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

_IMF Working Papers, August 1, 2008_

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## Bibliographic details
- Authors: Stephen J. Turnovsky, Serpil Tekin, Valerie Cerra
- Published: August 1, 2008
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451870626.001

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### Summary and central findings
- 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.
- Untied aid substitutes for exports in financing imports because aid is denominated in traded output, which produces a decline in the traded sector.
- Untied aid causes short-run real exchange appreciation, but this response is described as very temporary and negligibly small.
- Tied aid, by influencing sectoral productivity, does generate permanent relative price effects.
- The analysis employs extensive numerical simulations and emphasizes tradeoffs between real exchange adjustments, long-run capital accumulation, and economic welfare associated with alternative forms of foreign aid.

### Model assumptions and mechanisms
- Capital mobility between sectors is a key assumption: perfect mobility implies no longrun real exchange rate impact from untied aid.
- Aid denomination: aid being denominated in traded output leads to direct substitution effects with exports in financing imports.
- Distinction between untied and tied aid:
  - Untied aid: mainly affects short-run appreciation and sectoral output composition without longrun relative price changes under perfect capital mobility.
  - Tied aid: affects sectoral productivity and can induce permanent relative price (real exchange rate) shifts.

### Numerical simulations and tradeoffs
- The analysis relies on extensive numerical simulations to quantify outcomes and illustrate tradeoffs.
- Core tradeoffs highlighted:
  - Real exchange adjustments versus long-run capital accumulation.
  - Real exchange adjustments versus economic welfare.
- Sectoral outcomes: aid-induced shifts in the traded sector versus nontraded sector are central to welfare and accumulation implications.

### Policy-relevant implications
- Form of aid matters: tied aid can produce lasting real exchange and relative price effects through productivity channels, while untied aid is unlikely to change the longrun real exchange rate under perfect capital mobility.
- Short-run dynamics: policymakers should expect only a very temporary and small real exchange appreciation following untied aid inflows.
- Considerations for aid design: the productivity effects of tied aid and their longrun consequences for sectoral composition, capital accumulation, and welfare should guide aid modalities and conditionalities.

*Source: Stephen J. Turnovsky, Serpil Tekin, Valerie Cerra; "Foreign Aid and Real Exchange Rate Adjustments in a Financially Constrained Dependent Economy", IMF Working Paper, August 1, 2008.*

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_Source: https://www.imf.org/en/publications/wp/issues/2016/12/31/foreign-aid-and-real-exchange-rate-adjustments-in-a-financially-constrained-dependent-economy-22302_