Foreign Aid and Fiscal Policy in a Small-Open Economy with a Non-Market Sector

Abstract

This study examines the macroeconomic effects of foreign aid and fiscal policy by employing a multi-sector growth model. Foreign aid may decrease the recipient country’s market activities by lowering its capital accumulation and shifting market labour and capital to the non-market sector. This market activity shifting can improve the recipient country’s foreign asset/debt position where real exchange rate plays a role. We examine fiscal policies’ long- and short-run impacts and the recipient country’s administration efficiency in handling aid. Efficiency improvements in the recipient country’s governance of foreign aid can lower its real exchange rate, thereby contribute to improving foreign asset/debt holdings. Although administration costs in foreign aid may cause losses, by raising both market and non-market goods consumption, foreign aid improves the welfare of the recipient country. Our numerical analysis demonstrates the comparative statics and comparative dynamics impacts of several fiscal policy experiments. We illustrate that capital and labour income’s taxation effects can be very different.