Three essays on financing public spending in a small open economy
Byron, Sharri Cecile
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While foreign aid transfers, in theory, serve to relieve the national savings constraint as government’s ﬁnance their development agenda, the empirical evidence of its effectiveness is mixed. In fact, from the perspective of the donor community, the performance of foreign aid has been overwhelmingly unsatisfactory. But with aid transfers expected to increase, donors intensify their efforts towards improving the delivery and monitoring of aid trans- fers. The three essays examine how foreign aid and the government’s response to those aid transfers may inﬂuence output, total consumption, debt accumulation, public and private capital accumulation, and the real exchange rate. In the ﬁrst chapter, I use a neoclassical growth model to examine how the alloca- tion of aid among public investment expenditure, public consumption expenditure and a pure transfer can generate sometimes opposing long-run effects on key outcomes such as output, consumption, private and public capital accumulation. This study is not the ﬁrst to do this. However, the paper uses a neoclassical growth model that allows technology and capital accumulation to be endogenous, but where policy variables alone inﬂuence the long-run growth rate through their inﬂuence on population growth and the technological parameters. This model does not generate the scale effects that were a source of concern and limit the usefulness of predictions from endogenous growth models. One ﬁnding is that the allocation of foreign aid to different public expenditure categories matters for the responses. Also, the results suggest that there is no scenario in which the long-run levels of public and private capital are enhanced when governments alter their public spending commitments. Building on the ﬁrst chapter, the second paper presents another neoclassical growth model, but one to examine how the real exchange rate responds to foreign aid transfers. The link between the real exchange rate and foreign aid has received attention in the recent literature as researchers try to ﬁnd possible channels through which foreign aid mitigates its own effectiveness. The result highlight foreign aid scenarios in which the real exchange rate may either appreciate or depreciate in the long-run. The depreciation occurs: (i) under low adjustment costs to either the accumulation of public or private capital and when the foreign aid ﬁnances public investment expenditure; and (ii) when the government can alter its spending commitments in response to the allocation of aid to any type of expenditure. The third paper uses panel and cross-sectional data methods to analyze data from sixty- six aid recipient countries for any effect of foreign aid transfers on the real exchange rate. The results suggest economic signiﬁcance, and highlight the depreciation effect of foreign aid inﬂows. Overall the results suggest that to the extent that donors and recipients can engage in macroeconomic management of the aid resources, countries can beneﬁt from the growth potential while at the same time avert some of the adverse effects of foreign aid ﬂows.