Review paper on

AID VOLATILITY AND POVERTY TRAPS

Pierre-Richard Agénor and Joshua Aizenman

Submitted by
Md. Sohag
Student ID.: MDS-091518

Submitted to
Sheikh Sharafat Hossen
Course Instructor
MDS programme, Khulna University

Date of Submission: 8 January, 2011

 Aid Volatility and Poverty Traps
Pierre-Richard Agénor and Joshua Aizenman

Agénor P.R. and Aizenman J.(2009), studied the impact of aid volatility on economic
performance in African nations. They have prepared their model based on simple two-
period data with traditional and modern technologies. In their research they found that, an
increase in aid volatility raises the optimal tax rate and that if expected future aid is
dependent on the size of the contingency fund, the optimal policy may entail no self
insurance.

The possibility of a stagnation equilibrium or poverty trap is defined as a state where

second- period production continues to be carried out with the traditional technology and
public spending is assume to be productive and “time to build” requires expenditure in
both periods for the modern technology. High aid volatility is first examined in a
benchmark case where taxation is absent. Government spending whose sole purpose is to
provide productive services is thus financed in its entirety by aid.

Agénor and Aizenman proposes three important proposition as a findings of their

research-
Proposition 1: High aid volatility, by reducing expected private profits associated with the
modern technology and the social surplus, may lead to a poverty (or low output) trap.
Proposition 2: An increase in aid volatility raises the optimal tax rate.
Proposition 3: If existence of a contingency fund creates a moral hazard problem, the
optimal tax rate is lower than otherwise.

Agénor’s and Aizenman’s research has several broad implications. The first is that aid
volatility may not only potentially exacerbate the impact of macroeconomic shocks but it
may also contribute to the emergence, or persistence, of a poverty and low-output trap if
aid exerts productive effects either directly or through its impact on public spending. The
second is that although an increase in aid volatility may call for an increase in tax rates, in
practice these increases may not be feasible, due to various administrative and political
constraints. Aid volatility may therefore hamper resource mobilization. Finally, they doubt
on commonly suggested policy response to aid volatility–the buildup of a contingency or
buffer fund; typically in the form of accumulation of international official reserves. The
very existence of such a fund may lead donors to change their behavior in terms of future
aid commitments–which in turn would reduce the recipient’s incentives to raise taxes,
“save for a rainy day,” and maintain government spending plans at the desired level to
spur growth. The extent, to which these adverse moral hazard effects on individual donor
behavior can be mitigated through greater donor coordination, or a common external
agency, remains a matter for debate.

My comment
There are huge literature focusing on Volatility, growth and poverty, but Agénor and
Aizenman are the first who successfully make effective research on “Aid Volatility and
Poverty Traps”. Their three basic proposition based on findings of their research creates
new avenue of research regarding Aid and poverty issues. Besides this, the outcome of this
paper provide a alarming call to policy maker of Aid receipt country’s like Bangladesh as
Aid volatility, poverty trap and moral hazard are causally related.

This paper has few limitations; it is a theoretical research and there is little empirical
investigation to prove the objective of this paper. Panel estimation on “Aid Volatility and
Poverty Traps” will create more valid ground to support the result.