c ) and by he cenral bank (b cb ). The governmen also pays ineres on he share of governmen deb ha is held by consumers, (i )b c n. Then we can wrie he period-by-period governmen budge consrain as p g g = w l + s A d g d g + n where l = pl a + ( p)l h and b = b c + b cb : b b n (i )b c n ; (9) Governmen spending g, which is endogenously deermined by he consrain (9), can be used for public consumpion or invesmen purposes. 2 We disinguish beween he public invesmen ha is a consan share of seady-sae governmen spending, i.e., x gs = s g wih s 2 [; ]; and he public invesmen associaed wih he increase in aid, i.e., x ga = A (g g) wih A 2 [; ]: These invesmens serve o accumulae public capial q following nq = ( g )q + " s x gs + " A x ga ; (2) 9 On revenue-raising capaciies in low-income counries, see Heller e al. (26). 2 We do no model agency and asymmeric informaion problems beween donors and recipiens ha may deermine aid composiion as in Cordella and Dell Ariccia (27). Neiher do we consider he implicaions of aid for insiuional developmen, excep indirecly insofar as his is relaed o he size of he raded goods secor. On hese issues, see e.g. Johnson, Osry, and Subramanian (27).

4 where g is he depreciaion rae of public capial, and " s ; " A 2 [; ] measure he e ciencies of he wo ypes of public invesmen. These e ciency parameers " s and " A capure he idea ha less han one dollar of public capial is creaed for each public dollar spen on invesmen. The radiional perpeual invenory mehod infers he sock of public capial from informaion on public invesmen, and assumpions abou depreciaion raes, using equaion (2), wih he criical implici assumpion ha " s = and " A =. However, his assumpion is fraugh, paricularly in developing economies. Wheher because of wase and corrupion, an absence of marke pressures o ensure ha all projecs have he highes possible rae of reurn, or simply misclassi caion of curren spending (e.g. salary paymens o civil servans) as invesmen, a dollar of public invesmen spending may no always yields a full dollar of public capial, as argued by Priche (2). 2 The scal policy quesion of ineres here is how fas o spend he local currency counerpar o aid in ows. We assume ha aid dollars accrue o he scal auhoriy, which hen sells hem o he cenral bank in reurn for a domesic currency deposi. The accumulaion of governmen deposis is described by he following rule, which depends on he increase in aid: d g = dd g + ( d) d g + ( )s A A ; (2) where A and d g are he seady-sae levels of aid and deposis, and d 2 (; ). In his seup, he governmen will always spend he seady sae amoun of aid. However, an increase in aid A may or may no be spen iniially, depending on he policy parameer 2 [; ]. If aid is no spen, i will iniially accumulae as deposis bu will be gradually spen over ime. Boh d and deermine he speed of spending. To close he scal policy side of he model, we assume ha domesic governmen deb is consan: b = b: E. The Cenral Bank In a ypical aid-dependen counry, he canonical aid-relaed moneary policy problem can be described as follows: when he governmen spends he local-currency counerpar o aid in ows, how should he resuling moneary emission be handled? In paricular, how much should be serilized? And should he serilizaion be done hrough he sale of local-currency open-marke operaions or hrough he sale of foreign exchange? To sudy his problem, we inroduce in he model he cenral bank balance shee m m = b cb b cb d g d g + s R R n n n n ; (22) 2 The speci caion in (2) also capures some of he main insighs from he heoreical lieraure ha invesigaes how ine cien and corrup bureaucracies inerac wih he provision of public infrasrucure services and negaively a ec he produciviy of privae capial and growh. See Chakrabory and Dabla-Norris (29) and Sare (2), among ohers. A di eren approach o model ine ciency considers ha governmens can be viewed as producers of (public) goods. Governmens ha produce more of a paricular good while spending less on inpus can be viewed as more e cien han governmens ha produce less oupu and use more inpus. As an applicaion of his approach o esimae he e ciency of governmen expendiure on educaion and healh in Africa, see Gupa and Verhoeven (2).

where b cb are he governmen bonds held by he cenral bank and R denoes he foreign currency m value of reserves. The balance shee implies ha changes in money supply, m ; depend on open marke operaions, b cb b cb n ; changes in deposis, d g by assumpion are fully driven by changes in inernaional reserves, s R d g n n ; and changes in ne foreign asses, which R n The cenral bank implemens he following rule for he foreign currency value of reserves: : R = R R + ( R ) R + (!) A A! s ( S S ); (23) where S is he nominal depreciaion of he currency, and R and S are he seady-sae levels of reserves and nominal depreciaion. The persisence parameer R sais es R 2 (; ), while! s measures he degree of commimen o a nominal depreciaion arge. This rule implies ha he accumulaion of reserves is driven by hree separae facors. Firs, he cenral bank always sells he seady-sae value of aid, bu may reac di erenly o changes in he volume of aid. The coe cien! measures he fracion of addiional aid dollars sold on he marke by he cenral bank, i.e., he degree of immediae absorpion ouside of he seady sae. Second, he cenral bank may also follow a xed exchange rae regime by seing! s very high. 22 Finally, while he amoun of reserves may deviae persisenly from is long-run value, we assume ha he cenral bank arges a paricular long-run value of reserves, provided ha! s is no in nie, which may be calibraed o a counry s hisorical average or o some desired level of reserves. Regarding he moneary policy rule, we assume ha open-marke operaions adjus so ha reserve money always grows a he rae g. This capures he fac ha many low-income counries sill arge money, a leas de jure. Noe ha a he seady sae, reserve money grows a he rae g, and oherwise is growh rae is adjused in response o in aion. More speci cally, open-marke operaions imply he following process for b cb b cb b cb = m g n n : + d g d g n s R R n : (24) Therefore in he even ha aid is spen bu no absorbed, open-marke operaions would increase in order o fully serilize he direc moneary injecion ha would follow from incremenal aid in ows. Noe ha because he previously inroduced porfolio adjusmen coss P a are a funcion of privae secor ne foreign asses, cenral bank serilized inervenions will in general maer in his se-up, as we will see below. F. Aggregaion and he Goods Marke Equilibrium Condiions We aggregae across boh ypes of households, so a = pa a + ( p)a h for a = (c ; c N ; c T ; m ; l ; b ; b c ; rm ; ). We focus on a symmeric equilibrium, so we can drop he sub-indices ha disinguish among rms in he producive secor. The Appendix provides a de niion of equilibrium in his model. 22 Depending on he degree of capial mobiliy, he commimen o an exchange rae arge may be limied by he moneary policy rule.

6 Here we only sae he goods-marke equilibrium condiions. The equilibrium in he non-raded goods marke is described by: y N = p N D N ; (2) where D N = ' c + x N + x T + G + (p g ) g ; while he marke-clearing condiion for raded goods can be derived by combining he equilibrium condiion (2) and he budge consrains for all agens, including boh ypes of consumers, he governmen, and he cenral bank: A = c T + g T + x T T + x NT + pp a y T rm (i )b {z n + b } CAD b n {z } KAS + R R {z n ; } RA (26) where x T T and x NT correspond o he raded componens of he invesmens in he raded and nonraded secors, respecively. Equaion (26) also summarizes he possible uses of aid: i can nance a higher curren accoun de ci ne of aid (CAD), a capial accoun surplus (KAS), or an accumulaion of reserves (RA). III. Calibraion Our analysis will rely on calibraed numerical simulaions. 23 Because he model is micro-founded, some parameers can be based on microeconomic evidence, such as he e ciency of invesmen. Oher parameers depend on seady-sae raios ha can be deermined from naional income accouns, public and privae secor balance shees and inpu-oupu marices, or can be informed by moreor-less srucural macroeconomeric esimaes, e.g. money demand parameers. Oher parameers describe he policy response o aid or he policy regime in place and can herefore be reaed as free parameers ha are modi ed according o he policy experimen. Some parameers will remain poorly deermined, wheher because daa are unavailable or because he model s simpli caions imply ha an exac empirical counerpar may no exis. For hese parameers calibraion is based parly on sandard values found in he macro lieraure, and parly on desirable properies for he dynamics of he model following he increase in aid such as smooh hump-shaped responses. For his reason and, more generally, as a check on he overall calibraion, sysem properies of he model, such as on he e ecs of aid or public invesmen on growh, are also compared o reduced form macroeconomeric or case-sudy evidence. We calibrae mos of he parameers of he model o he Ugandan economy. Since here are a large number of parameers, we organize he discussion around hree groups: preferences, echnology, and policy. Tables -3 summarize he calibraion or policy reacions we will sudy below. We now brie y discuss he calibraion of some of he parameers ha are crucial for he policy experimens. The preference parameers are presened in Table. Regarding he value for p; he 29 Seadman Survey nds ha 62 percen of Ugandans do no have access o formal or informal nancial services. The ineracion of such large share of hand-o-mouh consumers wih he money argeing 23 The model was simulaed wih he sofware Dynare. See hp://www.cepremap.cnrs.fr/dynare.

