3 current account deficit rise by the magnitude of the aid inflow. In the latter case, aid is fully absorbed, the resource transfer from abroad to the recipient economy is complete, and the RER is likely to appreciate by little, if anything. By contrast, if aid is fully spent by the government on non-traded goods (for example, labor-intensive social services or reconstruction of domestic infrastructure), absorption of aid is very limited (the non-aid current account changes by little), but the RER is likely to appreciate significantly.

The other extreme choice for the government is not to spend aid but to save it, by building up its net asset position, which typically is weak after the end of conflict. In this case, the government can use aid by increasing its own or the central bank’s international reserves or by reducing public-sector debt. Debt reduction can be implemented by amortizing outstanding public debt or reducing new debt flows – in both cases the government uses aid to strengthen its debt position, avoiding an increase in government spending or a reduction in government revenue. If the government decides to increase international reserves or reducing foreign debt, the RER appreciates by little, if anything. However, if the government uses foreign-currency aid to pay back domestic-currency denominated domestic debt – an operation equivalent to a central bank sterilized forex intervention – the corresponding private-sector portfolio shift could lead to RER appreciation.

The latter description is simple because it abstracts from an explicit discussion of privatesector reaction, financial-market features, and monetary and exchange-rate policy considerations.<sup>8</sup> However, it identifies the main factors that determine the RER response to government use of foreign aid: spending vis-à-vis saving, the sector composition of government spending, and the currency composition of public saving. RER appreciation will be larger the more governments spend, the larger is the share of spending falling on non-traded goods, and the larger is the share of public-sector saving falling on net domestic-currency assets.

The RER appreciation leads to private-sector expenditure switching from traded to nontraded goods and resource allocation from traded to non-traded production sectors, further widening the current-account deficit. Resource allocation may be slow and costly, leading to temporary but protracted reduction in aggregate output and employment. The decline in exports and traded-goods production due to the loss in international competitiveness may lead to lower productivity gains – often concentrated in tradedgoods activities and particularly in export sectors – lowering economic growth. This result – termed Dutch disease – has often been associated to commodity price booms but may also be observed during post-conflict aid surges – a central issue of this paper.

> 8 IMF (2005) and Aiyar et al. (2005) provide a discussion of the accounting features and qualitative aspects of the macroeconomics of foreign aid. The appropriate way to analyze the macroeconomics of aid is by using a dynamic general-equilibrium framework, with explicit modeling of endogenous private sector expenditure, resource-allocation, and portfolio reactions to government spending and saving decisions in response to aid, giving rise to endogenous determination of the current account, the real exchange rate, domestic interest rates, risk premiums, and portfolio composition, as well as all relevant sector prices and quantities. Moreover, a general equilibrium framework is also the suitable way to address the problems of aid additionality and resource fungibility, by allowing to spell out explicit counterfactuals. However, a full general-equilibrium framework is well beyond the scope of this paper.