Aid and Fiscal Instability

Abstract

We show that a combination of temporariness and spending pressure is intrinsic to the aid relationship. In our analysis, recipients rationally discount the pronouncements of donors about the duration of their commitments because in equilibrium they know that some donors will honor those commitments while others will not. Donor types pool in equilibrium; in sharp contrast to conventional signaling situations, there is no separating equilibrium in pure strategies. Moreover, pooling necessarily creates what we call ex ante fiscal instability: expenditure smoothing is perfect ex post if the donor proves permanent, but if the donor is temporary the recipient faces an aid collapse and a fiscal adjustment problem. The Samaritan’s dilemma is at work here, in the guise of a use-it-or-lose-it restriction on spending out of aid. This restriction can produce ex ante fiscal instability even when information is symmetric.Aid, Fiscal instability, Use it or lose it, Samaritan’s dilemma, Pooling