Macroeconomic effects of foreign aid in the MIRAB economies of the South Pacific

Abstract

The macroeconomic effects of foreign aid have long been a matter of interest to economists specialising in the South Pacific. In contrast to small island economies in other parts of the world, South Pacific countries do not appear to have reaped long term benefits from the generous amounts of overseas assistance they receive. This thesis draws on both the MIRAB hypothesis and the findings of the international aid literature to examine the effects of aid in five South Pacific microstates-Kiribati, Tuvalu, Niue, Tokelau, and the Cook Islands-which are thought to form a distinct class of economies, within the South Pacific region. After confirming that the phenomena originally described in the MIRAB hypothesis continued in the 1980s, the various avenues through which aid is thought to affect an economy are investigated in detail. These include possible undesirable effects on domestic saving, on fiscal policy, and on economic structure. Particular attention is paid to the latter type of effect, also known as the 'Dutch Disease' or 'booming sector' effect. Further to the empirical investigation of these phenomena, stylised models of 'typical' MIRAB economies are constructed, in an attempt to identify more clearly any positive or negative macroeconomic effects of foreign aid. Finally, numerical parameters are attached to some of the models, so that the impact of aid may be quantified. The results reveal a somewhat multi-faceted picture of the impact of aid. However, two generalisations appear warranted: (i) foreign aid has been able to foster real economic growth in the economies considered and, in some cases, this growth has been sufficiently strong for income per head to increase; (ii) aid has led to some of the negative effects evoked in both the MIRAB and the international aid literatures. In particular, it appears to diminish the incentive for public saving, and to induce a relative decline of the tradable goods sector. In all models, foreign aid is shown to be an effective source of domestic employment creation and output growth. However, its capacity to increase average labour productivity-and hence output per capita-is found to depend crucially upon a number of factors, such as the degree of external labour mobility and sectoral labour intensities. Depending on the environment into which it is injected, the impact of foreign aid on the marginal product of labour could be positive, negative or nil. Finally, numerical simulations indicate that the chances of avoiding the relative decline of the tradables sector which aid causes are low.