Foreign Aid and Spending Strategies for Ethiopia: Productivity Effects in a Computable General Equilibrium Model

Michael Beilman AS 440.624 Computable General Equilibrium Modeling The Johns Hopkins University Applied Economics Masters Degree Program

Abstract Numerous econometric studies fail to detect a significant and robust relationship between international aid and economic growth in the recipient counties. This paper examines the relationships between foreign aid and its effectiveness in a multi-sector, multi-household Computable General Equilibrium (CGE)framework. Given that international transfers to African countries increasingly take the form of general financial support to the government, different spending strategies and their macroeconomic, sectoral, and distributional effects are evaluated in a simulation utilizing a social accounting matrix specific to Ethiopia in 2005. While the model simulates the effects of additional aid flows to Ethiopia, it can be used as a framework for other African counties in the region.

Contents
I. Introduction .......................................................................................................................................... 4 Ethiopia Country Context & Foreign Aid ................................................................................................... 6 Aid and Aid Effectiveness ........................................................................................................................ 10 II. III. IV. Hypothesis and Justification ............................................................................................................... 11 Data & Methodology....................................................................................................................... 13 Simulations...................................................................................................................................... 15

SIM1 ........................................................................................................................................................ 16 SIM2 ........................................................................................................................................................ 18 Closures ................................................................................................................................................... 19 V. VI. Results ................................................................................................................................................. 20 Conclusion ....................................................................................................................................... 22

Annex .......................................................................................................................................................... 23 Selected graphs of results ....................................................................................................................... 23 Works Cited ............................................................................................................................................. 28 Snapshot of CGE Model Used ................................................................................................................. 30

I.

Introduction

The question of whether international aid is an effective mechanism to foster sustainable economic development has been widely debated for decades (Bauer, 1972; Friedman, 1958). This debate gained momentum with Boone (Boone, 1994) who surprisingly found that aid had no impact on economic growth in developing counties. More recently, Easterly (Easterly, 2003) and Rajan & Subramanian (Rajan & Subramanian, 2005) provide empirical evidence in the same direction. In a comprehensive meta-study of the aid effectiveness literature, Doucouliagos & Paldam (Doucouliagos & Padam, 2008) conclude that international aid has no significant influence on growth in the recipient counties. Recent focus has also increased given different emerging donor country spending strategies; for example, the United States Agency for International Development (USAID) recently released policy reforms entitled USAID Forward which targets local government ministries and local Civil Society Organizations (CSOs) as recipients of aid money (USAID). Analysis of the sectoral effectiveness of aid spending has also recently increased as donors and recipients alike develop the framework for the post-2015 Millennium Development Goals (MDGs) (United Nations). A wide body of existing literature suggests that Dutch Disease effects are a possible explanation for the apparent ineffectiveness of international aid. This literature claims that Dutch Disease effects weaken the impact of aid on growth (Barder, 2006; Elbadawi, 1999; Fielding, 2007; Rajan & Subramanian, 2005). Aid inflows tend to be accompanied by an appreciation of the real exchange rate, a loss of international competitiveness, and a corresponding contraction of the export sector. More recent studies by Adam & Bevan (Adam & Bevan, 2006) and Agenor et al. (Agenor, Bayraktar, & Aynaoui, 2006) argue that these conventional Dutch Disease effects may be overstated. Given the econometric findings of aid ineffectiveness, the potential role of Dutch Disease effects, and different spending patterns of development aid; a more disaggregate analysis is required to assess the true impact of foreign aid on economic growth. In this context this paper analyzes the effects of

