Aid Transfers, Supply Shocks, Dutch Disease and the Informal Sector

In: Review of economics: Jahrbuch für Wirtschaftswissenschaften, Volume 63, Issue 1, p. 42-67

Abstract

Summary
I present an integral approach for the analysis of supply shocks, financial transfers and combinations thereof in a model of monopolistic competition. Introducing an informal sector reveals an asymmetry between "spending" the value of the transfer by the recipient government and "absorption", i. e. selling the foreign exchange by the recipient central bank: With flexible prices, the increased demand for formal sector domestic goods does not only crowd out exports, but also informal sector products. The real appreciation after selling foreign exchange crowds out exports and cheapens nontradables. With wage and price rigidities in the formal sectors, the adjustment pressure on the informal sector is increased.