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

  • Stephen J. Turnovsky
  • Serpil Tekin
  • Valerie Cerra

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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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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  1. A.K.M. Mahbub Morshed & Stephen Turnovsky, 2003. "Sectoral Adjustment Costs and Real Exchange Rate Dynamics in a Two-Sector Dependent Economy," Working Papers UWEC-2002-17-P, University of Washington, Department of Economics, revised Jan 2003.
  2. Christopher Adam & David Bevan, 2004. "Aid and the Supply Side: Public Investment, Export Performance and Dutch Disease in Low Income Countries," Economics Series Working Papers 201, University of Oxford, Department of Economics.
  3. 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.
  4. Raghuram G. Rajan & Arvind Subramanian, 2008. "Aid and Growth: What Does the Cross-Country Evidence Really Show?," The Review of Economics and Statistics, MIT Press, vol. 90(4), pages 643-665, November.
  5. Timothy D. Lane & Leslie Lipschitz & Cristina Arellano & Ales Bulir, 2005. "The Dynamic Implications of Foreign Aid and its Variability," IMF Working Papers 05/119, International Monetary Fund.
  6. 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.
  7. Chatterjee, Santanu & Sakoulis, Georgios & Turnovsky, Stephen J., 2003. "Unilateral capital transfers, public investment, and economic growth," European Economic Review, Elsevier, vol. 47(6), pages 1077-1103, December.
  8. Hansen, Henrik & Tarp, Finn, 1999. "Aid Effectiveness Disputed," MPRA Paper 62290, University Library of Munich, Germany.
  9. David Dollar & Craig Burnside, 2000. "Aid, Policies, and Growth," American Economic Review, American Economic Association, vol. 90(4), pages 847-868, September.
  10. Dalgaard, Carl-Johan, 2008. "Donor policy rules and aid effectiveness," Journal of Economic Dynamics and Control, Elsevier, vol. 32(6), pages 1895-1920, June.
  11. Mwanza Nkusu, 2004. "Aid and the Dutch Disease in Low-Income Countries; Informed Diagnoses for Prudent Prognoses," IMF Working Papers 04/49, International Monetary Fund.
  12. 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.
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