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Welfare Gains of Aid Indexation in Small Open Economies

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  • Anubha Dhasmana

Abstract

Foreign aid flows to poor, aid-dependent economies are highly volatile and pro-cyclical. Shortfalls in aid coincide with shortfalls in GDP and government revenues. This increases the consumption volatility in aid dependent countries, thereby causing substantial welfare losses. This paper finds that indexing aid flows to exogenous shocks like a change in the terms of trade can significantly improve the welfare of aid-dependent country by lowering its output and consumption volatility. Compared to the benchmark specification with stochastic aid flows, indexation of aid flows to terms of trade shocks can reduce the cost of business cycle fluctuations in the recipient country by four percent of permanent consumption. Moreover, use of indexed aid can allow donors to reduce the aid flows by three percent without lowering the level of welfare in the recipient country.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 08/101.

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Length: 38
Date of creation: 01 Apr 2008
Date of revision:
Handle: RePEc:imf:imfwpa:08/101

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Keywords: Welfare; Terms of trade; Aid flows; Indexation; Low-income developing countries; Small states; terms of trade shocks; trade shocks; tradable goods; capital adjustment; capital stock; commodity prices; risk aversion; access to international capital markets; capital markets; international capital markets; export revenues; access to international capital; exportable goods; exogenous shocks; elasticity of substitution; importable goods; international capital; domestic capital; capital goods; foreign capital; debt service; open economy; moral hazard; aggregate consumption; real appreciation; capital employed; trade shock; capital accumulation; equilibrium model; intermediate inputs; return on capital; export prices; domestic production; value of exports; international trade; transport costs; constant elasticity of substitution; exporting countries; world prices; capital intensity; imported inputs; agricultural commodities; world market; imported goods; debt service payments; export diversification; indexed bonds; access to international financial markets; countries ? volatility; world price; crisis prevention; capital substitution;

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References

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  1. Svensson, Jakob, 1997. "When is foreign aid policy credible : aid dependence and conditionality," Policy Research Working Paper Series 1740, The World Bank.
  2. Carmen M. Reinhart & Peter Wickham, 1994. "Commodity Prices: Cyclical Weakness or Secular Decline?," IMF Staff Papers, Palgrave Macmillan, vol. 41(2), pages 175-213, June.
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  5. Rebelo, Sérgio, 1995. "Real Effects of Exchange-Rate-Based Stabilization: An Analysis of Competing Theories," CEPR Discussion Papers 1220, C.E.P.R. Discussion Papers.
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  7. BERLAGE, Lode & CASSIMON, Danny & DREZE, Jacques & REDING, Paul, 2000. "Prospective aid and indebtedness relief: a proposal," CORE Discussion Papers 2000032, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  8. Cuddington, John T., 1992. "Long-run trends in 26 primary commodity prices : A disaggregated look at the Prebisch-Singer hypothesis," Journal of Development Economics, Elsevier, vol. 39(2), pages 207-227, October.
  9. Michel A. Robe & Stephane Pallage, 2000. "Foreign Aid And The Business Cycle," Computing in Economics and Finance 2000 107, Society for Computational Economics.
  10. Robert J. Barro, 1995. "Optimal Debt Management," NBER Working Papers 5327, National Bureau of Economic Research, Inc.
  11. Joseph Atta-Mensah, 2004. "Commodity-Linked Bonds: A Potential Means for Less-Developed Countries to Raise Foreign Capital," Working Papers 04-20, Bank of Canada.
  12. Mendoza, Enrique G, 1991. "Real Business Cycles in a Small Open Economy," American Economic Review, American Economic Association, vol. 81(4), pages 797-818, September.
  13. Stephane Pallage & Michel A. Robe, 2003. "On the Welfare Cost of Economic Fluctuations in Developing Countries," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 44(2), pages 677-698, 05.
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Cited by:
  1. International Monetary Fund, 2008. "Foreign Reserve Adequacy in Sub-Saharan Africa," IMF Working Papers 08/150, International Monetary Fund.
  2. Dobronogov, Anton & Keutiben, Octave, 2014. "Containing volatility : windfall revenues for resource-rich low-income countries," Policy Research Working Paper Series 6956, The World Bank.

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