7 rule resuls in large spikes in he real ineres rae in he baseline scenario ha do no seem plausible. As a resul, a lower share was chosen. Wih respec o he parameer %; which measures he elasiciy of subsiuion beween hours worked in he wo secors, here are no empirical esimaes for developing economies. We se i o, which corresponds o he economeric esimaes provided by Horvah (2). Table. Baseline Calibraion: Preference Parameers Parameers Value Source/Mehod '. Consisen wih Naional Income Accouns.89 Based on Tokarick (29) esimaes of impor demand elasiciies in Uganda 2 Sandard value in lieraure { a.6 Normalizes employmen of savers o a seady sae { h.6 Normalizes employmen of non-savers o a seady sae 2. Sandard value in lieraure # a.999 Help mach Uganda s annual real ineres rae # h.99 Help mach Uganda s real money balances in percen of GDP.8 Based on regression of real money balances on nominal ineres raes and GDP.6 Maches he share of non-raded producion in value added (6 percen) % In line wih Horvah (2). rm.28 Ensures rade de ci equals.2 percen of GDP a.99 Helps mach real ineres raes in Uganda p.67 Financial survey by Seadman Group (29); sysem properies As for echnology parameers presened in Table 2, we have relied on recen developing economy esimaes by Arslanalp e al. (2) on he impac of public capial on growh. These esimaes approximaely imply ha ( j ) j = : for j = N; T: 24 In he experimens below we assume ha he economy has a closed capial accoun, which makes serilizaion policies more e ecive. Consequenly, we choose a very high value for. The parameers of he learning-by-doing exernaliy, v and z ; are in line wih rm-level paneldaa esimaes of he learning-by-exporing lieraure in developing economies. Mengisae and Paillo (24) nd ha he growh rae of oal-facor produciviy of expor-oriened manufacuring rms in Sub-Saharan counries depends on lagged oal facor produciviy. Their esimaes roughly correspond o z = :: Calibraing v is more challenging, as mos of he learning-by-exporing lieraure esimae represenaions in which he curren produciviy of he rm depends on he dichoomous variable of lagged expor saus, which capures wheher he rm expored or no in he previous period. 2 By adoping his approach, mos of he works implicily assume ha here is also an asymmery in he e ec of lagged expor saus on produciviy. Isgu and Fernandes (27), however, ake an alernaive approach and repor esimaes of learning-by-exporing e ecs for Colombian manufacuring rms 24 The lieraure on he link beween public invesmen (capial) and growh seems o be reaching a consensus ha he link is posiive, bu no as big as originally esimaed by works such as Aschauer (989). 2 See for insance Van Biesebroeck (2), among ohers.

8 using he lagged raio of expors o oupu. Following heir esimaes, we se v = :: Table 2. Baseline Calibraion: Technology Parameers Parameers Values Source/Mehod Producion and Price Rigidiies T ; N.7 Uganda Inpu-Oupu ables T ; N.33 In line wih Arslanalp e al. (2) v. In line wih esimaes by Isgu and Fernandes (27) z. In line wih esimaes by Mengisae and Paillo (24) T ; N 2 Ensures smooh impulse responses for invesmen n.7 Maches Uganda s annual growh (7 percen) z T Normalizaion z N.4 Ensures he real exchange rae equals one a seady sae N ; T. In line wih Bu (24) 9 Sandard value in lieraure implying prices are sicky for almos one year Disorions and Subsidies $.74 Helps mach Uganda s invesmen share (6 percen) N.9 Eliminaes monopolisic disorion a seady sae Capial Mobiliy Implies he capial accoun is closed b a Normalizaion We model a emporary bu persisen increase in aid such ha, as a resul of he scaling up, aid is on average six percenage poins of GDP higher han is seady-sae value over he following ve years. Noe ha he coe cien A in he process for aid described in (6) resuls in a half life of he shock of slighly more han a year, which implies he aid increase is fron loaded. Finally he value of he seady-sae e ciency " s is based on work by Areso and Hurlin (26). 26 For our baseline calibraion we assume " s = :4. This assumpion, along wih he parameers ha govern he seady-sae invesmen rae, he depreciaion rae, and he parameers of he producion funcion, implies ha he marginal produc of public capial in he seady sae is 3 percen. One migh also calculae he marginal produc of public invesmen a he seady sae, which corresponds o he increase in oupu due o an addiional dollar of public invesmen. Wih our baseline calibraion, his equals 3" s or :2 percen. 26 Areso and Hurlin (26) ake a close look a he relaionship beween dollars spen on cerain speci c caegories of public invesmen and physical capial indicaors and were able o infer some public invesmen e ciency measures, in our sense, for Colombia and Mexico. They nd ha he relaionship beween public invesmen and he change in he capial sock is indeed linear, as assumed in equaion (2), and ha " s has a value of abou.4 for hese wo counries. Ineresingly, hey nd a value of abou. for he Unied Saes. Priche (2) calculaes, using a very di eren mehodology, ha " s equals abou. in many low-income counries, wih subsanial heerogeneiy across counries.

9 Table 3. Baseline Calibraion: Policy Parameers and Aid Process Parameers Value Source/Mehod Aid process A.9 Implies a half-life of he shock of abou one year A.49 Maches curren share of aid in GDP ( percen) A.226 Maches a scaling up on average of 6 percenage poins of GDP in years The Governmen.7 Endogenously deermined o clear non-raded goods marke.237 Helps mach he curren share of governmen spending (8 percen of GDP) s.3889 Maches he curren share of public invesmen (7 percen of GDP) A. Policy parameer b c.69 Maches he sock of ousanding domesic governmen deb (4.2 percen) b cb.828 Helps mach real money balances g.2 Broadly in line wih Arslanalp e al. (2) " s.4 In line wih Areso and Hurlin (26) " A.4 In line wih Areso and Hurlin (26) d.9 Policy parameer d g.28 Based on Uganda s Moneary Survey Policy parameer for he experimens The Cenral Bank R.9 Policy parameer R.298 Maches Uganda s sock of reserves (8 percen of GDP)! Policy parameer for he experimens! s Policy parameer for he experimens g.32 Consisen wih Uganda s in aion (6 percen) 3.863 Consisen wih a Taylor rule wih an in aion coe cien of. The impac of aid-surge-relaed public invesmen on he percenage deviaions of real GDP from is seady sae is deermined by he relaive e ciency " A "s ; and his wha we generally mean by e ciency in his paper. The reason is simple. Consider a change in he calibraion ha increases boh e ciencies by he same amoun. In his case, he given aid surge yields he same percenage GDP deviaions, because here are wo opposie e ecs. The good news is ha he aid surge will build more public capial, because " A is higher. The bad news is ha he higher value of " s means ha he seady-sae capial sock mus be larger, as implied by equaion (2). Bu he percenage change in oupu is proporional o he percenage change in he capial sock. Thus, a larger capial sock implies a smaller percenage increase in capial and hence oupu for he same dollar incremen o aid. As shown in he appendix, hese wo e ecs exacly o se for he Cobb-Douglas producion echnologies of our model. 27 27 This recalibraion of boh e ciency parameers can be undersood in di eren ways. We have in mind he noion ha he analys revises her assessmen of overall e ciency in a given counry, no ha we are comparing wo di eren counries. In he former case, he level of oupu is observable and unchanged. Thus, he level of oal facor produciviy

