Optimal Deficit and Debt in the Presence of Foreign Aid

Abstract

External revenue in the form of foreign aid constitutes an important component of the government’s budget constraint in many developing countries. We derive optimal public spending — and the resulting optimal deficit and debt — in an optimal control framework when the government seeks to maximize the utility of constituents in the presence of external revenue that cannot be influenced by the government directly but is contingent on public revenue and debt. We find that in this context, a policy of running budget deficits and accumulating debt becomes optimal. In simulations, we characterize the size and the path dependency of the optimal deficit and debt.

Keywords: ptimal budget deficits, optimal control, foreign aid, HIPC