Policy Responses to Aid Surges in Countries with Limited International Capital Mobility: The Role of the Exchange Rate Regime

Abstract

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF, IMF policy or of DFID. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.We study the role of the exchange rate regime, reserve accumulation, and sterilization policies in the macroeconomics of aid surges. Absent sterilization, a peg allows for almost full aid absorption-an increase in the current account deficit net of aid-delivering the same effects as those of a flexible regime but with a necessary increase in inflation. Regardless of the regime, policies that limit absorption-and result in large accumulation of reserves-are welfare reducing: they help reduce the real appreciation (and inflation under the peg), but at the expense of reducing private consumption and investment, and therefore medium-term growth.

Evaluating monetary policy options for managing resource revenue shocks when fiscal policy is laissez-faire: Application to Nigeria

“…We construct a three sector DSGE model of a resource-rich small open economy, similar in spirit to Berg et al (2015), Benkhodja (2014) and Dagher et al (2012). The core ingredients of the model are as follows; the economy consists of four agents: (i) firms, (ii) households, (iii) the monetary authority, and (iv) the fiscal authority.…”

“…To capture the general form of the Dutch disease syndrome, we follow a variant of the specification in Krugman (1987), and the integration of learning-by-doing effects in Berg et al (2015), which assumes that the productivity situation in the traded sector depends on the deviation of past output values in the traded sector from its steady state. Thus, Dutch disease effects and the learning-by-doing transmission is jointly described by;…”

“…The advantage of introducing portfolio adjustment costs to the household's budget constraint are two fold; first, it induces stationarity in foreign assets (b * t ), in which case we follow the specification in Schmitt-Grohé and Uribe (2003) and set P t = c 2 (b * t −b * ) 2 , whereb * is the steady state value of real foreign assets and c > 0 is a constant parameter. Second, as in Berg et al (2015) and Kollmann (2002), it allows us to model different scenarios of international capital mobility. Note that when c → +∞, then the capital account is virtually closed, whereas, when 0 < c < ∞, it is partially open.…”

“…On the other hand, in addition to the interest rate rule, the central bank also sets operational targets on reserve accumulation which it partly achieves through interventions in the foreign exchange market and the exchange rate policy in operation. Following the modified specifications in Dagher et al (2012) and Berg et al (2015), we assume that the central bank implements the following rule to achieve exchange rate and reserve accumulation targets;…”

“…Our paper is related to three strands of literature: (i) the literature on Dutch disease and macroeconomic performance, (see Benkhodja, 2014;Sachs and Warner, 2001;Gelb, 1988;Gylfason, 2002), (ii) the literature on fiscal and monetary counter-cyclicality (see Taylor, 1993;Galí et al, 2007;Frankel et al, 2013;García-Cicco and Kawamura, 2015) and (iii), the borrowed theoretical insights from the aid literature (see Berg et al, 2015;Agénor and Yilmaz, 2013;Adam and Bevan, 2006;Adam et al, 2009;Berg et al, 2010).…”