additional aid flows in a Computable General Equilibrium (CGE) model. The CGE framework allows for a detailed sectoral analysis that is often absent in regression analysis. The simulations contained in this paper discriminate between different spending strategies and considers different dimensions of aid effectiveness than is typically found in regression analysis. This setup clearly distinguishes between the negative side effects from a reallocation of resources at the sectoral level (i.e. Dutch Disease effects) and the potential positive effects from increased productivity. CGE models have a long and rich tradition in economics in general and particularly in development economics; however, the list of references with respect to the effects of international aid in these models is surprisingly short (Clausen & Schurenberg-Frosch, 2009). Numerous others (Adam & Bevan, 2006; Agenor et al., 2006; Bandara, 1995; Vos, 1998) use CGE models to investigate the effects of large capital inflows to specific counties. These studies concentrate either on the demand or the supply side. The individual model specifications vary as do the simulation results. Furthermore, these analyses typically focus on only one specific use of aid - most often public investment. All studies find evidence for aidinduced Dutch Disease effects but differ in their assessment of the magnitude of these effects. Bandara (Bandara, 1995) shows in a static model for Sri Lanka that the effects of aid depend on the flexibility of production (factor closures) in the receiving economy. He considers different degrees of factor mobility across sectors which explain different output and price responses across sectors. Vos (Vos, 1998) uses a four sector dynamic general equilibrium model for Pakistan with an integrated capital market. He finds that the strength of Dutch Disease depends on the nature of the international transfer; it is more severe if aid is paid in the form of grants and directly transferred to the government as compared to the effects of a simulation with increased foreign direct investment (FDI). Adam & Bevan (Adam & Bevan, 2002, 2006) find negative distributional effects. Agenor et al. (Agenor et al., 2006) use a dynamic one-sector one-household approach with a very elaborate government sector with various spending functions. Despite the fact that most aspects of Dutch Disease are excluded from their model design, they

conclude that negative effects from aid could be avoided if the supply response is sufficiently large and the absorptive capacity of the recipient country is sufficiently high.

Ethiopia Country Context & Foreign Aid

Ethiopia is one of the fastest growing economies in Africa and has managed to overcome the global economic crisis and the consequent macroeconomic challenges that hit the country in 2008 (The Economist Intelligence Unit, Ethiopia Country Report). However, Ethiopia is still a low-income country with a gross national income (GNI) of USD 330 per capita (2009) which has grown at an average rate of 8% per year since 2005. It has a population of 91.7 million as of 2012 and is expected to grow to a population of 124.5 million by 2025, a 2.5% C.A.G.R.1 (Group, 2014). Ethiopia is the third largest recipient of official development assistance (ODA) based on disbursements recorded by OECD in 2011; Ethiopia trailed only Afghanistan and the Democratic Republic of Congo and in total received 3% of all donor aid in 2011 (OECD, 2013). ODA figures may look small in overall magnitude when viewed alone; however, when looking at ODA as a percentage share of Ethiopias aggregate GDP one obtains a true sense of the impressive volume of overall aid money flowing into the Ethiopian economy. Country programmable aid (CPA) may be the more important aid statistic to analyze versus overall aid. CPA tracks the proportion of ODA over which recipient countries have, or could have significant say. CPA reflects the amount of aid that involves a cross-border flow and is subject to multiyear planning at country/regional level; several studies have also shown that CPA is a good proxy of aid recorded at the country level (OECD). Figure 2 disaggregates CPA by sector for 2005-2012 data; it is clear that in 2006 Social Infrastructure and Services (i.e. Health and Education) represents the largest sectoral allocation at 59.4% followed by Humanitarian Aid at 21.5%. It is interesting to note that these two categories have fallen as a percentage share of total aid, down to 47.1% and 19% respectively in 2012

C.A.G.R. represents Compound Annual Growth Rate; calculated as (Ending Value/Beginning Value)^(1/t)-1

while Production Sectors have largely increased their share from 2.4% in 2006 to 14.8% in 2012. Economic infrastructure, roads and other engineering services has fallen sharply from a high of 23.9% in 2005 to only 2.6% in 2012; this gives real life context to one of the simulations in this paper, Ethiopia may very well want to assess the impact of increased infrastructure in the coming years. This is especially true given the $75-79 USD Ethiopian Growth and Transformation Plan which allocates a large share of spending to industrial and infrastructure projects (MOFED GTP). These fluctuations illustrate the ever-fluctuating allocation of aid and differing donor strategies and further prove the importance of analyzing the effect of different spending strategies. The emphasis on increasing aid effectiveness and increased coordination amongst donors strategies in support of recipient country national planning has yielded The Paris Declaration and Accra Agenda for Action. They are founded on five core principles, born out of decades of experience of what works for development, and what doesn't. These principles have gained support across the development community, changing aid practice for the better. It is now the norm for aid recipients to forge their own national development strategies with their parliaments and electorates (ownership); for donors to support these strategies (alignment) and work to streamline their efforts in-country (harmonization); for development policies to be directed to achieving clear goals and for progress towards these goals to be monitored (results); and for donors and recipients alike to be jointly responsible for achieving these goals (mutual accountability) (OECD, 2011). As Ethiopia is a major recipient of aid, issues of aid effectiveness are particularly relevant for the country. Of the 13 indicators for which there are targets in the 2011 Paris Declaration Progress Survey, five have been met, overall progress has been uneven (OECD, 2011). Alemu (Alemu, 2009) also discusses how donor fragmentation and high diversification of aid has led to a great deal of ineffectiveness amongst Ethiopian aid; there is a clear need to harmonize donor priorities around the most effective sectors.

