Chapter 23: Does real exchange rate appreciation undermine aid effectiveness? Evidence from sub-Saharan Africa
In their survey of the aid effectiveness literature, Doucouliagos and Paldam (2009) suggest a number of reasons for the lack of robust, consistent evidence for a positive effect of foreign aid on recipient country gross domestic product (GDP). One possible reason is that aid has a Dutch disease effect: the extra income from aid is spent at least partly on goods and services that are not internationally tradable. This causes the price of these goods and services to rise relative to the price of internationally tradable goods; that is, there is a real exchange rate appreciation. Correspondingly, the domestic production of non-tradable goods expands and the production of tradable goods contracts. Under certain conditions – for example, if there are positive externalities in the production of some tradable goods, or if factors of production are unemployed during the resource reallocation following a relative price change – then the appreciation will be associated with a reduction in resource efficiency. However, it is important to stress that a real exchange rate appreciation does not necessarily lead to lower aggregate productivity. In a simple neoclassical model with no externalities and flexible goods and factor prices, the relative price change just entails a movement around the production possibility frontier.
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