This paper estimates a Bayesian Dynamic Stochastic General Equilibrium (DSGE) model of Malawi and uses it to account for short-run monetary policy response to aid inflows between 1980 and 2010. In particular, the paper evaluates the existence of a “Dutch Disease” following an increase in foreign aid and examines the Reserve Bank of Malawi (RBM) reaction to aid inflows under different monetary policy rules. The paper finds strong evidence of "Taylor rule" like response of monetary policy response to aid inflows. It also show that a "Dutch Disease" did not exist in Malawi because aid inflows were found to be associated with currency depreciation and not the expected real currency appreciation. There is also evidence of low impact of a positive aid shock on currency depreciation and inflation when RBM engages in targeting monetary aggregates than when the authorities use the Taylor rule and incomplete sterilization.

1. Monetary Policy Response to Foreign Aid in an Estimated
DSGEModel of Malawi
Dr Chance Mwabutwa
Prof Nicola Viegi
Prof Manoel Bittencourt
9th October 2014
2014-10-14 1

2. Outline
Background
Literature Review
Methodology
Estimated Model
Monetary policy responses
Conclusion
2014-10-14 2

3. Background
 Foreign Aid in Malawi
40% of resources to run the national budget (Malawi Govt.,
2006)
Research related to aid inflows in Malawi - fiscal impact
(Fagernas & Schurich, 2004; Lea & Hanmer, 2009)
Limited studies on the monetary policy responses to aid
2014-10-14 3

4. Some Key Macroeconomic Indicators
Pre aid increase-average Aid increase-average Difference
2004-2006 2007-2009
Official exchange rate (MK/US$, period avaerage - change) 11.79 1.25
REER index (2005-100) - change -4.65 3.48
Treasury bill rate (%) 24.08 11.91
Terms of trade -4.65 3.97
Export (% of GDP) 23.88 28.57
Of which tobacco 9.75 11.85
Import (% of GDP) 47.5 45.31
Of which oil 4.67 4.81
Net aid inflows (% of GDP-Fiscal) 13.75 16.49 2.74
Net aid inflows (% of GDP-BoP) 12.89 17.18 4.3
Budget support (% of GDP) 3.25 3.42 0.17
Current account balance (excluding grants - % of GDP) -18.28 -18.32 -0.04
Change in reserves (increase -) -1.11 0.55 1.66
Tax revenue (% of GDP 16.05 18.19 2.14
Domestic revenue (% of GDP) 17.94 20.6 2.66
Public Spending excl. interest payment (% of GDP) 23.57 28.48 4.91
Overall fiscal balance excl. grants (% of GDP) -5.63 -7.88 -2.25
Source: IMF country reports, World Bank Economic Indicators and RBM Financial and Economic reports: Note: Change in reserves (increase -) is
calculated as changes in the official reserves as a percent of GDP and a minus sign indicates that the official reserves increased during that period.
2014-10-14 4

5. Literature Review
Implications of large aid increases (Buffie et al. (2004); Adam et al.
(2009); Hanseen & Heady, 2009)
 Short-run macroeconomic management in small economies,
appreciation detrimental to export sector
Mixed Evidence
 Aid inflows associated with appreciation (Elbadawi, 1999; Adam &
O’Connell, 2004; Berg et al., 2010; Fielding and Gilbson, 2012)
 aid inflows associated with depreciation (Nyoni, 1998; Sackel, 2001;
Berg at al., 2010)
Aid Management (Gupta et al., 2005; Adam et al. 2007; Hussain et
al., 2009)
 Govt. immediately sell foreign exchange to RBM. Counter part funds
used to purchase domestic goods. Spending.
 RBM conduct sterilisation through securitisation of foreign exchange
(or accumulate foreign reserves): Absorption.

6. Literature Review
 Aid in-kind (drugs, food) and purchases imports directly, spending and
absorption equal, hence no immediate macroeconomic consequences.
 Aid used to purchase domestic goods (build up international reserves)
have immediate macroeconomic impacts: e.g. on price levels,
exchange rate, and interest rate (Gupta et al., 2005).
 Spending and absorption decisions between government and RBM
brings about macroeconomic imbalances.
Malawi Situation (using Hussain et al., 2009 methodology)
 Spending: widening in the government fiscal deficit excluding aid
responding to foreign aid increment. 88% of the increased aid was
spent.
 Absorption: widening in current account deficit excluding aid
responding to foreign aid increment. 0.9% of the increased aid was
absorbed.
 Aid was spent but absorption was limited

7. Key Research Questions
 Does Malawi spend or absorb aid inflows?
 How do authorities respond under different monetary policy
rules (Taylor rule, incomplete sterilization and money targeting)?
2014-10-14 7

8. Methodology
 Used a DSGE model and its features are:
• Small open economy – Traded and Non-Traded sector
• Households, Firms, Government and Reserve Bank
 Why DSGE model:
• Aid management-interaction of various players,
• Less susceptible to Lucas critique and suitable for policy
analysis (Teo, 2009).

