Ramsey-Optimal Fiscal Spending and Reserve Accumulation Policies under Volatile Aid

IMF Working Papers, August 1, 2025

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Examines Ramsey-optimal policies for fiscal spending and international reserve accumulation in response to volatile aid flows in Low-Income Countries (LICs).
Develops a real Dynamic Stochastic General Equilibrium (DSGE) model of a small open economy.
Fiscal spending components modeled: government transfers and public investment.
Key LIC characteristics incorporated: Dutch disease (DD) externalities and financially constrained households.
Central mechanism: precautionary saving leads to partial reserve accumulation and partial fiscal spending of aid.

Real DSGE framework for a small open economy.
Fiscal instruments: transfers (direct support to private consumption) and public investment (contributes to future income via capital accumulation).
Features emphasized: DD externalities; financially constrained households.
Objective: Ramsey-optimal allocation considering volatility of aid.

Ramsey-optimal policies involve:
- Partial reserve accumulation.
- Partial fiscal spending of aid.
Role of Dutch disease externalities:
- Stronger DD externalities require greater reserve accumulation to stabilize future output and mitigate consumption volatility.
Role of fiscal instruments:
- Transfers directly support private consumption smoothing.
- Public investment sustains future income through gradual capital accumulation and contributes to consumption smoothing.
Role of aid volatility:
- Higher aid volatility calls for increased public investment.
- Public capital accumulation functions as a precautionary saving instrument in addition to its developmental role.

Adopt policies that balance reserve accumulation and fiscal spending rather than fully spending or fully saving aid:
- Use partial reserve accumulation to stabilize output under strong DD externalities.
- Use transfers to smooth private consumption in the short run.
- Increase public investment when aid volatility is higher to accumulate public capital as precautionary saving for future income stabilization.
Recognize public investment’s dual role:
- Developmental role (long-run income effects).
- Precautionary saving role (insuring against aid volatility and smoothing consumption).