It is often argued that aid to developing countries may be a mixed blessing, or indeed no blessing at all. This issue was very much at the forefront of development economics in the 1950s and 1960s. In particular, Hollis Chenery and his collaborators developed the "Two-Gap Model' to investigate the effectiveness of aid under different macroeconomic conditions or "regimes'. In Discussion Paper No. 46 Research Fellow Sweder van Wijnbergen analyzes the macroeconomic aspects of the welfare effects of foreign aid. His analysis focusses on the key role of real exchange rate misalignment in a disequilibrium model, but he links his results to the earlier discussions of the two-gap model. He also draws a parallel with more recent research on the "Dutch disease' which focusses on the economic impact of natural resource discoveries.
Van Wijnbergen uses a simple short-run model of an open economy. Disequilibrium can occur in the model because of rigidities in wages and prices. Van Wijnbergen analyzes two forms this disequilibrium can take, a "Classical' and a "Keynesian' regime, In the "Keynesian' regime there is an excess supply of home (or non-traded) goods and downward pressure on the real exchange rate. In the "Classical' regime there is an exess demand for home or non-traded goods and upward pressure on the real exchange rate.
What is the effect of aid inflows in these two situations? Substantial but temporary aid flows lead to an appreciation of the real exchange rate and therefore to a decline in home production and export of internationally traded goods. Van Wijnbergen argues that aid increases the social costs of wage and price rigidities in the Classical regime but reduces them in the Keynesian case.
Why do the effects of aid differ in this way? In the Keynesian regime, the actual exchange rate is higher than it would be in equilibrium. Aid inflows increase the underlying, equilibrium exchange rate - that which would clear the market for non-traded goods. Therefore the discrepancy between the actual and the equilibrium real exchange rate goes down. The benefits of aid are augmented in this case, because the aid counteracts the distortions which result from wage and price rigidities. In the Classical regime, however, the actual exchange rate is below the equilibrium rate, and there is an excess demand for non-traded goods. In this situation, the inflow of aid increases the equilibrium exchange rate, moving it further from the actual exchange rate. This increases the distortions present in the economy and reduces the welfare benefits of the aid.
Van Wijnbergen provides simplified formulae for the welfare effects of aid in these two regimes. These simplifications should make it practical to apply his analysis to realistic policy questions.

Macroeconomic Aspects of the Effectiveness of Foreign Aid:On the Two-Gap Model, Home Goods Disequilibrium and Real Exchange Rate Misalignment
Sweder van Wijnbergen

Discussion Paper No. 45 (IT)