ABSTRACT
In the previous chapter, it was assumed that the budget deficit was given and that foreign aid played no role in financing government budget deficits. In this chapter, unlike all other works in this area, budget deficits are endogenized. This is done by using an explicit optimizing model for a government’s fiscal behavior. This approach allows us to consider the implications of deregulation policies when the budget deficit is no longer fixed. Moreover, we introduce foreign aid into the government budget constraint. While there is voluminous literature on the relationship between aid, growth, savings and investment (see, for example, Gupta and Islam, 1983; Lensink, 1993a and 1993b; Mosley et al., 1987; Papanek, 1973; Riddell, 1987; and White, 1992a and 1992b, among others), there is virtually none about the role which aid might play in the success or failure of interest rate deregulation policies. This omission is rather strange given the fact that in the structural adjustment programs of the IMF/ World Bank the adoption of reforms of the financial sector including interest rate deregulation is a condition for the provision of concessional loans/aid. Using an extended version of the model in Chapter 2, we examine the implications of financial deregulation and foreign aid on investment.
