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Ramsey-optimal fiscal spending and reserve accumulation policies under volatile aid

Author

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  • Moldovan, Ioana R.
  • Yang, Shu-Chun S.
  • Zanna, Luis-Felipe

Abstract

This paper studies Ramsey-optimal fiscal spending and reserve accumulation policies in response to volatile aid flows in low-income countries (LICs). We develop a real Dynamic Stochastic General Equilibrium (DSGE) model of a small open economy that features government transfers and public investment as fiscal instruments and incorporates two prominent characteristics of LICs—Dutch disease (DD) externalities and financially constrained households. Ramsey-optimal policies involve partial aid spending and partial reserve accumulation, motivated by precautionary considerations. Stronger DD externalities lead to greater reserve accumulation to stabilize output and mitigate consumption volatility. While transfers smooth consumption directly, public investment supports it indirectly by sustaining future income through capital accumulation. Greater aid volatility calls for increased public investment, highlighting its role as a precautionary savings instrument through capital accumulation, beyond its developmental function.

Suggested Citation

  • Moldovan, Ioana R. & Yang, Shu-Chun S. & Zanna, Luis-Felipe, 2026. "Ramsey-optimal fiscal spending and reserve accumulation policies under volatile aid," Journal of International Money and Finance, Elsevier, vol. 165(C).
    • Handle: RePEc:eee:jimfin:v:165:y:2026:i:c:s0261560626000690
    DOI: 10.1016/j.jimonfin.2026.103584
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    Keywords

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    JEL classification:

    • F35 - International Economics - - International Finance - - - Foreign Aid
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • O41 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - One, Two, and Multisector Growth Models
    • O55 - Economic Development, Innovation, Technological Change, and Growth - - Economywide Country Studies - - - Africa

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