Given the significance that foreign aid plays in the Ethiopian economy, the diversity of sectors it funds, and recent stagnant progress towards the Paris Declaration it is important to assess different spending strategies in order to make these large investments as effective as possible.
Figure 1- CPA & Aid as % of GDP (figures in $US millions)

CPA as % of Year 2004 2005 2006 2007 2008 2009 2010 2011 2012 CPA* 1528.2 1406.6 1633.2 2173.9 2157.5 3138.4 2669 2669.5 2580.4 GDP 14.0% 11.5% 12.1% 14.4% 12.9% 17.3% 13.4% 12.5% 11.1% Aid 2369.5 2500.1 7375.7 2755.4 3456.3 4125.3 3773.8 3640.6 3410.4

Aid as % of GDP 21.7% 20.5% 54.6% 18.3% 20.7% 22.7% 18.9% 17.0% 14.7% GDP 10896.5 12184.4 13504.5 15051.6 16675.4 18143.3 19946.2 21402.1 23213.92

OECD DAC Statistics only report $USD indexed to 2011. 2012 data is the latest available, 2005 data for CPA is the oldest historical record available. Aggregate aid flows range back to 1970s.

Figure 2- Sectoral Allocation of CPA 2005-2012 (figures in $US millions indexed to 2011)

Year: Sector: SOCIAL SERVICES ECONOMIC INFRASTRUCTURE PRODUCTION SECTORS MULTISECTOR PROGRAMME ASSISTANCE ACTION RELATING TO DEBT HUMANITARIAN AID UNALLOCATED/UNSPECIFIED Grand Total

2005

2006

2007

2008

2009

2010

2011

2012

268.0

970.0

1197.0

870.4

1625.5

956.1

1014.4

1216.0

336.1 62.3 24.4 97.6 123.0 481.8 13.5

1406.6

52.6 39.6 58.1 95.9 46.3 351.4 19.1

1633.2

47.6 142.8 109.7 123.8 5.1 533.6 14.2

2173.9

33.4 84.8 62.8 305.5 0.6 787.8 12.1

2157.5

160.6 110.5 101.3 252.5 0.1 870.5 17.4

3138.4

70.8 271.9 168.7 423.6 0.1 752.3 25.4

2669.0

240.5 187.7 74.5 275.4 0.1 866.5 10.4

2669.5

66.7 382.7 164.9 241.9 0.0 489.3 18.8

2580.43

This paper provides a comprehensive account of the issues in a detailed CGE model based on a real world dataset. The simulation results are generated by a multi-sector, multi-household static CGE framework for Ethiopia. The remainder of this paper is structured as follows: the next sub-section defines the terms aid and different concepts of aid effectiveness. Section 2 explores the hypothesis and justification for the simulations. Section 3 explains the Data and Methodology. Section 4 explains the

OECD DAC Statistics only report $USD indexed to 2011. 2012 data is the latest available, 2005 data for CPA is the oldest historical record available. Aggregate aid flows range back to 1970s.

design of the simulations and how they can be used to answer the hypothesis from Section 2. Section 5 explains the results. Section 6 discusses conclusions and recommendations.

