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Welfare Gains of Aid Indexation in Small Open Economies

  • Anubha Dhasmana

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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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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  1. BERLAGE, Lodewijk & CASSIMON, Danny & DRÈZE, Jacques & REDING, Paul, . "Prospective aid and indebtedness relief: a proposal," CORE Discussion Papers RP -1660, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
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  8. Svensson, Jakob, 2000. "When is foreign aid policy credible? Aid dependence and conditionality," Journal of Development Economics, Elsevier, vol. 61(1), pages 61-84, February.
  9. Bulír, Ales & Hamann, A. Javier, 2008. "Volatility of Development Aid: From the Frying Pan into the Fire?," World Development, Elsevier, vol. 36(10), pages 2048-2066, October.
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  11. 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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