_Absorption but not spending_ is a possible option in the short run, and simply substitutes financial inflows for domestic financing of the government deficit. This can be a useful strategy when the initial level of government deficit, and current deficit spending, is high, as it contributes to a stabilization of the debt level and consequently the economy.

_Spending but not absorbing_ is a more problematic response, and is similar to a fiscal stimulus in the absence of the financial transfer. Note here again that, in its nature, a transfer of international financial buying power to the receiving country is equivalent to a transfer of (or the right to purchase) international goods. When these goods are not purchased, the transfer is not made effective, at least not for the “time being”. Two different types of monetary policy can accompany this strategy. First, the central bank can leave the increased spending non-sterilized, thus leading to an increase in the money supply. An increase in the inflation rate is then a likely outcome. Secondly, the central bank can sterilize the primary money increase by sales of treasury bills. A typical outcome of the resulting monetary contraction is increased interest rates. This will typically reduce investment and then perhaps the economy’s long-run growth potential.

# **Box 1: Macroeconomic effects of scaling-up of aid in selected African economies**

Effects of some of these policy combinations discussed in the text, have been illustrated in a detailed IMF (2005) study of five African economies (Ethiopia; Ghana; Mozambique; Tanzania; and Uganda), for the years 1998-2003. See also Berg et al (2007) for further elaboration of some of the results.

During this period all five economies experienced “aid surges”, with general increases in aid by from about 3 percentage points of GDP (Tanzania), to about 10 percentage points (Ethiopia). Among these, Ghana neither spent nor absorbed; Ethiopia did not spend and only partly absorbed (20 percent); Tanzania spent but did not absorb; Uganda mostly spent (75 percent) and partly absorbed (27 percent); and Mozambique spent and mostly absorbed (66 percent).

Given the countries’ spending patterns, the effects of the “aid surge” in these countries **Specifically on macroeconomic effects of climate-related finance** were largely as expected, based on the analysis above. In Ethiopia and Ghana, where the aid on the whole was neither spent nor absorbed, aid had very little impact over the period of study. The only major impact was on reserves, which increased; pointing to positive future benefits. The three other countries largely spent their increased aid. None of them fully absorbed, but Mozambique most so. Inflationary pressure was still greatest in Mozambique, where the increased spending was accompanied by an increased money supply. In Tanzania and Uganda, monetary authorities increased the supply of government bonds to reduce liquidity, thus containing inflation. But this at the same time lead to a tighter money market, higher interest rates, and lower local investment. In all countries, concern for competitiveness of local industry was decisive for the decision not to absorb fully.

Surprisingly from the initial perspective of those conducting the study, in none of the five countries did the aid surge lead to a substantial real currency appreciation, and neither to a “Dutch disease” problem; these problems would have been expected to occur in the normal case of “spend and absorb”. The main reason, of course, was that in none of the five countries was this the chosen policy. Mozambique’s policy was closest to this pattern; but not even here was full absorption allowed, while excessive liquidity led to inflationary pressures and exchange rate depreciation. But it was clear that the very threat of a Dutch disease problem, together with an anticipation that the aid surge might be only 13 temporary, was a driving motivation behind the choice not to spend nor absorb, but rather to save.