on the policy response of the country, which can be examined along two distinct concepts: absorption and spending.<sup>2</sup> Absorption is defined as the extent to which a country’s non-aid current account deficit widens in response to increased aid flows.<sup>3</sup> This reflects the increase in imports related to higher aid attributable both to higher direct imports by the government as well as higher imports triggered by increases in private and other government spending due to aid. The level of absorption is controlled by the central bank that decides on the amount of foreign exchange to be sold. The interest rate policy constitutes another control mechanism through its influence on aggregate demand and therefore private imports. The possible extreme cases are full absorption, where all foreign exchange associated with the aid increase is sold for domestic currency, and no absorption, implying that aid is fully used to increase the level of international reserves.

**Table 1:** Combinations of spending and absorption in response to increased aid

||**Aid not spent**|**Aid fully spent**|
|---|---|---|
|**Aid not**<br>**absorbed**| Foreign exchange not sold<br> No increase in government expenditure<br> Higher level of foreign reserves<br> No impact on the aggregate demand, no<br>pressure on exchange rate or prices| Foreign exchange not sold<br> Increase in government expenditure without<br>using the aid received<br> Higher level of foreign reserves, larger non-aid<br>fiscal deficit<br> Option 1: Increase in money supply, leading to<br>higher inflation and lower private demand<br> Option 2: Sterilization of fiscal expansion with<br>government securities, leading to higher<br>interest rates and crowding out of the private<br>sector|
|**Aid fully**<br>**absorbed**| Foreign exchange sold<br> No increase in government expenditure<br> Option 1 – inflation stabilization: slower<br>growth in money supply, real exchange rate<br>appreciation and lower inflation, increase in<br>aggregate demand<br> Option 2 – use of proceeds from aid for<br>reduction of domestic debt stock: increased<br>private consumption and investment and net<br>imports,real exchange appreciation| Foreign exchange sold<br> Increase in government expenditure without<br>using the aid received<br> Non-aid current account deficit widens, larger<br>non-aid fiscal deficit<br> Some exchange rate appreciation possibly<br>required to generate increased imports|

Spending is defined as the widening of the government’s non-aid fiscal deficit related to an increase in aid.<sup>4</sup> In response to higher aid, the government can either increase expenditure, reduce taxes, or both. It can also decide not to spend the additional resources, thereby keeping the nonaid fiscal deficit unchanged. Higher aid-driven expenditure can be used on imports or domestically produced goods and services.

> 2 This section draws primarily from Gupta et al. (2006) and Berg et al. (2007).

> 3 Absorption=  Non-aid current account deficit/  Aid. An increase in aid can lead to a combination of three effects: an increase in the level of reserves, a widening of the non-aid current account deficit and an increase in non-aid capital outflows. This is based on the balance of payments identity, that current account plus capital account equal the change in foreign reserves. The non-aid current account balance is the current account balance excluding official grants and interest on public external debt and the non-aid capital account balance is the capital account balance excluding aidrelated capital flows (amortization, loan disbursement etc.). For a more detailed description see Berg et al. (2007).

> 4 Spending =  Non-aid fiscal deficit/  Aid. The non-aid fiscal deficit is defined as total expenditure excluding external interest payments minus domestic revenue.

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