2 For he baseline, we assume " A = " s. Of course, i could go eiher way. For example, rapid scaling up migh pu pressure on adminisraive procedures and absorpive capaciy and reduce e ciency " A relaive o is seady-sae counerpar " s. On he oher hand, a more careful preparaion of public invesmen programs, and more generally beer public-secor managemen and insiuions, would end o lead o higher e ciency " A. Overall, i mus be sressed ha he value of he e ciency parameer " A is surely counry and conex-speci c. IV. The Experimens A. The Baseline Scenario For he baseline scenario, we use he paramerizaion in Tables -3. In his scenario, aid-relaed public invesmen is as e cien as in seady sae (" A = " s ) and here are mild learning-by-doing exernaliies ( z = : and v = :). Moreover, he exchange rae regime is exible (! s = ), and he governmen deposis and reserve rules imply full spending ( = ) and full absorpion (! = ) of aid. We also assume ha open-marke operaions adjus so ha money always grows a he rae g. The resuls of he simulaions are presened in Figure, where he annual impulse responses of seleced macroeconomic variables are measured as percenage deviaions from seady sae. The shorrun macroeconomic e ec of he aid surge is driven by is impac on governmen spending, in paricular on non-raded goods. Because of nominal price rigidiies, he supply of non-raded goods expands in response o greaer demand, generaing a shor-lived spike in real GDP. This expansion in non-raded oupu is mosly accomplished hrough increased labor demand, which is parly sais ed by drawing labor from he raded secor. A higher demand for labor from he non-raded secor conribues o he rapid increase in real wages in he shor run, which ranslaes ino higher non-raded goods in aion. This, however, does no induce higher CPI in aion, because he nominal appreciaion causes raded goods de aion. The combinaion of higher wages and nominal appreciaion adversely a ecs pro abiliy in he raded secor leading o a decline of is oupu in he shor erm. 28 Over ime, as nominal rigidiies dissipae, he demand-driven boom fades. However, par of he governmen spending has been used o increase public invesmen. The public capial sock increases, causing a persisen and posiive e ec on GDP ha accouns for mos of he oupu increase in he medium erm. This process is reinforced by he expansion of privae capial socks in boh secors, following an increase in he marginal value of capial, re ecing he posiive e ec of more public mus fall if boh e ciencies are raised, in order o mach observed oupu wih he higher public capial sock. The bad news referred o above can hus be undersood as being relaed o he fac ha he marginal produc of capial which depends on oal facor produciviy mus be lower. Along he same lines, he marginal produc of public invesmen is invarian o " s; changes in " s a ec he marginal produc of capial in inverse proporion. This poin is made by Priche (2) in a di eren conex. 28 Noe ha he nominal ineres rae also increases. Using he money demand equaions from he savers and nonasse holders and he moneary rule, i is possible o show ha he nominal ineres rae is an increasing funcion of consumpion and in aion. As consumpion rises, hen he nominal ineres rae also goes up.

2 BASELINE Aid and Trade Defici (% of GDP) Aid Trade Defici Governmen Spending (% of GDP) 3 2 2 Inernaional Reserves 3 2 Real GDP 2 2 2 2 Inflaion Rae (in %) 2 Secoral Inflaion (in %) Nominal Exchange Rae (+ depreciaion) Real Exchange Rae 2 Non Traded Traded 2 2 2 CPI Based P T /P N Raio 2 Nominal Ineres (in %) 2 2 Privae Absorpion 3 2 Public Capial Sock 3 2 Labor Marke Toal Employmen Real Wages 2 2 2 2 Invesmen Secoral Oupu Non Traded Secor Traded Secor 2 2 2 2 2 2 Marginal Value of Capial Non Traded Traded Capial Employmen Capial Employmen Invesmen Figure : Baseline scenario. Impulse responses are shown in annual erms and as percenage deviaions from seady sae, unless oherwise noed.

22 capial on he marginal produciviy of privae capial. 29 The overall e ecs of aid on oupu do no appear srikingly large. Wih our 6 percen-of-gdp aid surge exending over some years, oupu is some 2.6 percen higher han seady sae a is maximum (6 years afer he beginning of he aid surge). To provide some conex, our baseline marginal produc of capial of 3 percen may be compared o esimaes of raes of reurn on World Bank projecs of roughly 2 percen. 3 However, oher evidence suggess our growh impacs may no be oo far o. We can also de ne he macro rae of reurn of public invesmen as he inernal rae of reurn implied by he sream of addiional oupu less addiional aid- nanced invesmen. This reurn is close o 7 percen in he baseline calibraion, re ecing all he fricions and feaures of he model. This resul is broadly consisen wih aggregae evidence in Arslanalp e al. (2) abou he growh e ecs of public invesmen and Clemens e al. (24) abou he growh e ecs of high-impac aid. Of course, an increase in public invesmen e ciency relaive o seady sae, more aid allocaed o invesmen, more responsive facor markes, and lower adjusmen coss o privae invesmen and oher changes in he calibraion would yield larger medium-erm growh e ecs, and sensiiviy exercises along hese lines may be worhwhile in paricular cases. The real exchange rae appreciaion plays numerous roles in he ransmission mechanism. Firs, by making raded goods relaively cheaper, he real appreciaion shifs privae secor demand from non-raded o raded goods. This frees domesic capaciy o mee he higher governmen demand for non-raded goods. Second, by increasing impors and lowering raded oupu, he real appreciaion conribues o an increase in he rade de ci. This implies ha for a given oupu, domesic consumpion and invesmen can expand. This is clearly faciliaed by he cenral bank s reserve policy of fully absorbing he aid. As we will discuss below, wihou such a reserves policy, higher governmen spending relaed o he aid surge would imply ha privae secor consumpion and/or invesmen would have o decline, meaning higher governmen spending would crowd ou he privae secor. B. Parial Aid Absorpion Policies B.. Reserve Accumulaion Rules under a Flexible Exchange Rae Regime Policy makers are likely o be mos worried abou he loss of compeiiveness due o he real exchange rae appreciaion resuling from he aid surge. The cenral bank may herefore decide o limi he amoun of foreign exchange sales o he marke, using he aid in ows insead o build up 29 The marginal value of capial is calculaed as a weighed average of he implied marginal Tobin Qs for each producive secor. 3 One migh consider ha he World Bank raes of reurn should be compared o he lower marginal produc of invesmen in our model. On he oher hand, World Bank projecs may be relaively e cien, paricularly he small fracion (well below half in recen years) for which ex pos raes of reurn are calculaed (Warner, 2). For example, very few projecs repor a negaive ne rae of reurn, even when oher indicaions exis ha reurns may be negaive, and ex pos reurns are calculaed for very few projecs whose execuion is deemed highly unsaisfacory. More generally, here are a number of reasons o hink ha hese esimaed projec reurns are subsanially oversaed.

23 PARTIAL ABSORPTION UNDER A FLEXIBLE EXCHANGE RATE: ACCUMULATING SOME AID FLOWS IN RESERVES Trade Defici (% of GDP) 3 Governmen Spending (% of GDP) 2 2 2 4 6 8 2 4 6 8 2 Inernaional Reserves 2 4 6 8 2 4 6 8 2 Nominal Exchange Rae 2 4 6 8 2 4 6 8 2 Privae Consumpion 2 4 6 8 2 4 6 8 2 4 2 Real GDP 2 4 6 8 2 4 6 8 2 Real Exchange Rae 2 4 6 8 2 4 6 8 2 Privae Invesmen 2 4 6 8 2 4 6 8 2 2 4 6 8 2 4 6 8 2 Parial Absorpion Full Absorpion Figure 2: Comparison of he impulse responses, in annual erms, for seleced macroeconomic variables under full and parial absorpion of aid, assuming exible exchange raes. Parial absorpion is he resul of accumulaing some of he aid surge in reserves. The responses are shown as percenage deviaions from seady sae, unless oherwise noed. foreign exchange reserves and, in his way, conain some of he appreciaion. 3 Berg e al. (27) nd ha his is exacly wha many sub-saharan cenral banks did during aid surges. As some governmens were also rying o spend mos of he aid, hen accumulaing aid ows in reserves creaed an excess of liquidiy and, consequenly, in aion pressures. Some cenral banks hen decided o implemen bond serilizaion policies o counerac hese pressures. We simulae he model o sudy he macroeconomic implicaions of accumulaing some of he increased aid ows in reserves (a parial absorpion policy wih! = :), while he governmen implemens a deposi rule ha implies full spending of aid. We compare his wih he full-absorpion policy of he baseline (! = ). We also assume full serilizaion hrough domesic open-marke operaions of he resuling moneary emission. The simulaions are shown in Figure 2. Limiing he sale of aid-relaed foreign exchange is indeed e ecive in reducing he appreciaion, boh in nominal and real erms. As a resul, he rade de ci widens by less, which implies only a parial absorpion of aid in ows. Given full aid spending, parial absorpion a an economy-wide level 3 Noe ha his ype of policies canno be a rs-bes way o address concerns abou compeiiveness. In principle, a remedy argeed a he roo disorion would be ideal. For example, a learning-by-doing exernaliy in he expor secor would call for an across-he-board expor subsidy. However, as Rodrik (28) noes, such policies can be very di cul o design and implemen and could run afoul of WTO resricions.

