Aid Flows and “Dutch Disease” in a General Equilibrium Framework for Pakistan

Abstract

The impact of development aid has been mainly studied through one-sector and or partial equilibrium models, such as the two-gap framework, “Dutch disease” models, and fiscal response models. These approaches tend to capture inadequately the general equilibrium effects of aid inflows, resulting from income and relative price responses, as well as from the effects on the financial constraints on investment by public and private sector agents in the economy. This article applies a multisectoral general equilibrium framework with a full specification of financial sector relations to Pakistan, overcoming the indicated shortcomings. The model tries to capture the Pakistan economy characterized by commodity and financial market imperfections and structural differences in savings and investment behavior of institutional agents. Model simulations suggest aid inflows tend to generate fairly strong Dutch disease effects in the case of Pakistan. However, more use of aid inflows to alleviate financing constraints on investment of household firms, which are mainly active in traded goods production, could mitigate the Dutch disease effects, whereas nominal exchange rate adjustment appears counterproductive. Comparative country analysis applying similar CGE models for Mexico, the Philippines, and Thailand indicates that the findings for Pakistan are not easily generalizable and depend strongly on the existing economic structure, investment and savings behavior of institutional agents, and the allocation additional capital inflows among public and private sector agents