Ramsey-Optimal Fiscal Spending and Reserve Accumulation Policies under Volatile Aid

Ramsey-Optimal Fiscal Spending and Reserve Accumulation Policies under Volatile Aid
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Volume/Issue: Volume 2025 Issue 154
Publication date: August 2025
ISBN: 9798229006798
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Summary

This paper examines Ramsey-optimal policies related to fiscal spending and international reserve accumulation in response to volatile aid flows in Low-Income Countries (LICs). We develop a real Dynamic Stochastic General Equilibrium (DSGE) model of a small open economy, incorporating government transfers and public investment as fiscal spending components, along with two prominent characteristics of LICs: Dutch disease (DD) externalities and financially constrained households. Driven by considerations of precautionary saving, Ramsey-optimal policies involve partial reserve accumulation and partial fiscal spending of aid. Stronger DD externalities necessitate greater reserve ac- cumulation to stabilize future output, thereby mitigating consumption volatility. While transfers directly support private consumption smoothing, public investment also con- tributes to this goal by sustaining future income through gradual capital accumulation. Higher aid volatility calls for increased public investment, underscoring the role of public capital accumulation as a precautionary saving instrument, beyond its developmental role discussed in the literature.