- The financial inflow is _absorbed_ if it leads to an equivalent increase in net imports, leaving the balance of payments unchanged. This can be achieved through a direct imports increase, or through a reduction in export production.

- The inflow is _spent_ if it leads to an equivalent increase in government spending, leaving the government budget balance unchanged.

- The inflow is _saved_ if it is neither absorbed nor spent. In effect, international reserves are then accumulated, and macroeconomic effects are likely to be small in the short run, apart from effects through strengthening of the country’s currency, interest rate policy, or international credit worthiness.

The short-run macroeconomic implications of such increased financial inflow are determined by the combination of absorption and spending chosen. These responses are in turn determined by the country’s macroeconomic policy response. Spending is affected by _fiscal policy_ . Full spending will occur if government expands its overall budgets equivalently to the financial inflow increase.

For given spending, absorption depends on exchange rate policy and monetary policy, which are usually in the hands of the country’s central bank. But as the central bank has only one basic instrument (the money supply) at its disposal, only one variable (the exchange rate, or the money supply alternatively the country’s interest rate) can be determined through this policy. Under a _fixed exchange rate regime_ , the exchange rate is managed directly, and must typically, for effective absorption to take place, be changed (appreciate) in response to an increased financial inflow. Under a _flexible exchange rate regime_ , the exchange rate will be endogenous and the interest rate typically managed by the central bank, to allow for a strengthened exchange rate.

The classical “textbook” response to increased aid is to _absorb and spend fully_ .<sup>9</sup> This is in particular the case when aid is given in kind, or the aid is used directly to finance additional imports. The shortrun macroeconomic effects of aid will then be small. Some appreciation of the exchange rate is typically necessary to achieve this outcome, leading to an increase in net imports (increased imports, and reduced output in export sectors). In particular, it will entail some reallocation of productive resources, away from producing export goods, and with more production of domestic goods. But this is just the desired outcome, “necessary” for a full short-run utilization of the initial aid.

_Saving_ the aid (implying that it is neither absorbed nor spent) may be a relevant response in some cases, in particular, when the country has an acute initial balance-of-payments deficit, or when the aid is temporary or volatile so that precautionary reserves may need to be built up. It may also be relevant when there is a fear that loss of competitiveness, following from a real exchange rate appreciation, is viewed as a long-term structural problem, hampering key export sectors in need of high initial growth. Note, however, that the “saving” alternative, if maintained indefinitely, effectively amounts to foregoing any possible direct benefits from the financial inflow.

The above analysis, presented in IMF (2005), is based on the assumption that the international financial flows fully benefit the public sector. In the case of climate-related finance, some part of additional finance will flow to the private sector, and some to the public sector. While the issue of absorption is similar in this case, the spending issue is slightly different. In this case, of course, government budget balance requires that government spending increases by only the government’s share of the increased inflow. Full spending of this inflow then requires that the private sector at the same time fully spends its inflow share. To achieve this, somewhat different fiscal policy instrument are required. While a direct increase in government purchases of goods and services may be sufficient in the former case, also changes in tax policy will usually be required when the private sector is the primary beneficiary of the financial inflow. The government can also use tax policy to capture parts of these inflows (and, perhaps, subsequently spend them).

> 9 See IMF (2005).

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