Aid and Aid Effectiveness

Most macroeconomic studies do not distinguish between different forms of aid as the underlying data, its specific uses are typically unavailable. The data set in this CGE model defines international aid as the Savings-Investment (S-I) account from the Rest of the World (RoW). Thus an increase in foreign aid can be simulated as an increase in foreign savings. Aid can be used for public consumption, public investment or for transfers to the private sector. Most previous CGE studies and also most theoretical analyses on aid effectiveness assume that aid is used for productive capital investment and increases public capital accumulation (Clausen & SchurenbergFrosch, 2009). However, a growing proportion of aid is provided as direct budgetary support (OECD & Bank, 2006) and does not necessarily increase public capital accumulation. For this reason this paper compares two different spending scenarios. The respective shares and activity of the two possible uses of aid are modified in order to focus on the effects of the different spending strategies; public investment in the form of increased infrastructure spending, and public consumption in the form of aid to education services. The effectiveness of aid is measured in most macroeconomic studies only with respect to economic growth (Doucouliagos & Padam, 2008). This paper broadens the perspective and evaluates three different types of indicators which are not traditionally available in non-CGE models. The simulations illustrate the effects of increased aid on sectoral and aggregate production, the trade balance and subsequently the real exchange rate, as well as on the welfare and income distribution amongst urban and rural households. Following this broader assessment aid will be considered effective as long

as it promotes growth and international trade and leads to (over-proportional) increases of the income of poor households.

II.

Hypothesis and Justification

Figure 3- Decomposition of Aid Effects

Figure 3 provides a brief and simple overview of the different types of aid effects. A first distinction can be drawn between demand and supply side effects. Demand side effects are mainly direct effects from the spending of aid in the recipient country. Governments tend to use aid mainly for the purchase of non-tradable goods (Clausen & Schurenberg-Frosch, 2009). The first and most direct effect from aid will be increased demand for non-tradable. This increase in domestic demand leads to rising domestic prices of non-tradables relative to tradables, i.e. to an appreciation of the real exchange rate. The recipient government can use aid either for recurrent or for capital expenditure, the share of imported goods increases with the importance of capital investment in the aid-financed expenditure (Clausen &

Clausen & Schurenberg-Frosch, 2007

Schurenberg-Frosch, 2009). Alternatively, the government could transfer the aid to the private sector where it allows for higher consumption or higher investment. The resulting increase in imports again depends on the type of spending. The supply side effects mostly arise from productive investment and increased capital accumulation. The government may use the additional funds for public capital accumulation as Adam & Bevan [2006] assume in their model of aid effectiveness. Aid may be invested in health and education programs which increase labor productivity. Or it may be used for infrastructure investment which increases total factor productivity (tfp) (Agenor et al., 2006). These productivity effects have the potential to increase domestic supply and to reduce Dutch Disease effects. In general the spending of additional aid incurs sectoral shifts in production; the direction of these sectoral reallocations depends on differences in factor intensity, the share of imported intermediates and increase productivity effects from aid. Distributional effects from aid inflows result in changes in the relative goods and factor prices. Undesirable distributional effects might occur as increased demand and prices might lead to a rise in the return to high-skilled labor which is mainly an income sources of wealthy households. On the other hand, the rise in domestic prices could be to the detriment of the poor. The CGE model allows for a comprehensive assessment of the effects of different spending scenarios on aggregate and sectoral production, international trade as well as welfare and income distribution. This paper will assess the differences between to plausible spending scenarios; (1) spending of foreign aid in public consumptions such as health or education services, and (2) spending of foreign on public investment to simulate infrastructure and construction investment.

III.

Data & Methodology

Over the past 25 years, CGE models have become a more common and standard tool of empirical economic analysis. In recent years, improvements in model specification, data availability, and computer processing technology have improved the outputs and payoffs while reducing the cost of policy analysis based on CGE models (Lofgren, Harris, & Robinson, 2002). These advancements have paved the way for the widespread use and adoption by policy analysts throughout the developed and developing world. This paper utilizes the standard model pioneered by staff at the International Food Policy Research Institute (IFPRI). The standard model includes a number of features designed to reflect the characteristics of developing countries following the neoclassical structural modeling presented in early CGE models (Dervis, Melo, & Robinson, 1982). The advancements made by IFPRI are of particular importance to developing countries, these include household consumption of non-marketed (or home) commodities, explicit treatment of transaction costs for commodities that enter the market sphere, and a separation between production activities and commodities that permits any activity to produce multiple commodities and similarly any commodity to be produced by multiple activities (Lofgren et al., 2002). This analysis uses the standard model though the computer application GAMS (General Algebraic Modelling System), in the GAMS code, the model is explicitly linked to a file for country data including a Social Accounting Matrix (SAM). A SAM is a comprehensive, economy wide data framework, typically representing the economy of a nation. More technically, a SAM is a square matrix in which each account is represented by a row and column (Fofana, Lemelin, & Cockburn, 2005). Each cell shows the payment from the account of its column to the account of its row. Therefore, the incomes of an account appear along its row and its expenditures along its column. Thus, given the double-entry the SAM requires that total revenue (row total) equals

