Aid, Public Expenditure and Dutch Disease

Abstract

Contemporary policy debates on the macroeconomics of aid often concentrate on short-run Dutch disease effects, ignoring the possible supply model of aid and public expenditure in which public infrastructure capital generates an inter-temporal productivity spill over for both tradable and non-tradable sectors, where these productivity effects may display sector-specific biases. The model also allows for non-homothetic demands. We then use an extended version of this model, calibrated to contemporary conditions in Uganda, to simulate the effect of a step increase in net aid flows. Our simulations show that beyond the short-run, where Dutch disease effect are present, the relationship between enhanced aid flows, real exchange rates and welfare is less straightforward than simple models of aid suggest. We show that public infrastructure which generates a productivity bias in favour of non-tradable production delivers the largest aggregate return to aid, with real exchange rate appreciation reduced or reserved and enhanced export performance, but it does so at the cost of a deterioration in the income distribution. Income gains accrue predominantly to urban skilled and unskilled household, leaving the rural poor relatively worse off. Under plausible parameterizations of models the rural poor may also be worse off in absolute terms.

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