IMF Working Papers

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

By Ioana Moldovan, Shu-Chun S. Yang, Luis-Felipe Zanna

August 1, 2025

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Ioana Moldovan, Shu-Chun S. Yang, and Luis-Felipe Zanna. "Ramsey-Optimal Fiscal Spending and Reserve Accumulation Policies under Volatile Aid", IMF Working Papers 2025, 154 (2025), accessed August 2, 2025, https://doi.org/10.5089/9798229006798.001

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Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

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.

Subject: Central Banks, Consumption, Dutch disease, Economic theory, Expenditure, Foreign exchange, Income, International reserves, National accounts, Private investment, Public investment spending, Real exchange rates, Reserves accumulation

Keywords: Aid, Capital accumulation, Consumption, Dutch disease, Fiscal policy, Foreign aid, Foreign exchange intervention, Income, International reserves, Low-income countries, Optimal policy, Private investment, Public investment spending, Real exchange rates, Reserve policy, Reserves accumulation

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