total expenditure (column total).5 This paper utilizes a SAM for Ethiopia from 2005 measured in Billions of LCU (Ethiopian birr), the detailed SAM can be found in the Appendix. The SAM features a number of features that are noteworthy. First, the SAM distinguishes between accounts for activities (the entities that carry out production) and commodities. The receipts are all valued at producer prices in the activity accounts and at market prices in the commodity accounts; the commodities are activity outputs, either exported or sold domestically, and imports. The separation of activities from commodities is preferred because it permits activities to produce multiple commodities (for example an agriculture activity can produce multiple crops) while any commodity may be produced by multiple activities (Lofgren et al., 2002). In the commodity columns, payments are made to domestic activities, the RoW, and various tax accounts (for domestic and import taxes). Further, the government is disaggregated into a core government account and different tax accounts (one for each tax type). This is often necessary because the economic interpretation of some payments may otherwise be too ambiguous (Lofgren et al., 2002). Additionally, the domestic

nongovernment institutions in the SAM consist of households and enterprises, the enterprises earn factor incomes (reflecting ownership of capital and/or land). They may also receive transfers from households or government; the government taxes the enterprises income while other income is used as savings and transfers to households. One key element to note is that enterprises do not consume, unlike households and government. The CGE model explains all of the payments recorded in the SAM through sets of simultaneous equations, many of which are nonlinear (Lofgren et al., 2002). These equations define the behavior of various actors within the economy. Production and consumption decisions and behavior are represented

THE GAMS code checks that the SAM is entered and is balanced (row and column totals equal). The SAM must be balanced for the rest of the GAMS code to run.

by nonlinear, first-order optimality conditions; production and consumption decisions are driven by the maximization of profits and utility following traditional neoclassical theory (Lofgren et al., 2002). The equations also include a key set of constraints that have to be satisfied by the system as a whole; these cover markets (factors of production and commodities), balances for savings-investment, government, and the RoW. Further detail of the equations used in this model can be found in the Appendix. Now that the framework of the CGE model and SAM are complete, we turn to an overview of the methodology of the simulations.

IV.

Simulations

CGE models allow policy-makers to easily compare various exogenous shocks within a static or dynamic framework. In order to model an increase in foreign aid we must first analyze historic and recent aid flows to Ethiopia, as previously discussed in Section 1 of this paper. As Figure 2 indicates, Ethiopia saw an 83.5% increase and a 9.1% C.A.G.R. in CPA inflows from 2005 to 2012 based on OECD DAC estimates. While this is large growth, Ethiopia is now at the top of recipient countries foreign aid spending, so it is unlikely that this growth rate will continue. However, given that the context of this analysis utilizes data from 2005 from the Ethiopian SAM, we will use the figure of a 20% increase in foreign aid. This increase can be implemented through the S-I account on the SAM, specifically savings from RoW increase. In the model this is implemented through a scalar shock to the parameter fsav which represents Foreign Savings. This 20% shock is constant across our 2 simulations for comparison sake. Moving forward this paper defines the two simulations as: SIM1: a simulation representing channeling the increase in foreign aid to infrastructure, particularly rural infrastructure. At a basic level this can be thought of as increased in public investment.

SIM2: a simulation representing channeling the increase in foreign aid to education services. At a basic level this can be thought of as increased investment to public consumption.

SIM1
The first effect of the increase in foreign aid channeled to rural infrastructure is modeled by a capital stock increase. This is relatively self-explanatory, in order to build the infrastructure the economy must first increase its capital stock. We proxy the effectiveness of this spending by implementing a 5% shock to the factor of capital, factor supply (qfs in the model) increases by 5%. The 5% increase is also relatively conservative in the sense that it takes into account depreciation, it is not plausible that the 20% investment can all directly be seen as a 20% increase in capital stock. This is consistent with literature as presented by the OECD (see Englander and Mittelstadt). We then model the effect of the increase in infrastructure investment on total factor productivity (tfp). This analysis requires a brief review of the existing literature in order to obtain a plausible percentage change. Economists have viewed infrastructure as a key ingredient for productivity and growth since at least Adam Smith. Conceptually, infrastructure may affect aggregate output in two main ways: first, directly because infrastructure services enter production as an additional input, and second, because they raise total factor productivity by reducing transaction and other costs thus allowing a more efficient use of conventional productive inputs (see Gramlich 1994, Romp & de Haan 2007, Straub 2008). While literature equating increases in foreign aid to overall aggregate growth or total factor productivity growth (tfp) is numerous, there is not an empirical consensus on how much GDP or total factor productivity increases. A 2010 research brief by Serven of the World Bank explores and summarizes the existing literature on this topic. The earliest empirical literature aimed to explain how much infrastructure increases GDP. Such quantitative assessments took off with the work of Aschauer (1989) on the effects of public infrastructure

