Aid, Public Expenditure and Dutch Disease

1. Aid, Public Expenditureand Dutch Disease Christopher Adam and David Bevan Department of Economics and CSAE University of Oxford This Version March 2004 Christopher Adam, Department of Economics, Oxford 1 January, 2020

2. Our Contribution • We examine the macroeconomic consequences of productivity effects from public infrastructure in circumstances where these may have differential consequences for tradable and non-tradable production. • We explore how income distribution may move against net producers of non-tradable food (i.e. the poor). This is a distinct possibility in circumstances when income elasticity of demand for food is low. • We consider how these effects may be modified in the presence of dynamic externalities from (non-traditional) export growth. • Basic arguments laid out in a ‘model of the model’ • Simulation results generated by an extended version of this model Christopher Adam, Department of Economics, Oxford 1 January, 2020

3. The Simulation Model Horizon: 10-years (“Medium Run”) • physical capital accumulation but no change in, e.g. human capital, institutions, or global credit rating (country remains ‘aid-dependent’); Production • 5 Sectors • Food crops (tradable but big domestic share) • Cash crops (export only) • Manufactured goods (tradable) • Services (non-traded) • Public services (non-traded) Each sector has standard C-D production functions augmented by infrastructure capital. • CRS in private factors but IRS in presence of infrastructure Christopher Adam, Department of Economics, Oxford 1 January, 2020

4. Distribution: Household Types Rural • Owns land and capital in food sector and supplies labour, principally on-farm. Some off-farm labour supply (to cash crop sector). Zero net saving. Urban-Unskilled • Supplies unskilled labour to manufacturing, services, and public services. No saving. Urban-Skilled • Owns capital in all other sectors, supplies skilled labour. Net saver in base year. Christopher Adam, Department of Economics, Oxford 1 January, 2020

5. Fiscal structure • Model replicates basic structure of Ugandan budget for FY 2000/01 (with experiments replicating MTEF expectations). • Public expenditure (at the margin) • 40% recurrent • 10% ‘sector-specific’ investment • 50% ‘infrastructure-related’ Christopher Adam, Department of Economics, Oxford 1 January, 2020

6. Medium-run supply responses E E-biased supply response Neutral supply response D-biased supply response D Christopher Adam, Department of Economics, Oxford 1 January, 2020

7. How productive is infrastructure capital? Hulten (NBER Working Paper 1996) • Estimates CD production functions for 43 developing countries (1970-1990) • Parameter on infrastructure approximately 0.25 (t=2.81). Fan and Rao (Unpublished IFPRI report 2004). • Focus on total public expenditure rather than infrastructure and find much lower estimates (possibly because significant proportion of public expenditure is competitive with private) • Agriculture (0.05); health (0.21); transport (0.021); defence (-0.182); education (-0.099 !!). We use values of 0.25 and 0.50 (this presentation) • Since the model is forward looking and economy (public) capital scarce (in the types identified by PRSP), higher elasticity value is plausible • Model assumes that 100% of planned expenditure is executed (no ‘wastage’). Christopher Adam, Department of Economics, Oxford 1 January, 2020

8. Consumption Functions Constant Elasticity of Substitution – Linear Expenditure System Income elasticity of demand is is the marginal budget share of good i is the share of good i in total consumption Implication: the higher the subsistence share of good i in consumption, the lower income elasticity of demand Christopher Adam, Department of Economics, Oxford 1 January, 2020

9. Learning-by-doing spillover Productivity growth in manufacturing is driven by export production so that (temporary) RER appreciation chokes off this productivity growth (relative to counterfactual) Calibration based on evidence in Adam & O’Connell (2004) • We consider a range from . • Suppose TFP = 5%. If export growth cut from 8% to 5% this would reduce TFP by 0.5% per annum for For simplicity we assume zero TFP growth in baseline; therefore this specification can imply ‘forgetting-by-not-doing’ Christopher Adam, Department of Economics, Oxford 1 January, 2020

10. Saving, Investment and Dynamics • Aggregate Investment is determined by total savings (public, private and foreign) • sectoral allocation is determined by rates of return • Model is recursively dynamic • Public and private capital stock updated between years (but current simulations assume constant labour supply) Christopher Adam, Department of Economics, Oxford 1 January, 2020

11. Experiments • ‘Permanent’ 12.5 percent increase in net (grant) aid inflow. Equivalent to 2% of base-year GDP. Aid is fully spent • [also examined 6 percent and 15 percent increases]. • No adjustment to tax structure so that all experiments are (ex ante) domestic budget neutral • We consider alternative patterns of public expenditure out of aid Christopher Adam, Department of Economics, Oxford 1 January, 2020

12. Experiments (contd) 1. Benchmark (‘unproductive’ public expenditure) 2. Productive public expenditure 3. As 2 with productivity gains biased towards export production (E-biased) 4. As 2 with (D-biased production) 5. As 4 with LES consumption Christopher Adam, Department of Economics, Oxford 1 January, 2020

