Policy Responses to Aid Surges in Countries with Limited International Capital Mobility : The Role of the Exchange Rate Regime

We study the role of the exchange rate regime, reserve accumulation, and sterilization policies in the macroeconomics of aid surges. Absent sterilization, a peg allows for almost full aid absorption — an increase in the current account deficit net of aid — delivering the same effects as those of a flexible regime but with a necessary increase in inflation. Regardless of the regime, policies that limit absorption — and result in large accumulation of reserves — are welfare reducing: they help reduce the real appreciation (and inflation under the peg), but at the expense of reducing private consumption and investment, and therefore medium-term growth