Vos: Aid FLows and 'Dutch Disease' in a General Equilibrium Framework for Pakistan

Vos, Rob. (1998). "Aid Flows and "Dutch Disease" in a General Equilibrium Framework for Pakistan". Journal of Policy Modeling, 20(1), 77-109. http://www.sciencedirect.com/science/article/B6V82-3SX6HSV-6/1/cd1b6de0d68586564f4b283a05e0e972

This is a paper about the effects of aid flows to Pakistan. It uses a multisectoral general equilibrium framework to examine how aid inflows may have similar effects to large natural resource discoveries on an economy, must like the Dutch Disease. The attempt to make this model more broadly applied were not successful, suggesting that they depend, “…strongly on the existing economic structure, investment and savings behavior of institutional agents, and the allocation [of] additional capital inflows among public and private sector agents” (77).

Traditional models of international aid have shown that aid increases economic growth. This assumption has been reified through the application of two-gap models of the effect of aid on an economy. However, the effects of aid on a country’s growth possibilities is not necessarily straight-forward. There are many complicating factors that arise when a country receives foreign aid, including increasing domestic demand, possibly crowding out domestic investment, and changing the value of a country’s exports.

“One basic criticism against the fiscal response model is that it fails to take account of general equilibrium effects, such as the impact of aid on aggregate income and hence the indirect impact on tax revenue. Other more complex stories have focused attention on changes in the composition of both public and private expenditures. The increased demand for nontradables and the rising relative price of nontradables in this analysis can explain the emergence of construction booms” (79).

There have been many accounts of the Dutch Disease that use CGE models, however, these authors claim that their model is more rigorous because, “(1) more rigidities in commodity, foreign exchange, and labor markets and (2) a full accounting of financial flows and stocks in an economy with controlled and imperfect markets for domestic and foreign assets” (79). The model is built around a SAM built by Naqvi and Sarmad (1993). The model supposedly fits into the “structuralist CGE tradition, as it emphasizes different closure rules for distinct commodity and asset markets…and for the savings-investment balances of the different institutional agents” (80). This footnote asks readers to see Robinson (1988) and Taylor (1990) for more information. “…the present model can be seen as a dynamic multisectoral general-equilibrium elaboration of the three-gap model that in recent years has come to replace the celebrated two-gap model” (80).

Over the next 10 pages, the model structure is outlined in much detail. Some notable features: sectoral production and price is market-clearing, labor is exogenous, production is CES based and technology is non-changing. “Unemployment results from a mismatch between labor demand and supply (the nominal wage adjustment in response to a higher unemployment rate is not large enough to clear the labor market)” (88). While there is much market-clearing behavior, “…the model system described above defines a system of segmented and imperfect markets” (90).