capital on U.S. tfp. Using time-series data, he found an extremely (and, for most observers, implausibly) large effect. Subsequent empirical research has employed a variety of data, empirical methods and infrastructure measures (see Romp & de Haan 2007, Straub 2008, Bom and Lighthart 2009). These studies were far from a consensus on the overall effect of infrastructure on GDP and tfp growth; however their underlying assumptions and geographic contexts varied widely (Serven 2010). Recent literature tends to find smaller - and more plausible - effects than those reported in the earlier studies (Romp and de Haan 2007); in a production-function setting, the mid-point estimate from recent studies of the elasticity of GDP with respect to infrastructure capital lies around 0.15 for developed countries (Bom and Ligthart 2009). This means that a doubling of infrastructure capital raises GDP by roughly 10 percent. As will be presented later in Section 5, this simulation generates a GDP growth with a similar but more conservative magnitude. This is done by channeling the 20% increase in foreign aid (again through a scalar shock on the S-I account) to activity shocks after an increase in capital. The activity shocks in SIM1 explain the effects in a rural context, agriculture activity is what realistically receives the shock while more urban activity is not. SIM1 keeps the same magnitude as the increase in capital stock (factor shock to capital) and shocks the activity of: teff, maize & wheat, export crops, livestock, and food (agro-processing). While country dynamics may dictate a different distribution of these increases this analysis keeps a constant 5% increase across all agricultural activity for ease of comparison. Finally, increased tfp of agricultural activities subsequently lowers transaction costs of theses activities from a commodities perspective. In keeping consistent with the 5% magnitude used for capital stock and tfp increases, this model shocks transaction costs by-5%. This is consistent with economic theory and is recently documented by the United Nations Industrial Development Organization (UNIDO) (see Isacksson, 2007). In the model this is implemented by a -5% shock to all three of the transaction costs exports, imports, and domestic across the commodities associated with the above mentioned

activities, commodities of: teff, maize & wheat, export crops, livestock, and food (agro-processing). The results of SIM1 are presented in Section 5.6

SIM2
Sim2 keeps constant the 20% increase in the S-I account to model the increase of foreign aid. However, the rest of the simulation differs greatly from SIM1. In general few other parameters are shocked unlike SIM1. As increased investment in education does not necessarily increase tfp we must model this spending scenario in a much different manner. We are required to complete a brief review of the existing literature to estimate a plausible effect and magnitude of the increased investment in education services. Judson (1998) takes a regression approach to determining whether or not increased spending on education yields increased growth rates. While her findings do not show statistically significant results for settings which have a poor allocation of education resources; however, she does find a statistically significant positive correlation between increased education spending and GDP growth in settings that have better allocations of education resources. While this paper is unable to determine whether or not Ethiopia falls under the poor or better classification, we can make proxy assumptions based on available data and indicators. According the World Bank, Ethiopia has achieved the Millennium Development Goals (MDGs) for child mortality and is on track for achieving them in gender parity in education, HIV/AIDS, and malaria. Good progress has been achieved in universal primary education, although the MDG target may not be met. Given the countrys progress towards MDG goals for education we make a general assumption that Ethiopia falls in the better classification of education resource allocation and thus we can make the assumption that an increase in education spending yields an increase in aggregate

It is important to note that since this CGE model is a static single-period framework we must implement all shocks in a single period. The author recognizes that this is not plausible in real world setting, as some of these effects such as an increase in capital, depreciation, and the construction of the infrastructure occurs over multiple periods.

output. Judsons literature also explains that the mechanism for growth is typically through more efficient workers or an increase in labor supply given increase skills, education, and training. Following existing literature SIM2 channels the 20% increase in foreign aid to factor shocks. As investments to flow to education it can be argued that more skilled workers are the result, either the existing workforce can become more productive or the quantity of labor supplied (size of the workforce) can increase as more unskilled workers become skilled workers. Therefore we shock the factor supply of labor (flab). In keeping consistent with the magnitudes of SIM2, SIM1 implements a 5% shock to the factor supply of labor.

