ChainWhat it assumes · how to break it
Start
A small developing country receives large inflows of aid in dollars, which the government converts into local currency to pay for schools and clinics.
1
As a result, demand for the local currency rises on the foreign exchange market, so the currency appreciates.
exchange rate appreciation
exchange rate appreciation
Assumes: The aid is converted into local currency rather than spent directly on imports.
But: If the aid is spent on imported equipment, or the central bank holds it as reserves, there is little pressure on the exchange rate.
2
In addition, spending on local services such as building and teaching bids up wages and prices in the non-tradable sector, so the real exchange rate rises further.
real exchange rate · non-tradables
real exchange rate · non-tradables
Assumes: The economy is close to capacity in the non-tradable sector.
But: Where there is spare labour and capacity, extra spending raises output rather than wages and prices.
3
Consequently, exports such as cash crops and simple manufactures become less price competitive abroad, while imports become cheaper.
international competitiveness · Dutch disease
international competitiveness · Dutch disease
Best link to attack
Assumes: Demand for the country's exports and imports is price elastic.
Assumes: Demand for the country's exports and imports is price elastic.
But: Many developing countries export primary goods with price-inelastic demand priced in dollars, so export volumes change little.
4
Therefore, export volumes fall and import volumes rise, so the trade balance worsens.
trade balance · Marshall–Lerner condition
trade balance · Marshall–Lerner condition
Assumes: The Marshall–Lerner condition holds.
But: If the combined PED of exports and imports is below one, an appreciation can improve the trade balance in value terms for a time.
End
The trade balance worsens as aid inflows raise the real exchange rate and erode the competitiveness of exports.
Evaluation chain
- E1However, the damage to the trade balance depends on how price elastic demand for the country's exports and imports is.
- E2Since many developing countries export primary goods priced in dollars on world markets, an appreciation changes their dollar price very little.
- E3As a result, export volumes hold up and the main effect is lower local-currency earnings for farmers and miners.
- E4So the trade balance worsens most where exports are price-sensitive manufactures and services, and much less where the country relies on primary exports.
Another way to attack it: Aid grants are themselves recorded as a credit on the current account as current transfers, so the current account as a whole can improve even while the trade balance worsens.
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Questions this answers
- Assess whether large aid inflows can harm a developing country's international competitiveness.
- Explain how foreign aid might cause Dutch disease.
- Discuss the impact of foreign aid on the balance of payments of a developing economy.
Diagram
Currency market diagram: demand for the local currency shifts right, so the exchange rate appreciates.
Reverse and related
Aid falls → less demand for the local currency, so it depreciates and exports regain competitiveness, though imports needed for development become dearer.