9. Methodology cont.…
 The DSGE model was estimated using Bayesian approach which
depends on specifications of priors (beliefs) - Smets and Waters
(2007); Peiris and Saxegaard (2007) and DeJong et al. (2000)
 Before estimations, derived the solutions of the structural model
represented as a log- linear approximation around its steady
states (Berg at al., (2010) as in Gali et al., (2007))
 Apart from structural shock on aid, incorporated invariant shocks
as in Ireland (2004)
 Some parameters were calibrated and others were estimated
2014-10-14 9

10. Examples of interactions in the model
 Internal Balance
푠 푡 = −푧푤푤 푡 − 푧푐푐푡 − 푧퐴퐴 푡 − 푧휋휋 푡 − 푧푑
푑 푡−1 + 푧푏
푐 −
푏 푡−1
푧푢푢 푡
where: z퐴 = 훾휑푔푘퐴
Z
↑ initial aid spent 훾 leads to appreciation of exchange rate 푠 푡
↓ initial aid spent훾 leads to depreciation of exchange rate 푠 푡
 External Balance
푠 푡 = 푥푤푤 푡 + 푥푐푐푡 + 푥푑
푑 푡−1 − 푥푓
푓 푡 − 1
훽푓푡−1 − 푥퐴퐴 푡 −
푥푅푅 푡−1 − 푥푏
푐 where: 푥퐴 = 푘퐴 휔− 1−휑푔 훾
푏 푡−1
ℋ
↑ rate of reserve accumulation 휔 leads to appreciation 푠 푡
↓ rate of reserve accumulation 휔 leads to depreciation 푠 푡
2014-10-14 10

11. Findings from estimated model
Monetary authorities reacted to aid inflows in Malawi
Results same as in Uganda (Berg et al., 2010) but different from
Mozambique (Peiris & Saxegaard, 2007)
Some estimated structural parameters
2014-10-14 11

12. Findings based on monetary policy responses
 Aid is associated with depreciation of exchange rate – no
“Dutch Disease” threat
 Impacts much smaller under money targeting (Taylor rule and
incomplete sterilisation)
 Performs better under full optimisation, opening capital
account, minimal control over prices
2014-10-14 12

13. Baseline Response: Aid Spent and Absorbed
Figure 3: Response to Aid Shock - Aid Fully Spent and Fully Absorbed
5 10 15 20
10
5
0
-3 Consumption
5
0
-5
-3 Inflation
0
-0.005
-0.01
0.01
0.005
0
-0.005
5 10 15 20
-3 Output
2014-10-14 13
0.1
0.08
0.06
0.04
0.02
0
Aid
5 10 15 20
-5
x 10
5 10 15 20
0.06
0.04
0.02
0
-0.02
Spending
5 10 15 20
-10
x 10
5 10 15 20
-0.01
Interest Rate
-0.015
Exchange Rate
5 10 15 20
6
4
2
0
-2
-4
-6
x 10
Taylor Reule
Incomplete Sterilisation
Money Targeting

14. Response: Spent and Not Absorbed
Figure 4: Response to Aid Shock - Aid Fully Spent and Not Absorbed
5 10 15 20
0.01
0.005
0
-0.005
20
15
10
5
0
-3 Inflation
15
10
5
0
20
15
10
5
0
-3 Exchange Rate
-3 Interest Rate
2014-10-14 14
0.2
0.15
0.1
0.05
0
Aid
5 10 15 20
-0.01
Consumption
5 10 15 20
0.06
0.04
0.02
0
-0.02
Spending
5 10 15 20
-5
x 10
5 10 15 20
-5
x 10
5 10 15 20
-5
x 10
5 10 15 20
0.03
0.02
0.01
0
-0.01
Output
Taylor Reule
Incomplete Sterilisation
Money Targeting

15. Conclusion
 Key results and policy implications
Monetary authorities reacted to aid inflows in Malawi
Increased aid flows induced depreciation contributing to inflation
pressures
Impacts much smaller under money targeting (Taylor rule and
incomplete sterilisation)
 Further research
Impact of aid on real sector (investment)
Heterogeneity of aid (project and budget support)
Impacts of other flows (FDI, remittances, commodity prices)
Using the model to estimate the fiscal multipliers to be used in
revenue and expenditure management.
2014-10-14 15

16. Limitations
 Quality of data - use of interpolated quarterly data may have
implications on the dynamics of time series data.
 The choice of priors in the Bayesian methods in the DSGE model
reflective of Malawian economy.
2014-10-14 16

17. Thank You Very Much
Zikomo Kwambiri
2014-10-14 17