Aid Volatility and Dutch Disease: Is there a Role for Macroeconomic Policies?

Abstract

This paper studies how macroeconomic policies can respond to aid volatility and head off unintended consequences of foreign aid such as Dutch disease. First, we study the welfare implications of macroeconomic policies in a general equilibrium model where aid does not only support consumption but can also affect (positively or negatively) productivity growth through externalities. In this setting, monetary policy has permanent real effects. We find that the less productive aid is the more aggressive monetary and fiscal policies should be in containing the impact of aid on the trade balance. Conversely, if aid has large immediate consumption and productivity benefits but donors’ disbursements are back-loaded, macroeconomic policies should be expansionary and allow the trade balance to deteriorate. Second, we present evidence consistent with the presence of Dutch disease effects of aid in certain conditions, and show that recipient countries can smooth aid-driven fluctuations of the trade balance and support export levels by adjusting the net domestic assets of the central bank—a variable that reflects both monetary and fiscal policy decisions.