_5_ institutional organization. They were cognizant that redressing these constraints required sustained internal resource support; however, in application, the two-gap model glossed over the importance of local funds for the execution of projects and for the overall sound economic management that is critical for growth. Similarly, while Taylor was fully cognizant of the import of the fiscal gap, presumption of aid fungibility may have led him to overlook the inner local financing gap that is embedded in the current fiscal gap. (This issue of aid fungibility will be examined later in section IV).

9. The rest of this section formulates a three-gap model for exploring local financing issues. Eq2 is derived from Eql by defining G as the sum of development expenditure (Gd) and recurrent expenditure (Gr). In Eq2, development expenditure is presented as a counterpart of three financing gaps: (a) the current fiscal gap; (b) the savings-investment gap; and (c) the current account deficit. Since completed development projects have to be maintained and operated, recurrent cost expenditure, Gr, reflects the past levels of Gd. Given revenues and other things the same, increasing Gd will eventually cause the current fiscal deficit, (T-Gr), to widen. Eq3 shows the financing sources of Gd: the current fiscal balance (T-Gr); money printing (MP); use of reserves (UR); domestic borrowing (Bd); local counterpart currency obtained from non-project aid (An); and project aid (FF). Eq4 simplifies Eq3 as the sum of local funds (LF) and foreign fimds (FF). In Eq4, LF has domestic resource components and an aid component, An. FF is project aid.

|Gd|= (T-Gr)+(Sp-Ip)+(M-E)|Eq2|
|---|---|---|
|Gd|= [(T-Gr)+MP+UR+Bd+An ]+FF|Eq3|
|Gd|= LF + FF|Eq4|

10. From Eq2, both private and public sector investments are necessary to foster economic growth. For example, education infrastructure helps to create skills needed to complement private investment activities. From Eq2, (T-Gr)>O provides a recurrent surplus to finance development by providing matching funds for aided projects and supporting fully government-funded projects. The implementation of aided projects as well as fully government funded projects will be difficult if the current surplus is less than the local matching funds required by the projects. (T-Gr)<O means an inability to cover recurrent costs from internal revenues, let alone support project implementation.

11 In the short term, there is no direct causality between the current fiscal gap and investment in development projects. Increased financing for development activity can result from increased private savings as well as lower private investments; from various sources of local funds, including seigniorage, as indicated in Eq3; and from "turnkey" projects, which are executed directly by donors without local matching funds. While high social aspirations often make development expenditure plans exceed expected resources ex ante, an ex post accounting balance is always obtained between the demand for local funds and supply. Most often, this balance is obtained at the cost of reduced quality and quantity of government services, or more indebtedness. The need for fiscal stability and a prudent debt service burden limit dependence on the various local financing sources.