Closures
The CGE model includes 5 macroeconomic balances: the numeraire, the savings-investment balance, the government account balance, the government revenue balance, and the current account balance. The choices made have no influence on the solution to the base simulation but will typically influence the results for the simulations. This analysis keeps the closures in both simulations constant for ease of comparison, it also utilizes the set of closures more commonly known as the Johansen closure7. This closure avoids the misleading welfare effects that appear when foreign savings and real investment change in simulations with a single period model ceteris paribus, for the simulated period (Lofgren et al.). This is an important closure for this paper as this analysis explores the effects of increased foreign aid modeled through an increase in foreign savings. In keeping consistent with standard CGE models and the Johansen closure, this analysis selects a consumer price index (CPI) as the closure for the numeraire. A numeraire is required since the model is homogenous of degree zero in prices- a doubling of the value of the numeraire would double all prices but leave all real quantities unchanged. Therefore, all simulated price and income changes should be

A closure of this type was used in the first CGE model, developed by Leif Johansen (1960).

interpreted as changes vis--vis the numeraire price index, in this case the CPI (Lofgren et al.). This is a sound approach to policy analysis as it articulates the effects to households in an easily understandable manner. For the S-I balance closure this model selects fixed investment with scaled MPS, this is consistent under the Johansen closure. Further consistency of the Johansen closure is represented by the choice of government account and revenue closures; this model specifies a fixed government savings while government expenditure adjusts, similarly the model fixes the government income while activity taxes adjust. Lastly, also consistent with the Johansen closure this model fixes foreign savings while the exchange rate is in flex (adjusts) for the current account balance.

V.

Results

Detailed graphs are presented in the Appendix of this paper to detail disaggregate sectoral changes. The first result we note from the simulations is the overall effect of aid on sectoral use of labor. Obviously with increased productivity under SIM2 we expect labor to increase, similarly we expect labor use to increase given an increase in infrastructure as overall tfp increases shift the production possibilities frontier curve out (ppf). The sectoral production effects result from a movement of productive resources from the non-tradeable sectors, particularly construction and machinery decrease. It comes as no surprise that SIM2 increases overall labor by more, in SIM2 we shocked the qfs of labor (labor supply) so all sectors utilize more. It is interesting to note that under SIM1 there are substantial decreases in the non-traded goods, again this is due to the movement of productive resources from the non-traded sectors. SIM2 however ends up driving wages down as labor supply increases, this follows standard economic theory as supply increases, price (wage in this case) tends to decrease. Overall wages fall 2% in SIM2 while they increase 6.6% in SIM1. Next we analyze the effect of aid on the trade balances. Referring to figures 2 and 3 of the annex we can see that in both scenarios imports increase while exports for the most part decrease. This is likely

due to Dutch disease effects as we can see in both simulations the exchange rate appreciates, so exports are much less competitive on the open world market (as noted in Figure 4). The shift of production and factor use from exporting to domestic sectors clearly documents considerable Dutch Disease effects from international aid. This is likely due to the fact that increased savings from the RoW (increase of foreign aid by 20%0 allows for an increased current account deficit. The increased deficit could either allow for increase imports as noted by Heller 2005 or for reduced exports. The increased quantity of imports in SIM1 is greater overall than the increased quantity of imports in SIM2 while the quantities of exports decreases much more in SIM2 than in SIM1. For this reason it is hard to discern under which scenario the effects of Dutch Disease are more greatly felt. This is further noted in the fact that the exchange rate appreciates slight more (falls more) in SIM2 as compared to SIM1, they are within 0.08 percentage points. Overall the effects of Dutch Disease are clearly noted in both simulations which supports our hypothesis and literature review; an increase in foreign aid is followed by an appreciation of the exchange rate, an increase in imports, and a decrease in exports. We now round out our aggregate analysis by turning to the effects of foreign aid on GDP (real). Referring to Figures 7 and 8 of the appendix it is obvious that SIM1 increases aggregate output and a much greater rate than SIM2. This is inherent in the nature of the simulations. If we recall from Section 4, SIM1 had many more parameter shocks than SIM2. By the very nature of a tfp outward shift overall aggregate production would be expected to increase far greater than a scenario where only the quantity of factors of labor is increased. Future analysis however should incorporate more of a sensitivity shock to SIM2, and given future empirical evidence it may be plausible that an increase in spending on education may increase qfs of labor by more than a modest 5%. We now shift our analysis of the results from aggregate effects to relative measures of welfare. While we have not calculated a Hicksian effect we can analyze welfare changes at a much more basic level to obtain a clear picture of which spending scenario should be used to increase welfare (particularly