24 mus imply a reducion in privae secor demand. This implies a signi can privae secor consumpion and invesmen crowding ou, which akes place in he rs hree o ve years. Moreover, he reducion in privae invesmen has a signi can adverse impac on real GDP, roughly halving he posiive GDP e ec of scaled-up aid over he ve-o-en-year horizon. Hence, limiing foreign exchange sales in order o sem he nominal appreciaion comes a a signi can cos. 32 The underlying cause of he privae secor crowding ou is he auhoriies aemp o use he same aid resources wice: on he one hand, he cenral bank uses he foreign exchange value of aid in ows o build up reserves; on he oher hand, he governmen uses he domesic currency counerpar o increase spending. Whereas governmen spending of aid resources would normally correspond o an exernally- nanced increase in spending, he cenral bank use of he foreign exchange counerpar for building up is foreign reserves e ecively ransforms his ino domesically- nanced spending. Exernally- and domesically- nanced governmen spending have very di eren impacs on he privae secor. In an exernally- nanced case, he foreign exchange in ows are used for nancing a larger curren accoun de ci. This allows governmen spending o increase wihou crowding ou privae secor demand. In he case where he foreign counerpar of aid in ows is used for reserve buildup, he curren accoun de ci does no increase. Consequenly, higher governmen spending necessiaes a lower privae secor demand, unless here is a very large supply response. B.2. A Fixed Exchange Rae Regime wih Serilizaion Many aid recipiens have xed exchange rae regimes or may consider pegging as a way o avoid nominal appreciaions associaed wih aid surges. Therefore, we proceed o sudy he implicaions of implemening a xed exchange rae regime (! s = ) in comparison o he exible regime of he baseline scenario (! s = ). For he simulaions we consider boh full serilizaion bond policies, as in he baseline, and no serilizaion. To shu down serilizaion, we replace he serilizaion rule (24) by a rule in which cenral bank purchases of nominal governmen bonds grow a he rae g ; implying he following process: b cb b cb = bcb g : n n A seady sae, his process ensures ha nominal money supply grows a he gross rae g, which pins down he seady-sae level of in aion. Ouside of he seady sae, however, his rule does no ensure a consan growh rae for nominal money, as he growh rae will be a eced by wheher aid is spen bu no absorbed. Speci cally, equaion (22) shows ha he combinaion of declining governmen deposis (spending aid) and increased accumulaion of reserves (no fully absorbing aid) may lead o a faser nominal money growh rae han g. We sar wih he case of no serilizaion under a xed regime. The simulaions are presened in 32 Noe ha real GDP is higher in he shor run wih he parial absorpion policy. This is explained by he more pronounced expansion of he non-raded secor in response o higher demand pressures generaed by he parial absorpion.

2 FULL ABSORPTION: A FIXED EXCHANGE RATE REGIME WITHOUT STERILIZATION Trade Defici (% of GDP) 4 Inernaional Reserves 2 2 4 6 8 2 4 6 8 2 4 Real GDP 2 4 6 8 2 4 6 8 2 2 Inflaion (in %) 2 2 4 6 8 2 4 6 8 2 2 4 6 8 2 4 6 8 2 Nominal Exchange Rae Real Ineres Rae (Deviaion from Baseline in pp) 2 4 6 8 2 4 6 8 2 2 4 6 8 2 4 6 8 2 Real Exchange Rae 2 4 6 8 2 4 6 8 2 6 4 2 Privae Invesmen 2 4 6 8 2 4 6 8 2 Fixed Exchange Rae Regime Wihou Serilizaion Flexible Exchange Rae Regime (Baseline) Figure 3: Comparison of he impulse responses, in annual erms, for seleced macroeconomic variables under a exible exchange rae regime and a xed exchange rae regime wihou money supply serilizaion. The responses are shown as percenage deviaions from seady sae, unless oherwise noed.

26 PARTIAL ABSORPTION: A FIXED EXCHANGE RATE REGIME WITH STERILIZATION Trade Defici (% of GDP) 6 Inernaional Reserves 4 2 2 4 6 8 2 4 6 8 2 Real GDP 2 4 6 8 2 4 6 8 2 2 Inflaion (in %) 2 4 6 8 2 4 6 8 2 2 4 6 8 2 4 6 8 2 2 Nominal Exchange Rae Real Ineres Rae (Deviaion from Baseline in pp) 2 4 6 8 2 4 6 8 2 2 4 6 8 2 4 6 8 2 Real Exchange Rae 2 4 6 8 2 4 6 8 2 Privae Invesmen 2 4 6 8 2 4 6 8 2 Fixed Regime Wih Full Serilizaion (Parial Absorpion) Fixed Regime Wihou Serilizaion (Full Absorpion) Figure 4: Comparison of he impulse responses, in annual erms, for seleced macroeconomic variables under a xed exchange rae regime wihou money supply serilizaion (full absorpion) and wih full serilizaion (parial absorpion). The responses are shown as percenage deviaions from seady sae, unless oherwise noed. Figure 3. The real exchange rae appreciaion is similar o ha under a exible regime, bu because raded goods prices remain consan, non-raded in aion has o increase signi canly more o bring abou he same relaive price change. This also means subsanially higher overall in aion, because unlike he exible regime case, here is no raded de aion. Wihou raded de aion, here are larger demand pressures in he non-raded secor, as re eced by a more pronounced shor-run spike in GDP, relaive o he one in he exible regime scenario. Over he medium erm, however, oupu responses are almos idenical o he baseline. Wih a xed regime, he accumulaion of inernaional reserves is no a policy choice bu is governed by he need o sell as much foreign exchange as needed o keep he nominal exchange rae consan. In conras o he baseline scenario, where aid in ows were sold o bring abou a nominal currency appreciaion, under he xed regime par of hese in ows are accumulaed as reserves. Absen serilizaion, and provided he domesic currency counerpar is fully spen by he governmen, his reserve accumulaion leads o a large increase in he money supply. 33 This money supply expansion is insrumenal in accommodaing he overall increase in in aion, which in urn brings abou he real appreciaion necessary for close-o-full absorpion of he aid in ows. In fac, he dynamics 33 This follows from he cenral bank s balance shee in equaion (22), where he reserve buildup increases he hird erm on he righ hand side, whereas no serilizaion and full governmen spending keep he rs and second erms consan.

