Essays on foreign aid, trade and fiscal policy

Satu Kristiina Kahkonen, University of Pennsylvania


The first essay shows that the commonly held view that a higher government debt is sustainable if it results from public investment than from public consumption is not necessarily true. Although it is widely held that the sustainable level of debt depends on the composition of government spending, the previous literature has not examined this issue in an optimizing framework. Using an overlapping generations model expanded by productive public spending it is demonstrated that increasing the share of public investment in total public spending may either increase or decrease the sustainable level of depth depending on the initial level of public debt and private capital in the economy, and on whether the increase in public investment raises primarily the marginal productivity of private capital or labor. Even though a large part of foreign aid goes to finance government budgets in developing countries, the existing literature has not studied how aid which is given to finance public expenditure affects welfare. The second paper analyzes in a two-country overlapping generations framework how a transfer which is given to finance either public investment or public consumption and made conditional on recipient's fiscal policy affects welfare in the donor and the recipient country. It is shown that a transfer for public spending may have paradoxical welfare effects. If the donor wants to raise welfare of both the current and future generations in the recipient country, it should give aid for public investment projects that raise the marginal productivity of labor. The third essay examines the combined effects of trade liberalization and government budgetary policies in an intertemporal optimizing trade framework. Unlike industrial countries, many developing economies rely on trade taxes as a source of revenue for the government. Therefore, since in practice lump sum taxes are not available, reducing tariffs forces the government to adjust either public spending or other distortionary taxes to balance the budget. The paper shows that gradual liberalization is superior to abrupt one, if the tariff and the public capital stock are initially small or if the country faces a foreign borrowing constraint.

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Recommended Citation

Kahkonen, Satu Kristiina, "Essays on foreign aid, trade and fiscal policy" (1992). Dissertations available from ProQuest. AAI9227691.