Proceedings of the German Development Economics Conference, Kiel 2005 No. 1
A perfect foresight OLG model is set up to study the dynamic response of a small open economy to a temporary fiscal impetus (bond-financed government deficit) anticipated to be closed by a mix of taxes, money finance and grant aid. The model is solved for the general mixed tax-money-aid finance case with a focus on the conclusions for the full-grant finance case in the hope to inform the ongoing debate on debt sustainability in post-HIPC Africa and to some extent crisis-prone emerging markets like Turkey and Argentina. The conclusions emanating from the model are that anticipated aid (or debt forgiveness) works like a ?proborrowing policy? inducing the economy to consume more, save less and hence run bigger current account deficits; the size of the immediate responses to the impetus as well as the long-term trajectory of the economy depends critically on whether domestic agents start off as net debtors or net creditors, outcomes being much less desirable in the former case; if future aid expects to replace taxes, consumption and the current account jump more when the real interest rate is low, consumption less important in the utility function relative to real balances, the instantaneous probability of death higher, and the bond-financed deficit regime of longer duration. To the extent that these conditions hold in the current HIPC context, and given the earlier results, the paper reinforces existing doubts over about the prospects of attaining longterm debt sustainability in Africa.