27 of privae invesmen is broadly he same across regimes. The real shor ineres rae increases o help keep in aion expecaions anchored, bu his increase is moderae and shor-lived, despie he accommodaive moneary policy sance. The cenral bank could preven he money supply expansion hrough open marke operaions ha serilize he domesic currency counerpar of he foreign reserve accumulaion. 34 In his case, he moneary policy sance would become much igher, wih real ineres raes increasing by much more and remaining high for a longer period, as shown in Figure 4. This would lead o signi can privae-secor crowding ou. The associaed reducion in privae secor impor demand would limi economy-wide absorpion, including privae invesmen, as well as he real exchange rae appreciaion. Bu once more, lower privae invesmen would reduce he medium-erm impac of aid on real GDP. These e ecs are very similar o hose of he parial absorpion scenario under he exible exchange rae regime, and he corresponding policy consideraions apply here as well. C. Learning-by-Doing Exernaliies, The E ciency of Public Invesmen, and Parial Absorpion Policies In his secion we explore he ineracions of he learning-by-doing (LBD) exernaliies, he ef- ciency of public invesmen, and parial absorpion policies. We proceed in hree seps. Firs, we discuss he implicaions of varying e ciency in our model. Second, we explore he consequences of increasing he LBD exernaliies and is ineracion wih low e ciency of public invesmen. And hird, we examine he e ecs of parial absorpion policies in he conex of srong exernaliies and low e ciency. C.. The E ciency of Public Invesmen A signi can change in he (relaive) e ciency wih which public invesmens ranslae ino public capial may have a large impac on GDP. Figure illusraes his by keeping he e ciency of he general public invesmen process a 4 percen (" s = :4), and comparing hree scenarios: (i) a low-e ciency scenario where he e ciency of aid-surge- nanced invesmen is reduced o percen (" A = :); (ii) he baseline scenario (" A = :4); and (iii) a high-e ciency scenario, re ecing percen e ciency (" A = ). The di erence in he GDP e ec beween he high- and low-e ciency scenarios is sizeable. In he high-e ciency scenario, he GDP e ecs are large and persisen, owing o public capial accumulaion and he associaed crowding in e ec on privae invesmen: he larger public capial accumulaion 34 An imporan cavea is ha serilizaion is feasible only wih a su cienly closed capial accoun, as is he case wih he Uganda calibraion used here. Wih an open capial accoun, he aemp o raise ineres raes as par of he serilizaion e or would arac privae secor capial in ows. This would add o he foreign reserve buildup and, herefore, o he serilizaion need, hereby quickly overwhelming he cenral bank s abiliy o conrol he money supply while mainaining a xed exchange rae. In pracice, many low-income counry cenral banks seem o have some room o serilize even wih pegged regimes and de jure open capial accouns.

28 8 7 THE EFFICIENCY OF PUBLIC INVESTMENT AND REAL GDP Baseline High Efficiency of Public Invesmen Low Efficiency of Public Invesmen 6 Real GDP 4 3 2 2 4 6 8 2 4 6 8 2 Time Figure : Comparison of he real GDP impulse responses, in annual erms, under di eren assumpions for he e ciency of he public invesmen. The responses are shown as percenage deviaions from seady sae. raises he marginal value of privae capial, which riggers an increase in privae invesmen. In conras, he low-e ciency scenario is characerized by a large bu shor-lived demand-driven boom and pracically no GDP e ecs beyond he shor erm. 3 C.2. The Learning-by-Doing (LBD) Exernaliies The erm Duch disease in his paper is reserved o describe he poenial negaive e ecs of he smaller raded-goods secor on produciviy, here modeled hrough powerful LBD exernaliies. Bu hese exernaliies cu boh ways: increases of raded oupu relaive o is rend can also generae produciviy gains in his secor and, herefore, amplify he posiive e ecs of aid, especially over longer horizons. We will call his Duch vigor. The LBD exernaliies are governed by he parameers v and z of he speci caion in (), which measure he srengh and persisence of raded oupu changes on is TFP deviaions from rend. To undersand he role of hese exernaliies, we compare he model dynamics under srong exernaliies (v = : and z = :) wih he baseline scenario (v = : and z = :). Figure 6 shows his comparison, wih he line marked wih dos represening he srong exernaliies scenario. Relaive o he baseline, srong exernaliies have he expeced e ec of amplifying he decline in he raded 3 I should be noed ha a change of hese relaive e ciencies is akin o changing he disribuion beween public invesmen and public consumpion ( A ). Therefore, given s, fully invesing he aid ( A = ) is comparable o he high-e ciency scenario, while fully consuming he aid ( A = ) is equivalen o he low-e ciency scenario.

29 4 2 2 THE EFFECTS OF LOW EFFICIENCY AND STRONG EXTERNALITIES Real GDP 2 2 Public Capial 4 2 4 6 8 2 4 6 8 2 2 4 6 8 2 4 6 8 2 Traded Oupu Non Traded Oupu 2 4 6 8 2 4 6 8 2 2 4 6 8 2 4 6 8 2 Privae Invesmen Real Exchange Rae 2 4 6 8 2 4 6 8 2 2 4 6 8 2 4 6 8 2 Baseline Srong LBD Exernaliy Srong LBD Exernaliy and Low Efficiency of Public Invesmen Figure 6: Impulse responses, in annual erms, for seleced macroeconomic variables under full spending and absorpion, assuming very low e ciency and srong learning-by-doing exernaliies. The responses are shown as percenage deviaions from seady sae, unless oherwise noed. secor, which leads o a fall in GDP in he shor-erm and a lower economy-wide GDP e ec over he rs eigh years. Moreover, he real exchange rae appreciaion is less pronounced, re ecing a reverse Balassa-Samuelson e ec due o he decline in produciviy in he raded secor relaive o ha of he non-raded secor. The non-raded secor, in conras, is broadly una eced by varying he LBD exernaliies. Looking beyond he rs eigh years, however, shows a sronger economic performance under he srong LBD exernaliies he Duch vigor. The key here is ha higher public capial accumulaion induces crowding in e ecs on privae capial accumulaion, as capured by he expansion of privae invesmen in Figure 6. This evenually helps raise raded oupu above is seady sae level. Once oupu exceeds he seady sae, he exernaliies boos raded secor TFP, which ampli es he posiive medium-erm e ec of public and privae capial accumulaion on his secor and he whole economy. Moreover, as prediced by he Balassa-Samuelson e ec, he increase in he raded secor TFP causes and appreciaion of he real exchange rae relaive o he baseline scenario. LBD exernaliies raise he sakes. They can amplify posiive e ecs of aid, bu hey may also make aid harmful in erms of real GDP e ecs. The key deerminan of wheher hey amplify or undermine aid s posiive e ecs is he relaive e ciency of public invesmen. The use of aid maers, because his will deermine wheher a shrinkage in he raded secor is emporary or proraced and hereby wheher he exernaliies have posiive or negaive e ecs. The line marked wih circles in

3 Figure 6 illusraes his poin, by represening he combinaion of srong LBD exernaliies wih low e ciency of public invesmen (" A = :). In his case, srong exernaliies sill lead o a shor-erm drop in GDP, and he brun falls on he raded secor. Bu he low e ciency of public invesmen accenuaes hese negaive e ecs, including he decline in privae invesmen. In addiion, over he medium erm, he low e ciency of public invesmen precludes crowding in e ecs on privae capial accumulaion. Aid is harmful in his conex, a leas for growh. C.3. Parial Absorpion Policies We now explore he macroeconomic implicaions of accumulaing some of he addiional aid ows in reserves, a parial absorpion policy, in he conex of srong LBD exernaliies and low e ciency of public invesmen. 36 This policy implies a rade-o. On he one hand, as Figure 7 shows, i does indeed succeed in diminishing some of he shor-erm appreciaion pressures. On he oher, i crowds ou privae invesmen (and consumpion), as we saw in he baseline scenario. When e ciency is low and he exernaliies srong, however, he coss in erms of lower privae invesmen are low and medium-erm real GDP e ecs benign. The reason lies in he ineracion of low e ciency and srong exernaliies. When e ciency is low, here is less public capial accumulaion and hus less crowdingin. Indeed, he parial absorpion policy encourages privae invesmen insofar as i reduces miigaes he real appreciaion and relaed negaive e ec on produciviy growh. These wo e ecs on privae invesmen roughly counerbalance, as Figure 7 also shows. These resuls lend some suppor o he noion ha parial absorpion policies may be an appropriae response o aid surges. I is imporan o underscore, hough, ha boh he low e ciency and he srong exernaliies are imporan here. This is con rmed by he resuls presened in Figure 8, which shows he simulaions for boh parial and full absorpion policies, in he conex of srong exernaliies and fully e cien public invesmen (" A = ). In his case, he GDP e ec of scaled-up aid is always posiive, and more so over ime in he presence of full absorpion. Afer ve years, GDP exceeds ha under parial absorpion and mainains his rend in he longer erm. An imporan par of he ransmission mechanism is a large increase in privae capial accumulaion due o he TFP gains ha are muliplied by srong exernaliies (he Duch Vigor e ec). In fac, raded-secor oupu overshoos is rend over he medium erm, while he real exchange rae displays a persisen appreciaion, in line wih he Balassa-Samuelson e ec. 37 V. Discussion A heme running hrough he paper is ha e ors o suppress he real exchange rae appreciaion pressures associaed wih aid surges may be misguided. The baseline simulaion showed ha he resuling real appreciaion is a criical elemen of he ransmission mechanism ha shifs resources from 36 Similar resuls o hose in his secion are obained under a xed exchange rae regime wih money supply serilizaion. 37 Full absorpion sill yields higher GDP over he medium erm even wih srong LBD exernaliies when he e ciency of aid-relaed invesmen is he same as seady-sae e ciency.

