Aid Volatility and Dutch Disease: Is There a Role for Macroeconomic Policies?

IMF Working Papers, June 1, 2006

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Aid volatility augments trade balance volatility.
Foreign aid, with the important exception of years of adverse shocks, depresses exports.
The adverse effects of aid volatility and Dutch disease can be mitigated through changes in net domestic assets of the central bank—a variable that reflects both monetary and fiscal policy.
Macroeconomic policies can permanently affect real variables in the model developed by the authors.
Macroeconomic policies can improve welfare if donors do not distribute foreign aid optimally over time.

A general equilibrium model is developed in which:
- The capital account is closed.
- Aid influences productivity growth through positive externalities (public expenditure) and negative externalities (Dutch disease).
Net domestic assets of the central bank are used as a policy instrument that captures combined monetary and fiscal policy actions.
The model implies that policy responses to aid flows can affect long-run real outcomes and welfare.

Use changes in net domestic assets of the central bank to mitigate:
- Trade balance volatility caused by aid volatility.
- Export depressions associated with foreign aid, except in years of adverse shocks.
Design macroeconomic policies recognizing that:
- They can have permanent effects on real variables.
- They can partially offset suboptimal time-paths of aid distribution by donors, improving welfare.