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

Ioana Moldovan, Shu-Chun Yang and Luis-Felipe Zanna

No 2025/154, IMF Working Papers from International Monetary Fund

Abstract: This paper examines Ramsey-optimal policies related to fiscal spending and international reserve accumulation in response to volatile aid flows in Low-Income Countries (LICs). We develop a real Dynamic Stochastic General Equilibrium (DSGE) model of a small open economy, incorporating government transfers and public investment as fiscal spending components, along with two prominent characteristics of LICs: Dutch disease (DD) externalities and financially constrained households. Driven by considerations of precautionary saving, Ramsey-optimal policies involve partial reserve accumulation and partial fiscal spending of aid. Stronger DD externalities necessitate greater reserve ac- cumulation to stabilize future output, thereby mitigating consumption volatility. While transfers directly support private consumption smoothing, public investment also con- tributes to this goal by sustaining future income through gradual capital accumulation. Higher aid volatility calls for increased public investment, underscoring the role of public capital accumulation as a precautionary saving instrument, beyond its developmental role discussed in the literature.

Keywords: aid; fiscal policy; reserve policy; foreign exchange intervention; optimal policy; low-income countries (search for similar items in EconPapers)
Pages: 63
Date: 2025-08-01
New Economics Papers: this item is included in nep-dge and nep-fdg
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