3 PARTIAL ABSORPTION POLICIES UNDER LOW EFFICIENCY AND STRONG EXTERNALITIES Trade Defici (% of GDP) 3 Governmen Spending (% of GDP) 2 2 2 4 6 8 2 4 6 8 2 2 4 6 8 2 4 6 8 2 Real Exchange Rae 2 4 6 8 2 4 6 8 2 2 2 Traded Oupu Privae Consumpion 4 2 4 6 8 2 4 6 8 2 2 4 6 8 2 4 6 8 2 Real GDP 2 4 6 8 2 4 6 8 2 Non Traded Oupu 2 4 6 8 2 4 6 8 2 Privae Invesmen 2 4 6 8 2 4 6 8 2 Parial Absorpion Full Absorpion Figure 7: Comparison of impulse responses, in annual erms, for seleced macroeconomic variables under full and parial absorpion for an economy wih low e ciency of public invesmen and srong learning-by-doing exernaliies. The responses are shown as percenage deviaions from seady sae, unless oherwise noed.

32 PARTIAL ABSORPTION POLICIES UNDER HIGH EFFICIENCY AND STRONG EXTERNALITIES Trade Defici (% of GDP) 3 Governmen Spending (% of GDP) 2 2 2 4 6 8 2 4 6 8 2 2 4 6 8 2 4 6 8 2 4 2 Real Exchange Rae 2 2 4 6 8 2 4 6 8 2 2 Traded Oupu Privae Consumpion 2 4 6 8 2 4 6 8 2 2 4 6 8 2 4 6 8 2 2 Real GDP 2 4 6 8 2 4 6 8 2 Non Traded Oupu 2 4 6 8 2 4 6 8 2 4 2 Privae Invesmen 2 2 4 6 8 2 4 6 8 2 Parial Absorpion Full Absorpion Figure 8: Comparison of impulse responses, in annual erms, for seleced macroeconomic variables under full and parial absorpion for an economy wih high e ciency of public invesmen and srong learning-by-doing exernaliies. The responses are shown as percenage deviaions from seady sae, unless oherwise noed.

33 PARTIAL ABSORPTION AND PARTIAL SPENDING POLICIES Trade Defici (% of GDP) 3 Governmen Spending (% of GDP) 2 2 2 4 6 8 2 4 6 8 2 Real Exchange Rae 2 4 6 8 2 4 6 8 2 Real GDP 2 4 6 8 2 4 6 8 2 Traded Oupu 2 4 6 8 2 4 6 8 2 2 2 Privae Consumpion 4 2 4 6 8 2 4 6 8 2 2 4 6 8 2 4 6 8 2 Non Traded Oupu 2 4 6 8 2 4 6 8 2 2 2 Privae Invesmen 4 2 4 6 8 2 4 6 8 2 Parial Spending and Parial Absorpion Full Spending and Parial Absorpion Figure 9: Comparison of he impulse responses, in annual erms, for seleced macroeconomic variables under parial spending and parial absorpion versus full spending and parial absorpion of aid, assuming exible exchange raes, srong learning-by-doing exernaliies, and low e ciency of public invesmen. Parial absorpion is he resul of accumulaing some of he aid surge in reserves. The responses are shown as percenage deviaions from seady sae, unless oherwise noed. he raded o he non-raded secor, hereby enabling a supply response o he governmen s increased demand for nonradables and reducing he raded secor oupu. More imporanly our experimens show ha parial absorpion policies designed o choke o he real exchange rae appreciaion in he shor erm can crowd ou privae consumpion and invesmen, and have adverse real GDP e ecs over he medium erm. The quesion remains, why do policy-makers coninue o consider such e ors? One answer is ha, conrary o our baseline calibraion, he relaive e ciency of public invesmen, or he share of spending allocaed o public invesmen, is low, while LBD exernaliies are srong. As explored above, fully spending and absorbing aid may be harmful in his conex. However, even wih srong exernaliies and low e ciency, i is possible o do beer han parial absorpion policies avoid he crowding ou of he privae secor by combining hem wih parial spending policies. Figure 9 illusraes his, when only half of he aid in ows are iniially spen by he governmen ( = :), and when half of he ows are accumulaed as reserves by he cenral bank (! = :). In his case, appreciaion pressures can be diminished, amelioraing he shor-erm crowding ou e ec on privae consumpion and invesmen of fully spending and parially absorbing he aid. In pracice, parial spending may face donor objecions, given ha hey expec heir scarce

34 WELFARE GAINS AND ABSORPTION POLICIES Srong Exernaliies and Low Efficiency.22 Srong Exernaliies and High Efficiency 9.24 Full Spending Parial Spending 8 Full Spending Parial Spending.26 7 Welfare Gains.28.3 Welfare Gains 6.32 4.34 3.36.2.4.6.8 2.2.4.6.8 Reserve Accumulaion Parameer ω Reserve Accumulaion Parameer ω Figure : Welfare gains of di eren reserve accumulaion policies (aid absorpion policies), assuming LBD exernaliies are srong, and he e ciency of public invesmen is eiher low (lef-hand side) or high (righ-hand side). Full spending corresponds o =, while parial spending corresponds o = :: budgeary resources o be used for developmen and no o be saved by he recipien governmen. This adds he need for donor coordinaion o he policy mix. In principle, donors could scale up heir aid a a pace ha akes macroeconomic concerns ino accoun or allow he governmen o smooh aid- nanced expendiures over ime by saving iniially par of he ows. 38 A welfare analysis con rms ha parial absorpion policies may indeed induce welfare gains relaive o full absorpion policies, in he conex of low e ciency and srong exernaliies. To see his, we calculae he welfare gains of di eren reserve accumulaion policies (aid absorpion policies). We de ne he welfare gain as he di erence beween he governmen life-ime uiliy funcion U g o and is seady-sae value. In urn, U g o is de ned as he weighed average of he life-ime uiliy funcions of he wo ypes of households. 39 Speci cally, where Uo j = P h = (a ) u j (c j ; mj ) consumers (j = h). U g o = puo a + ( p)uo h i { j + (lj )+ for he asse holders (j = a) and hand-o-mouh Figure presens he resuls of his welfare analysis. Consider rs he lef-hand side, which 38 Figure 9 ha represens a scenario of limiing iniial spending of aid is an example of such expendiure smoohing, because he scal spending rule in equaion (2) ensures ha all aid is evenually fully spen. 39 Noe ha since our model is non-sochasic, he spiri of our analysis di ers from ha of he recen opimal policy analysis of he New-Keynesian lieraure. This lieraure sudies he opimal scal and moneary policies in he conex of sochasic models in which he volailiy of he shocks plays a crucial role (see for insance Schmi-Grohé and Uribe, 27, among ohers). Here we abrac from hese issues.