among the urban and rural poor). As Figures 5 and 6 of the Appendix make clear, both income and consumption at the household and enterprise level increase more in SIM1 than they do in SIM2. For policy-makers it is important to note that in both scenarios there is a relatively large increase in all representative agents, enterprise and household income increase in the range of 1.5-3% in SIM2 while they increase in the range of 3-5.5% in SIM1. It is also important to note that poor households (both urban and rural) increase by more than non-poor in both scenarios; as development policies become more and more pro-poor both of these spending mechanisms should be considered. The same holds true for household consumption but we note a greater magnitude of change. SIM1 ranges from 6-9% increases (notably rural poor see the greatest increase in consumption likely due to decrease costs of agricultural commodities) while SIM2 ranges from 4-6% increases (again rural poor note the greatest increase). Again, this is important for policy-makers to note as development aid increasingly targets the most marginalized members of society.

VI.

Conclusion

This paper evaluates by means of a multi-sector, multi-household model for Ethiopia the aggregate and sectoral effects of international aid, its trade balance effects as well as the implications for income distribution. Given the growing importance of budgetary support to developing countries, this paper analyzes two separate spending scenarios given an overall increase in foreign aid. Overall SIM1 appears to have greater effects on welfare and aggregate measures as compared to SIM2. It is based on these results that policy-makers should increasingly look towards infrastructure investment and development to increase aggregate output and benefit the most marginalized members of society. However, in the context of foreign aid at the donor and recipient level it is important to note that political motives still support spending money on human capital such as education or health services in the near and long term.

Annex
Selected graphs of results
*(all % changes refer to % change from the base model)*
Figure 4- Effect of aid on sectoral use labor by sector (%change) 10.000

8.000

6.000

4.000

2.000

0.000

-2.000

-4.000

-6.000 sim1 sim2

Figure 5- Effect of aid on trade balance - Quantity of Imports (%change) 18.000 16.000 14.000 12.000 10.000 8.000 6.000 4.000 2.000 0.000 cmzwh cntag cxcrp clive cfood cfuel sim1 cchem sim2 cmach coman ccons ctrad cpsrv cgsrv

Figure 6- Effect of aid on trade balance - Quantity of exports (%change) 6.00 4.00 2.00 0.00 cntag -2.00 -4.00 -6.00 -8.00 sim1 sim2 cxcrp clive cfood cchem cmach coman cutil ctrad cpsrv cgsrv

Figure 7- Effect of aid on exchange rate (%change)

sim2

sim1

-1.126

-1.124

-1.122

-1.120

-1.118

-1.116

-1.114

Figure 8- Effect of Aid on welfare measures Disaggregated household Income (%change) 6.000 5.000 4.000 3.000 2.000 1.000 0.000 ent hhd-rurp hhd-rurn sim1 sim2 hhd-urbp hhd-urbn

Figure 9- Effect of aid on welfare measures - Disaggregated household consumption (%change) 10.000 9.000 8.000 7.000 6.000 5.000 4.000 3.000 2.000 1.000 0.000 hhd-rurp hhd-rurn hhd-urbp sim1 sim2 hhd-urbn total

Figure 10- Real aggregate GDP results (%change) 8.00 6.00 4.00 2.00 0.00 ABSORP -2.00 -4.00 sim1 sim2 PRVCON FIXINV DSTOCK GOVCON EXPORTS IMPORTS GDPMP NETITAX GDPFC2

Figure 11- Real sectoral GDP results (%change) 10.00

8.00

6.00

4.00

2.00

0.00 ateff amzwh antag axcrp -2.00 sim1 sim2 alive afood achem amach aoman acons autil atrad apsrv agsrv total

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Snapshot of CGE Model Used

SIM1

SIM2