Fiscal Policy and Adjustment in a Foreign Exchange Constrained Economy: Evidence from Malawi

Most of the recent literature analysing the adjustments of macroeconomic variables to fiscal policy shocks rely on the inclusion of non-Ricardian households to generate a positive response of consumption to an increase in government spending. This paper examines the dynamic effects of government financing behaviour in a foreign exchange constrained low income economy on key macroeconomic aggregates such as output, consumption, wages and labour supply. Using a dynamic stochastic general equilibrium (DSGE) model with Ricardian households calibrated to Malawian data, we find that consumption, wages and labour supply increase with increased government expenditure. This is contrary to popular arguments that government expenditure is inversely associated with the private consumption of intertemporal optimizing households in DSGE models. We argue that the positive response of consumption to increased government expenditure arises from the inclusion of aid in the government budget since government expenditure in low income economies may rise with increases in aid inflows for a given level of taxes. We also show that a positive shock to aid relaxes the foreign exchange constraint and improves the economy although it induces an appreciation of the real exchange rate.