Monetary Policy Response to Capital Inflows in Form of Foreign Aid in Malawi

This paper estimates the Bayesian dynamic stochastic general equilibrium (DSGE) model and uses the model to account for the short-run monetary policy response to increased aid inflows in Malawi. The estimates reveal that the monetary authorities reacted to increased foreign aid inflows the same way as was experienced in other African countries. The model also suggests that there was non-existence of the threats of the ‘Dutch Disease’ in contrast to what was found in Mozambique. The country can continue to receive aid by targeting the supply side of the economy with an aim of improving the competiveness of the export sector. Evidently, the conduct of monetary policy performs better under the assumption of full accessibility of financial assets. In addition, the impact of aid inflows on depreciation and inflation are much smaller when monetary authorities indulge in money targeting other than following the Taylor rule and incomplete sterilisation. On the small note, the study suggests that actual spending of aid should be aligned with the actual absorption of increased aid. Nevertheless, the outcome of the aid effects has been clouded out by the limitation of the exchange rate management in Malawi.