# **I. Introduction**

Existing empirical evidence (Fajnzylber and Lopez, 2005) indicates that at the country level higher remittances inflows tend to be associated with lower poverty indicators and higher growth rates. Beyond these typical income dimensions of welfare, remittances seem to reduce output volatility (a measure of risk faced by countries<sup>1</sup> ), and at least in some countries and for some socio-economic groups lead to improvements in social indicators. Yet, the magnitude of these flows relative to the size of the receiving economies<sup>2</sup> implies that remittances may also pose an important number of challenges. For while these inflows may ease external financing constraints and therefore hold the potential for higher investment by developing countries, in many circumstances remittances are so large that they can impact macroeconomic stability and more specifically carry a potential for Dutch Disease type of phenomena (see the International Monetary Fund’s _World Economic Outlook 2005_ , and the _Work Bank’s Global Economic Prospects 2006_ ).

Workers’ remittances can be viewed as a capital inflow, and therefore the theory on the Dutch Disease phenomenon associated with a surge in inflows (perhaps because of a discovery of new natural resources) can also be applied in this context. In order to isolate the specific channels transmitting remittance shocks through the economy, consider first a small open economy model with no leisure-consumption trade off. In this setup, an increase in remittances is equivalent to a (permanent) increase in incomes of the households.

Assuming that non-tradables are normal goods, this positive income shock results in extra spending on both tradables and non-tradables. Since most Latin American countries are price takers in international markets, a growing demand does not raise prices of tradables. However, since the prices of non-tradables are determined in the domestic economy, they increase due to additional demand, the so-called ‘spending effect’. There is also a ‘resource movement effect’. The relative price change between tradables and non-tradables makes production in the latter more profitable. Output growth in the non-tradable sectors will push up factor demands, especially for those factors used intensively in these sectors. Increased factor demand by the expanding sectors will be accommodated by factors released from other sectors (the resource movement effect) and, depending on the behavior of total supply of factor, will normally result in higher factor returns in the final equilibrium. The price shift and resource reallocation in favor of non-tradables erode the competitiveness of export oriented sectors and hurt import competing sectors. The final result of this real exchange rate appreciation is normally increased import flows and lower export sales. When the above assumption of no consumption-leisure trade-off in the household utility function is removed the above effects are exacerbated. Without this assumption, an increase in non-labor income, as is the case with remittances, influences household decision to supply labor; namely, individuals can now consume more of both goods and leisure (i.e. the income effect dominates) and thus their labor supply is reduced. In turn, reduced labor supply implies raising wages and this additional pressure on wages intensifies the effects of real exchange rate appreciation described earlier.

> 1 See Perry, Arias, Lopez, Maloney and Serven (2006) for a discussion of non-monetary dimensions (including risks considerations) of welfare.

> 2 It has to be mentioned that there are a number of Latin American countries where remittances are above 10 percent of GDP and there are cases, such as Haiti, where they reach almost 40 percent.

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