3 shows he welfare gains for di eren reserve accumulaion policies (aid absorpion) as measured by he parameer! in equaion (23), assuming e ciency is low. The solid line shows he resuls for he baseline case of full spending. Welfare gains are maximized for! :2 implying a quie signi can reserve accumulaion and, herefore, a parial absorpion policy. Noe also ha wih low e ciency, a beer approach would be o parially spend he aid ( = :) as well. As he line wih dos shows, his raises welfare relaive o he full-spending case. 4 Bu he same welfare analysis also reveals ha a beer approach han implemening parial absorpion policies migh be o redirec e ors o quickly increase he e ciency of public invesmen o enjoy he bene s of aid surges. 4 The righ-hand side of Figure con rms he exisence of very large gains of fully absorbing he aid (! = ); relaive o no absorbing i (! = ), when exernaliies are srong and public invesmen is highly e cien. In fac, i can be shown ha hese gains increase wih he e ciency of public invesmen. The same gure shows ha, in his case, parially spending he aid is a misake from a welfare perspecive, conrary o he low-e ciency case. Our previous analysis does no capure oher concerns ha may explain parial absorpion policies. For insance concerns ha may be relaed o volailiy in relaive prices, which is paricularly relevan if a surge in aid is perceived o be emporary or of uncerain duraion. If a emporary spike in aid is fully spen and absorbed, resources have o be shifed from he non-raded o he raded secor and hen back again as he aid in ows recede. This process inroduces considerable volailiy ino he economy, including large swings in he real exchange rae and oher relaive prices. This is likely o be a cosly process involving considerable urmoil in he raded and non-raded secor, as companies in boh secors are bu eed by large swings in prices and conrac or expand rapidly. Ideally, hese coss would be avoided by reducing he volailiy of aid in ows, bu his is mosly a ask for donors; aid-recipien counries could address aid volailiy on he scal side hrough expendiure smoohing accompanied by cenral bank foreign exchange sales ha are limied o he amoun of aid spen, in line wih he discussion above. Furhermore, counries may simply wish o accumulae inernaional reserves, for reasons ouside we have no modeled, such as a need for bu ers agains capial accoun shocks. The lesson of his paper is ha, while his may of course be a valid goal, policymakers need o carefully consider he ineracions of discreionary policies by he governmen and he cenral bank in his conex. An e or o accumulae inernaional reserves wihou a corresponding ighening of scal policy is like spending bu no absorbing aid. In paricular, i calls for an increase in privae savings o nance he reserve accumulaion and may hus require crowding ou of privae secor invesmen and consumpion. Finally, i is imporan o menion ha besides he e ciency of public invesmen and he inensiy of LBD exernaliies, here are oher feaures of he model ha maer for he implicaions of parial absorpion policies. These feaures include he share of hand-o-mouh consumers, he access o 4 The opimal degree of spending in general may also depend on he degree of absorpion. A full welfare analysis of alernaive opimal and implemenable reserve accumulaion and scal spending rules in response o unpredicable and volaile aid shocks is ouside he scope of his paper and is addressed in Porillo and Zanna (2). 4 In fac, public managemen capaciy consrains in hemselves may call for furher invesmens in capaciy, i.e. o inves in invesing in he words of Collier (27). I has been nooriously di cul for aid donors o improve public managemen, however, as discussed for example in Berg (993).

36 inernaional capial markes, and he mobiliy of producive facors across secors. The presence of hand-o-mouh consumers can give scal policy and aggregae demand larger real e ecs, including appreciaion e ecs, in he shor run; he degree of access o inernaional capial markes conrols he e eciveness of serilized inervenions; and he degree of facor mobiliy a ecs he degree of real exchange rae appreciaion. We refer he ineresed reader o Berg e al. (2) ha discuss in deail he role of all hese feaures in a shor-run analysis of policy responses o aid shocks. VI. Conclusions Our approach in his paper and in our conribuion o he broader Gleneagles aid scaling-up scenarios projec is o build and calibrae a dynamic micro-founded srucural economic model o consruc scenarios ha can help us undersand he shor- and medium-erm issues associaed wih large aid surges. Our model capures a bes only crudely mos of wha is mos imporan abou aid. Purely real CGE models such as he World Bank s MAMS (Maquee for MDG Simulaions) address a much richer se of secoral issues. 42 Our purpose here is o capure he key microeconomic issues e cienly in a way ha informs a macroeconomic analysis, such as ha required in he conex of IMF-suppored programs. We believe here has been underinvesmen in his sor of analysis and view i as complemenary o, raher han a subsiue for, oher approaches. We also see our conribuion as complemenary o he empirical work ha has examined he issues we sudy here, such as Arslanalp e al. (2). From he perspecive of a policy maker or IMF counry eam conducing an analysis for a paricular counry, such empirical resuls are helpful background bu can only be useful if undersood in a srucural sense, ha is, in erms of fully ariculaed causal channels. The oucome of an aid surge depends on a number of counry-speci c facors, such as he macroeconomic policy response, he uses o which he aid is pu, he e ciency of public invesmen, and various parameers of he economy. This, in fac, has been one of he overarching lessons of he macroeconomic assessmens in he Gleneagles aid scaling-up scenarios projec. The model we presen here like any such model is incomplee and indeed incorrec in many ways. We do no expec ha on is own i will produce good forecass. Bu we believe ha i can help organize hinking; provide a way o sysemaically incorporae various sors of empirical evidence; and provide a vehicle for ransparenly producing alernaive scenarios and comparing resuls across counries. In his regard, he calibraion here is only a rs sep, and he quaniaive properies of he model need o be more sysemaically compared o evidence. In paricular, he applicaion of varians of he model o hisorical episodes should help provide more reliable calibraions. Noneheless, a few criical hemes emerge ha we believe ranscend a paricular calibraion. These include: I is he e ciency of aid-relaed public invesmen relaive o seady-sae invesmen e ciency 42 See he applicaions of Bourguignon and Sundberg (26) and Goschalk e al. (29), for insance.

37 ha deermines he growh impac of aid- nance public invesmen; raher surprisingly, changing assumpions abou boh seady-sae and aid-surge-relaed e ciency has o seing e ecs. The LBD exernaliy raises he sakes for aid e ciency: if aid is invesed well, he ineracion of boh can produce even greaer gains producing Duch vigor. If i is no, aid can be harmful for growh. Parial absorpion policies such as accumulaing aid in reserves while spending he local counerpar can succeed in narrow erms in resising appreciaion, bu a a cos o privae invesmen and medium-erm growh. As a speci c example of parial absorpion, resising in aion in a xed exchange rae regime may be a bad idea, if he in aion is par of he relaive price adjusmen required o absorb aid. When e ciency is low and exernaliies srong, and hus aid is bad for growh, parial absorpion policies may be beer han full absorpion, bu even beer would be parial spending. E ors o increase e ciency would have poenially he greaes impac. Much work remains o be done. Opimal scal spending and reserve accumulaion reacions o aid shocks and volailiy, including he appropriae degree of smoohing, deserve more work. The experimens sudied here demonsrae ha he mixure of hese responses inerac wih all he feaures of he model o drive growh as well as privae consumpion and hence welfare. Porillo and Zanna (2) considers a range of assumpions abou hese facors looking for simple and implemenable scal spending and reserve accumulaion rules ha maximize welfare in he conex of unpredicable and volaile aid shocks. We also defer o fuure work he quesion of endogenizing oher policies responses, or for ha maer hose of aid donors, believing ha such analyses would bene from a clear undersanding of he underlying economics. A number of model design issues and assumpions could be invesigaed o move forward from here. A semi-closed capial accoun is key o many of our resuls. Human capial would seem worh incorporaing, a leas for longer-erm analyses. Public capial could be made secor-speci c o permi he analysis of anoher policy opion in he face of Duch disease concerns: direcing public invesmen owards he raded secor would presumably promoe ha secor s expansion, even as Balassa-Samuelson e ecs cause a real appreciaion. Variaions of he model could shed ligh on a number of imporan shocks. Naural resource booms and erms of rade shocks in resource-rich counries have many similar feaures o he aid shocks examined here. 43 For example, he managemen of resource booms involve similar decisions regarding spending and absorbing he capial in ows associaed wih hese booms. Similarly, he model could be exended o invesigae deb- nanced public invesmen shocks and heir implicaions for deb susainabiliy. The IMF and he World Bank conduc deb susainabiliy analysis roughly every year for each low-income counry. In principle, he framework of his paper could provide economic srucure o hese assessmens and faciliae scenario analysis and sochasic simulaions. We are currenly working on such an exension. 43 See for insance Dagher e al. (2).