13. ResultsExport weighted real exchange rate Christopher Adam, Department of Economics, Oxford 1 January, 2020

14. ResultsTotal Exports Christopher Adam, Department of Economics, Oxford 1 January, 2020

15. ResultsReal GDP Christopher Adam, Department of Economics, Oxford 1 January, 2020

16. Summary Results I • Demand side ‘Dutch Disease’ effects are present in short run unless D-good productivity effect is strong enough [Runs 4 & 5] • Export-weighted RER appreciates and export declines. • In longer-run however RER effect moderates and exports recover (significantly so in Runs 2-5). • Note: exports can increase with RER appreciation because of productivity gains Christopher Adam, Department of Economics, Oxford 1 January, 2020

17. ResultsFiscal Balance Christopher Adam, Department of Economics, Oxford 1 January, 2020

18. Simulation Results II • Aid inflows tend to worsen fiscal balance in short run but improve it in the long-run • If the appreciation is large enough total revenue declines (RER appreciation reduces the domestic value of taxes on trade) • …but reduces the (domestic) cost of debt service • In the long run the tax base expands. Christopher Adam, Department of Economics, Oxford 1 January, 2020

19. ResultsTotal Real Disposable Income Christopher Adam, Department of Economics, Oxford 1 January, 2020

20. ResultsRelative Income Distribution Christopher Adam, Department of Economics, Oxford 1 January, 2020

21. Simulation Results III • Public expenditure is intensive in formal sector (urban) employment and draws disproportionately on manufactured and service intermediate inputs: hence limited direct impact on rural sector • If supply side effects are strong enough prices for domestic goods fall (relative to tradable goods) as supply response is larger than demand effect. • This is reinforced by low income elasticity of demand for food. • Hence real consumption income gains skewed in favour of net consumers of food and away from net producers. Christopher Adam, Department of Economics, Oxford 1 January, 2020

22. ResultsExports: Experiment 1 with LBD Christopher Adam, Department of Economics, Oxford 1 January, 2020

23. Results Exports: Experiment 5 with LBD Christopher Adam, Department of Economics, Oxford 1 January, 2020

24. Simulation Results IV This effect is moderated when the short-run contraction of non-traditional exports erodes dynamic LBD productivity growth. However, for reasonable parameter values this latter effect is not sufficiently strong to reverse the previous results. Christopher Adam, Department of Economics, Oxford 1 January, 2020

25. Summary Beyond the short-run aid financed public infrastructure expenditure which has a pro-domestic bias has strong positive effects on exports, investment, aggregate output growth and the fiscal balance. However, the benefits of this growth are skewed away from rural household whose income derives mainly from food crop production and in favour of groups supplying labour and capital to manufacturing and services. If the income elasticity of food consumption is low enough rural household could experience an absolute as well as relative decline in real income. Christopher Adam, Department of Economics, Oxford 1 January, 2020

26. Caveats and Limitations • Paper focussed on the macroeconomics of aid within a deterministic general equilibrium framework: • Analytics of argument are clear but scale of effects will be very country-specific… • size of (positive) productivity spill-overs; • size of growth externality in export production; • structure of production (especially tradability of agricultural production); • characteristics of consumption patterns. Christopher Adam, Department of Economics, Oxford 1 January, 2020

27. Caveats and Limitations Some key factors still missing: • productivity returns to health and education • substitution between public and private services Issues not addressed in this paper • monetary management issues • Micro-economics of absorptive capacity • labour market effects • The political economy of aid flows Christopher Adam, Department of Economics, Oxford 1 January, 2020

28. AnnexThe ‘model of the model’ • Two-period ‘Ricardo-Viner’ model (fixed K, mobile L) • Fixed Terms of Trade, no tariffs or taxes • Aid is only capital flow, occurs in period one • Aid finances public infrastructure which may augment private productivity in second-period • Composition of public expenditure matters: productivity effects may vary between T and NT sectors • Private demand not necessarily homothetic (scope for ‘luxury’ and ‘necessity’ consumption). Christopher Adam, Department of Economics, Oxford 1 January, 2020

29. Short-run results Model generates standard ‘demand side’ Dutch disease effects in short run [period 1] • Unless private sector income elasticity of demand for NT is very high, aid inflow, used to finance increased public infrastructure expenditure, will lead to RER appreciation and increase stock of infrastructure capital • Private welfare increases (since private sector is net seller of NTs to government and government expenditure on T and NT) Evolution of RER reflects underlying structure: • RER appreciation more pronounced the higher are public and private income elasticities of demand for NT • Less pronounced the higher are public and private price elasticities of supply and demand for NTs Christopher Adam, Department of Economics, Oxford 1 January, 2020

30. Long-run results Long-run [period 2] welfare depends on volume of infrastructure capital and not its composition But RER evolution reflects productivity biases • If bias towards NT productivity RER more depreciated And again results are moderated by income elasticity of demand for non-tradables • The lower this elasticity, the weaker the tendency for real exchange rate appreciation Christopher Adam, Department of Economics, Oxford 1 January, 2020