Is There a Case for Sterilizing Foreign Aid Inflows? Alessandro Prati, Ratna Sahay, and Thierry Tressel 1 July 14, 2003 Preliminary draft Abstract This paper presents evidence that aid inflows can cause a significant but small real exchange rate appreciation and develops a theoretical model to identify the conditions under which a policy that prevents the real appreciation by sterilizing the base money effect of aid improves welfare. The empirical results are based on a real exchange rate measure that uses black- market nominal exchange rates in place of official rates for all countries with dual exchange rate systems. We also use a country-specific export-weighted commodity price index to control for terms of trade shocks and country-specific trends to capture the possible effect of productivity growth. A doubling of ODA flows is estimated to cause a real appreciation of up to 4 percent at impact which could increase to about 18 percent after 5 years. Sterilization policy is found to be quite effective in preventing real appreciation. In the theoretical open economy model, we assume that aid cannot be saved directly, the capital account is closed, and there is a learning-by-doing externality in the tradable sector. In this framework, monetary policy has permanent effects on real variables and sterilization can increase national savings by leading to an accumulation of international reserves. Sterilization increases welfare whenever aid is too front-loaded (i.e., its Dutch disease costs are greater than its consumption and productivity benefits) and the economy is better off saving part of the aid for later use. Sterilization can, instead, reduce welfare when the consumption and productivity benefits of aid are large relative to its Dutch disease costs. The case for sterilization is also weaker when aid is in the form of grants rather than loans or sterilization crowds out private investment. 1 Research Department, International Monetary Fund, 700 19 th street N.W., Washington DC 20431. E-mails: aprati@imf.org , rsahay@imf.org , and ttressel@imf.org . We thank, without implication, Tito Cordella and Olivier Jeanne for useful comments. The views are those of the authors and do not necessarily represent those of the IMF or IMF policy.