38 Appendix A. Wriing he Model in Saionary Terms In his par of he Appendix, we show how he model is ransformed in saionary erms. As menioned above, here is exogenous growh of he labor-augmening ype, which is he same across secors. The producive unis of labor ha are used in he producion of he raded and non-raded goods correspond o T l T and T l N, respecively, where T is he produciviy level ha grows a he consan facor n, and l k corresponds o he amoun of raw labor used in he producion of he good k = T; N: Presening he model in saionary erms involves rescaling variables by he produciviy level T ; when required. To show how he model is ransformed in saionary erms, i su ces o show he ransformaion of a few equaions. For insance, o obain he objecive funcion (4) of he asse holders represenaive agen we manipulae he original funcion X ( a ) u a C a ; M a { a (l a ) + + = P o obain X ( a ) u a T C a = T ; T M a T P { a (l a ) + + = X C ( a ) u a a ; M a { a (l a ) + T T P + = + log(t ) ; where he las expression corresponds o (4). Similarly he original budge consrain of he asse holder can be wrien in nominal erms as P C a + M a + B ac + S B a = ( )W l a + M a + i B ac + S i B a + a + S RM a where for simpliciy we have ignored he porfolio adjusmen coss and ransfers. Dividing boh sides by P T and manipulaing i we obain C a + M a + Bac + s B a W M T P T P T P T = ( ) l a a + i B ac + P T n P T n P T +s i B a P T + a RM a + s P T P T ; where s = SP P and n = TP T P. Using appropriae de niions for he saionary variables, he equivalence beween his consrain and consrain (8), where a = a P T ; becomes eviden. The producion funcion of he represenaive monopolis in he non-raded secor h Yi N = z N Ki N N i (Q ) N N T li N N ; can be also ransformed ino saionary erms by dividing boh sides by T : Then 2! 3 Yi N N N = z N 4 KN N N i Q T li N ; T T T T ;

39 which corresponds o equaion (). Noe he iming convenion for capial socks, i.e., k N i KN i T : Finally he equaion of accumulaion of capial for each rm in he non-raded secor is 2! 3 2 Ki N = ( N )Ki N N Xi + 4 N Xi N ; 2 nx N i which can be wrien as 8 T+ K N i = ( N ) KN < i + T + T : N 2 T " T Xi N=T # 9 2= nt Xi N =T ; X N i T ; which is equivalen o equaion (). B. The Equaions of he Model and De niion of Equilibrium B.. The Firs Order Condiions of he Households Problem and The rs order condiions of he asse holders opimizaion problem correspond o (8) and u a u a c = a c+ i n + u a m = wih u a c h# a (c a ) + ( # a ) (m a ) u a c + (b a i h# a (c a ) + ( # a ) (m a ) # a (c a ) ; (27) i ( # a ) (m a ) = u a c i b a ) = a u a c + i n s+ s i ; (28) ; (29) u a l = {a (l a ) = u a c w ( ); (3) w N % = l a ; (3) l an w w l at T % = ( ) l a : (32) w When h =, he rs order condiions of he hand-o-mouh consumers opimizaion problem correspond o (9) and u h m = # h c h + ( # h ) m h ( # h ) m h = u h c (33) wih u h c # h c h + ( # h ) m h # h c h ; u h l = {h (l h ) = u h c w ( ); (34)

4 and l hn w N % = l h ; (3) w w l ht T % = ( ) l h : (36) w B.2. The Firs Order Condiions of he Firms Problem In a symmeric equilibrium (dropping he sub-indices), he rs order condiions of he represenaive monopolis in he non-raded secor are equaions ()-(2) and: (!) u a a c+ u a ( N ) N + + N( N ) w N l+ N + = n N ; (37) c N N = F N x N x N! N x N x N x N x N! + a N 2 k N 4 ua c + u a c N + N x N + x N! x N + x N! 2 3 ; (38) and N " u a = a c+ p N + u a c p N! y+ N y N! N + # + where N is relaed o Tobin s Q and N N N N N ( )( $)( + N ) N : w N l N p N yn ; (39) On he oher hand, in a symmeric equilibrium (dropping he sub-indices), he opimizing condiions for he rm in he raded secor correspond o (3), (4), and l T s T ( = w T $)z T T k T T (q ) T ; (4) and T = F T x T i x T i a ( u a c+ u a c ( T ) T + + T ( T )( $)s + y T + k N! x T T x T x T x T! + a T 2 4 ua c + u a c T + T!) x T + x T = n T ; (4)! x T + x T! 2 3 : (42) B.3. Demand Funcions, Aggregaion, Marke Clearing Condiions, and Oher Equaions For consumpion of raded and non-raded goods he demand funcions are c jn = ' p N c j and c jt = ( ')s c j for j = a; h; (43)

4 while he demand of invesmen of raded goods in he raded and non-raded secors correspond o x NT = ( ') (s ) x N and x T T = ( ') (s ) x T : (44) Public invesmen a seady sae and ha nanced by he aid surge are deermined by x gs = s g and x ga = A (g g): (4) By he de niions of he CPI, he governmen price index, he nominal depreciaion rae, and he in aion of non-raded goods we have = h ' p N + ( ')(s ) i ; (46) p g = h p N + ( )(s ) i (47) and S = s s ; (48) N = pn p N : (49) Finally he aggregaion equaions and he marke clearing condiions for bonds, labor, and money imply a = pa a + ( p)a h () for a = c ; c N ; c T ; m ; l ; b ; b c ; l T ; l N, where b h = b hc = ; and b = b c + b cb : () B.4. De niion of Equilibrium The simulaions of he paper conform wih he following de niion of equilibrium. De niion Given fm a ; bac ; ba ; mh ; kn ; kt ; zt ; q ; A ; dg ; R ; b, b a ; h ; a ; z T g 44 ; he exernal variables fi ;, A ; rm g; he arge and policies f; $; N ; ; S ; b; g; d g ; R g and he exogenous increase in aid f A g =, a symmeric equilibrium is a se of sequences fca ; c an ; c at ; c h ; c hn ; c ht ; c ; c T ; c N ; l a ; l an ; l at ; l h ; l hn ; l ht ; l ; m a ; m h ; m ; b ca ; b a ; b c ; A ; g ; g N ; g T ; q ; x gs x ga ; d g ; b ; R ; b cb ; b ; k N ; l N ; y N ; x N ; k T ; z T ; l T ; y T ; x T ; x NT ; x T T ; y ; N ; T ; w N ; w T ; w ; N ; S ; ; p g ; pn ; i ; s g = saisfying (i) he price indices and de niions (), and (46)-(49); (ii) he processes () and (6); (iii) he opimal condiions for consumers (7), (9), (27)-(36), and (43); (iv) he opimal condiions for rms (), (), (3), (4), (37)-(42), and (44); (v) he governmen rules and consrain (8)-(2), (4), b = b; (vi) he cenral bank rules and consrain (22)-(24); and (vii) he aggregaion and equilibrium marke condiions for labor, non-raded goods, raded goods, money and asses (2), (26), (), and (). 44 Noe ha m, b ; b cb, b ; and b c can be calculaed using equaions lised in ()-(). ;

42 C. The E ciency of Public Invesmen and GDP In his par of he Appendix, we prove ha he percenage increase in GDP ha resuls from a percenage increase in governmen spending depends on he raio of he e ciency of he aid-surge nanced public invesmen and he e ciency of he seady-sae public invesmen. To do his, i is su cien o simplify he model o one secor and consider he producion funcion h y = z (k ) (q ) i (l ) ; (2) and he public capial accumulaion equaion nq = ( g )q + " s s g + " A A (g g): (3) and where ^x = x Linearizing hese equaions around he seady sae yields x x he seady sae g q ^y = ( )^k + ( )( )^q + ^l (4) ^q = ( g) ^q + n "A A n g ^g ; q denoe percenage deviaions from seady sae for x = y ; k ; q ; l ; g : Bu since a = (n+g ) " s ; hen he las equaion can be re-wrien as s ^q = ( g) ^q + (n+ g ) A "A ^g : () n n s " s We are ineresed in nding Using (4), (), and (6) we obain @ ^y @^g ; o see how i depends on he e ciencies. Noe ha @^y @^g = @^y @ ^q @ ^q @^g : (6) @^y = ( )( ) (n+ g ) @^g n which underscores he role of he relaive e ciency " A "s. A s "A I should be noed ha his resul depends on he Cobb-Douglas producion funcion assumpion. By assuming a CES producion funcion n h y = z ( ) (k ) (q ) i + (l ) o : we would obain @^y = ( )( )z (n+ g ) ( ) @^g n "s s n+ g " k g y ( ) " s ; # ( s " s ) ( ) A "A ; where we have used q g =. Bu noe ha he Cobb-Douglas resul is no fragile, in he sense ha if he CES funcion is close o Cobb-Douglas ( ); hen he resul holds approximaely. s " s

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