Optimal Fiscal Spending and Reserve Accumulation Policies under Volatile Aid

IMF Working Papers, June 11, 2019

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Canonical URL: Optimal Fiscal Spending and Reserve Accumulation Policies under Volatile Aid

Authors: Ioana Moldovan, Shu-Chun Susan Yang, Luis-Felipe Zanna
Publication date: June 11, 2019
Type: IMF Working Papers, Working Paper No. 2019/126
Core objective: Assess optimal fiscal spending and foreign exchange intervention policies in response to volatile foreign aid within a small open economy model that incorporates typical features of low-income countries.
Main conclusion: It is optimal to adjust government spending gradually in response to unpredictable fluctuations in aid, while partially accumulating foreign exchange reserves to offset Dutch disease effects. Allocating relatively more government spending to productive public investment and less to government consumption is welfare improving.

Framework: Small open economy model tailored to typical features of low-income countries.
Policy class considered: A class of policy rules jointly determining aid spending and international reserve accumulation.
Behavioural/structural elements referenced: CES consumption basket; hand-to-mouth consumer; goods sector; public goods; public investment spending; depreciation rate; spending process.

Optimal spending response:
- Adjust government spending gradually to unpredictable fluctuations in aid (described as "gradual aid spending" or "gradual spending").
Reserve accumulation:
- Partially accumulate foreign exchange reserves to offset Dutch disease effects.
Composition of government spending:
- Welfare improves by allocating relatively more of government spending to productive public investment and less to government consumption.
Welfare and dynamics:
- The paper reports impulse response analysis and welfare change results (details in full paper).
Scope and relevance:
- Focused on low-income countries, with keywords explicitly including Africa and Sub-Saharan Africa.

Fiscal policy design:
- Prefer rule-based, gradual adjustment of fiscal spending in response to aid volatility rather than abrupt full passthrough of aid shocks to spending.
Reserve policy:
- Use partial accumulation of international reserves as a tool to mitigate adverse terms-of-trade and Dutch disease effects arising from volatile aid inflows.
Spending composition:
- Reprioritize spending toward productive public investment relative to government consumption to enhance welfare outcomes.

Subjects: Central banks, Consumption, Expenditure, National accounts, Private consumption, Public investment spending, Reserves accumulation
Keywords: Africa, aid, aid spending, CES consumption basket, Consumption, consumption decision, consumption level, depreciation rate, fiscal policy, foreign exchange intervention, goods sector, government spending, gradual aid spending, gradual spending, hand-to-mouth consumer, impulse response, low-income countries, optimal policy, Private consumption, public goods, Public investment spending, reserve accumulation policy, Reserves accumulation, spending of aid, spending policy, spending process, Sub-Saharan Africa, welfare change, WP