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Monetary Policy Response to Capital Inflows in Form of Foreign Aid in Malawi

Chance Mwabutwa (), Nicola Viegi () and Manoel Bittencourt
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Chance Mwabutwa: Department of Economics, University of Pretoria

No 201232, Working Papers from University of Pretoria, Department of Economics

Abstract: This paper estimates the Bayesian dynamic stochastic general equilibrium (DSGE) model and uses the model to account for the short-run monetary policy response to increased aid inflows in Malawi. The estimates reveal that the monetary authorities reacted to increased foreign aid inflows the same way as was experienced in other African countries. The model also suggests that there was non-existence of the threats of the ‘Dutch Disease’ in contrast to what was found in Mozambique. The country can continue to receive aid by targeting the supply side of the economy with an aim of improving the competiveness of the export sector. Evidently, the conduct of monetary policy performs better under the assumption of full accessibility of financial assets. In addition, the impact of aid inflows on depreciation and inflation are much smaller when monetary authorities indulge in money targeting other than following the Taylor rule and incomplete sterilisation. On the small note, the study suggests that actual spending of aid should be aligned with the actual absorption of increased aid. Nevertheless, the outcome of the aid effects has been clouded out by the limitation of the exchange rate management in Malawi.

Keywords: Taylor Rule; DSGE Model; Rule-of-Thumb; Spending; Absorption; Foreign Exchange Rate; Bayesian Methods (search for similar items in EconPapers)
JEL-codes: C11 C13 E52 E62 F31 F35 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-afr, nep-cba, nep-dge, nep-mac and nep-mon
Date: 2012-12
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