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Foreign Aid and Real Exchange Rate Adjustments in a Financially Constrained Dependent Economy

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Author Info

  • Stephen J. Turnovsky
  • Serpil Tekin
  • Valerie Cerra

Abstract

A dynamic dependent-economy model is developed to investigate the role of the real exchange rate in determining the effects of foreign aid. If capital is perfectly mobile between sectors, untied aid has no longrun impact on the real exchange rate. A decline in the traded sector occurs because aid, being denominated in traded output, substitutes for exports in financing imports. While untied aid causes short-run real exchange appreciation, this response is very temporary and negligibly small. Tied aid, by influencing sectoral productivity, does generate permanent relative price effects. The analysis, which employs extensive numerical simulations, emphasizes the tradeoffs between real exchange adjustments, long-run capital accumulation, and economic welfare, associated with alternative forms of foreign aid.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 08/204.

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Length: 45
Date of creation: 01 Aug 2008
Date of revision:
Handle: RePEc:imf:imfwpa:08/204

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Related research

Keywords: Fiscal policy; Debt; Capital accumulation; Aid flows; Real effective exchange rates; External debt; Trade; Economic models; exchange rate; real exchange rate; capital stock; capital markets; capital intensity; international capital markets; real appreciation; access to international capital markets; international capital; exchange rate appreciation; current account balance; access to international capital; capital market; real exchange rate appreciation; exchange rates; exchange rate dynamics; real exchange rates; real exchange rate dynamics; capital goods; private capital markets; capital movements; exchange rate depreciation; capital mobility; exchange rate adjustments; real exchange rate depreciation; private capital; foreign bonds; real exchange rate movements; capital increases; effective exchange rates; exchange rate increases; capital flows; exchange rate over-valuation; excess demand; productive capital; state real exchange rate; current account deficit; exchange rate movements; world capital market; international borrowing;

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References

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  1. Santanu Chatterjee & Stephen Turnovsky, 2005. "Foreign Aid and Economic Growth: The Role of Flexible Labor Supply," Working Papers UWEC-2004-07-P, University of Washington, Department of Economics, revised Nov 2005.
  2. Mwanza Nkusu, 2004. "Aid and the Dutch Disease in Low-Income Countries," IMF Working Papers 04/49, International Monetary Fund.
  3. Christopher S. Adam & David L. Bevan, 2006. "Aid and the Supply Side: Public Investment, Export Performance, and Dutch Disease in Low-Income Countries," World Bank Economic Review, World Bank Group, vol. 20(2), pages 261-290.
  4. Burnside, Craig & Dollar, David, 1997. "Aid, policies, and growth," Policy Research Working Paper Series 1777, The World Bank.
  5. Mahbub Morshed, A. K. M. & Turnovsky, Stephen J., 2004. "Sectoral adjustment costs and real exchange rate dynamics in a two-sector dependent economy," Journal of International Economics, Elsevier, vol. 63(1), pages 147-177, May.
  6. Raghuram G. Rajan & Arvind Subramanian, 2005. "Aid and Growth: What Does the Cross-Country Evidence Really Show?," NBER Working Papers 11513, National Bureau of Economic Research, Inc.
  7. Arellano, Cristina & BulĂ­r, Ales & Lane, Timothy & Lipschitz, Leslie, 2009. "The dynamic implications of foreign aid and its variability," Journal of Development Economics, Elsevier, vol. 88(1), pages 87-102, January.
  8. Santanu Chatterjee & Georgios Sakoulis & Stephen Turnovsky, 2000. "Unilateral Capital Transfers, Public Investment, and Economic Growth," Discussion Papers in Economics at the University of Washington 0008, Department of Economics at the University of Washington.
  9. Raghuram Rajan & Arvind Subramanian, 2005. "Aid and Growth," IMF Working Papers 05/127, International Monetary Fund.
  10. William Easterly & Ross Levine & David Roodman, 2004. "Aid, Policies, and Growth: Comment," American Economic Review, American Economic Association, vol. 94(3), pages 774-780, June.
  11. Carl-Johan Dalgaard & Henrik Hansen & Finn Tarp, 2001. "On the Empirics of Foreign Aid and Growth," EPRU Working Paper Series 03-13, Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics, revised Sep 2003.
  12. Dalgaard, Carl-Johan, 2008. "Donor policy rules and aid effectiveness," Journal of Economic Dynamics and Control, Elsevier, vol. 32(6), pages 1895-1920, June.
  13. Henrik Hansen & Finn Tarp, 2000. "Aid effectiveness disputed," Journal of International Development, John Wiley & Sons, Ltd., vol. 12(3), pages 375-398.
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Citations

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Cited by:
  1. Combes, Jean-Louis & Kinda, Tidiane & Plane, Patrick, 2012. "Capital flows, exchange rate flexibility, and the real exchange rate," Journal of Macroeconomics, Elsevier, vol. 34(4), pages 1034-1043.
  2. Pedro M. G. Martins, 2010. "Do Capital Inflows Hinder Competitiveness? The Real Exchange Rate in Ethiopia," Working Paper Series 1110, Department of Economics, University of Sussex.
  3. Salifou Issoufou & Edward F. Buffie & Mouhamadou Bamba Diop & Kalidou Thiaw, 2014. "Efficient Energy Investment and Fiscal Adjustment in Senegal," IMF Working Papers 14/44, International Monetary Fund.
  4. Joannes Mongardini & Brett Rayner, 2009. "Grants, Remittances, and the Equilibrium Real Exchange Rate in Sub-Saharan African Countries," IMF Working Papers 09/75, International Monetary Fund.

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