Aid and Real Exchange Rate Dynanmics in Malawi

Aid and Real Exchange Rate Dynanmics in Malawi
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KDI School of Public Policy and Management
This study sought to determine the relationship between ODA and real effective exchange rate (REER) in Malawi by using time series data for the period 1980 to 2010. The Error Correction Mechanism was employed based on the time series properties of the data as well as the superiority of the technique in analyzing the dynamics during the transition from the short run to the long run. The regression results do not only support the Dutch Disease theoretical postulation that aid appreciates the REER in Malawi but also show that the observed REER overshoots its long run equilibrium level in the short run. In other words, a reduction in, or suspension of, ODA leads to a depreciation of Malawi’s currency and the adjustment to this depreciated equilibrium level will be volatile in the short run. The policy implication, therefore, is that both the donors and, most importantly, the Government of Malawi should moderate the REER volatility in the short and neutralize the aid-induced appreciation of the REER in the long run. To achieve this, Malawi may consider accumulating some reserves; improving the CAB by cutting on luxury imports and expanding exports; and offsetting the loss in competitiveness triggered by aid-induced appreciation of the REER by investing aid in areas that lower overhead cost of producing exports. On their part, donors ought to make ODA predictable through multi-year commitments while giving the government discretion on the sectors where to allocate the ODA to.
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Master's Thesis (2013)

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