Bachas 3-gap model: Public investment can be defined as the difference between government gross income (tax revenue,

T) and government consumption (G). Foreign investment can be defined as foreign savings, given by net capital inflows (F) minus net factor payments abroad (J). Assume full employment income (Y*), distinguishing private income (Yp*) and consumption (Cp), and a constant I !" (#incremental capital output ratio) (for the underlying relationship g # g(I)). ($) IS # Sp* % (T-G) % (F-J)

&here IS # savings constrained level of investment Sp* # private savings at full employment (Yp*-Cp) ('()) # )overnment gross Income As an increase in aid is e*uivalent to an increase in F foreign saving increases, +(F-J),-, and this permits an e*uivalent increase in investment (relaxes the IS constraint by the amount of the aid). 'he slope of IS with respect to (F-J), the responsiveness of the constraint to aid, is the partial derivative .IS/. (F-J) # $ (0) IE # ($/1)2E* % (F-J)3 where IE # foreign exchange (forex) constrained level of investment 1 # capital goods import content of investment (MK # 1 I) E* # net exports (given world demand) As ($/ 1) ,$, an increase in aid permits an increase in investment by more than the value of the aid (the imports are combined with additional domestic investment). For example, if an investment pro4ect of 5$--m re*uires imported capital of 56-m (1#-.6) and domestic resources (e.g. labour) of 50-m, 56-m of aid permits a 5$--m increase in investment, ($/ 1)#$.07, as long as the domestic resources re*uired to match imported capital are available. 'he slope of IE with respect to (F-J), the responsiveness of the constraint to aid, is the partial derivative .IE/. (F-J) # ($/ 1) , $. onse*uently, aid has a greater impact on forex( constrained economies than on savings constrained economies. Also, an increase in exports has the same impact as an increase in aid.

(8) IT # ($%9)2f(p,h) % (T-G) % (F-J)3 where IT # fiscally constrained level of investment 9 # interaction parameter: Ip # 9 Ig p # rate of inflation h # propensity to hoard cash Ip # private investment Ig # public investment

In this context 9 ;- implies crowding(out and 9 ,- implies crowding(in, i.e. complementarity between private (Ip) and public investment (Ig). For developing countries, especially the poorer ones (that are more li<ely to receive aid), one expects that public investment is needed

to provide the infrastructure to attract private investment so there will be crowding in. 'he function f(p,h) represents seignorage: if private investment is too low the government can print money, an inflation tax. 'his will increase inflation and discourage people from hoarding cash, hence savings increases. =owever, if inflation gets too high savings will be sent abroad (capital flight). Aid inflows can reduce the need for seignorage (which in turn can reduce the impact of aid). 'he effectiveness of aid in reducing the IT constraint will depend on the value of 9. 'he slope of IT with respect to (F-J), the responsiveness of the constraint to aid, is the partial derivative .IT/. (F-J) # ($%9) , $. 'his serves to highlight the importance of the impact of aid on investment, the relationship between private and public investment, and the relevance of government macroeconomic policy. As we have seen when analysing the causes for africas slow growth, not 4ust one, but all three of these constrains on Investment seem to be binding>. Figures $ and 0 (below) illustrate how aid alone may be insufficient to achieve a target investment (hence growth) rate in the presence of multiple constraints. For convenience we assume that the constraints are e*ual (intersect) initially, i.e. at the initial level of foreign savings (N0) the level of investment allowed by the constraints is I0 for both constraints. An in4ection of aid represented as a move from N0 to N1 allows an increase in investment which in turn permits higher growth, according to some function g(I). ?ote that policies that increase the productivity of investment (e.g. technology, private sector development, improvements in human capital and/or institutions) influence the effect of investment on growth, whereas we are here concentrating on the effect of aid on investment. 'he types of policy reform conditions associated with aid are usually intended to increase the productivity of investment, but may also affect the position or slopes of the investment constraints. ?ote finally that the point where the constraint intercepts the vertical axis represents the level of investment permitted if N # (F-J) # -. In other words, the position (level) of IS is given by Sp* % (T-G), the position of IE is given by E* and the position of IT is given by f(p,h) % (T-G). Figure $ depicts the IS (given by e*uation $) and IE (given by e*uation 0) constraints. As noted above, the slope of IS is unity (it can be drawn at a @7o angle from the horiAontal) whereas the slope of IE is clearly greater as ($/ 1) , $. Aid is given with the intention of attaining I* but the IS0 constraint is binding at d so only the constrained level of investment (IC) can be reached. 'he distance e-d implies that domestic savings at the level IS0 is too low to provide the re*uired matching of imported capital allowed by IE0. 'o meet the target I* it is necessary to shift IS0 to IS1, which means increasing Sp* or (T-G), so that the two constraints intersect at e. 'his demonstrates that aid alone may not be sufficient to achieve the target investment rate, although aid does permit increased investment: other policies or actions will be re*uired to relax the binding constraint (increasing private and/or public savings). ?ote that as aid typically finances G directly it will tend to have the effect of increasing public saving so I* can be met.

Figure 0 depicts the IT (given by e*uation 8) and IE (given by e*uation 0) constraints. As noted above, the slope of IT is ($%9) , $ and we cannot <now a priori if this is greater or less

than the slope of IE. In poor countries, public investment is li<ely to be essential to provide infrastructure (and human capital) to attract private investment, whereas the import content of physical investment is li<ely to be very high, so we assume ($%9) , ($/ 1) , $. Aid is given with the intention of attaining I* but the IE0 constraint is binding at a so only the constrained level of investment (IC) can be reached. 'he distance b-a implies that exports at the level IE0 are too low to provide the foreign exchange re*uired to support the investment allowed by IT0. 'o meet the target I* it is necessary to shift IE0 to IE1, which means increasing E*. 'his demonstrates that aid alone may not be sufficient to achieve the target investment rate, although aid does permit increased investment: other policies or actions will be re*uired to relax the binding constraint (trade liberalisation and/or export diversification). ?ote that if it is the IT constraint that is binding, one again re*uires policies to increase public or private savings (in this case, monetary policy). Finally, note that policy conditions associated with aid may affect the slopes of the constraints (e.g. promoting the private sector may increase 9).