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How does fiat currency help a country's economic growth? For example, if a certain country such as the U.S or Brazil gives 1billion dollars to a developing country like Angola or Congo, how does that money help build its economy? The fiat money we use today is an imaginary instrument. Federal Reserve prints 1 billion dollars and gives it to a developing country. How does that imaginary money, often in computer digits format, help improve the day to day life of the receiving country's people. It is just mind-boggling to think that if people receive money which is created from thin air, their life somehow improves. Can someone explain how all of this magic works in a most clear way?

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    $\begingroup$ Please clarify by answering this question: if you were given ownership of a bank account with 1 million US dollars (imaginary digital mone) that you can spend because stores/businesses accept it, do you think that would benefit you? Could you grow your assets? $\endgroup$
    – Giskard
    Oct 20 at 7:03
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How does that imaginary money, often in computer digits format, help improve the day to day life of the receiving country's people.

This is no magic trick. Of course, if recipient country would keep that foreign aid money locked in a museum as an art installation it would have no effect. However, money serve as a medium of exchange, people or organizations can exchange money for goods and services. For example, a country might use \$1 billion to improve nutrition by buying food and distributing it to the poor.

Even if the program is funded with newly created money which, ceteris pariubs, would lower their value the recipients would benefit, just the benefit in real terms would not be exactly equal to its nominal value.

How does foreign aid money help another country develop?

Foreign aid is actually highly controversial within the field of developmental economics so it is actually not clear at all if foreign aid money help, but this is for reasons having absolutely nothing to do with fiat money.

There are three main strands of literature when it comes to foreign aid:

  1. Foreign aid is harmful:

This is the view of scholars such as Easterly (2014) and Moyo (2010). It is argued that foreign aid fosters corruption in the country, since empirically a lot of aid money in many developing countries is spent on dubious projects that often help those with political connections rather than population at large. It is also argued that aid creates dependency. Next also aid represents a capital inflow to a country, this makes the currency of developing country more valuable as it causes it to appreciate. This might sound as a good thing, but in reality it hurts exports of the developing country, and leads to higher levels of unemployment in the short run.

  1. Foreign aid is not working because we did not spent enough:

The most prominent member of this camp is Stiglitz (2002). This camp basically argues that aid is on net beneficial and the previously mentioned drawbacks are overblown. It is argued that even if some of the aid money might end up in pockets of corrupt officials, it still funds programs that benefit people, and if we could just spend more on those programs it would help these countries develop faster.

  1. Foreign aid sometimes work and sometimes it is harmful so funding needs to be allocated on case by case basis by Randomized Control Trials (RCT)

This strand of literature is best represented by Banerjee and Duflo (2011) and Collier (2007). These authors basically argue that it is misleading to even try to answer the 'big question' of whether foreign aid works or not. They argue that sometimes it does and sometimes it doesn't. All aid programs should be evaluated and regularly re-evaluated using RCTs. Only programs where RCTs show substantial net benefit should be funded.

As mentioned earlier, there is no clear cut consensus among economists, so feel free to go over the sources cited in each of the three views and you can decide yourself which arguments make the most sense. However, as mentioned earlier, the literature on foreign aid does not consider fiat money a problem at all.

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  • $\begingroup$ Thank you for your thorough answer. I want to understand how the monetary system works in the world, so please bear with my questions. For the example, you gave, from where would the country buy the food from? From the neighboring countries? Why don't the central bank just print money and use that money to buy food instead of using the foreign aid money? What difference does it make when all fiat currencies are printed by the central banks? If we assume the foreign aid works, how does the money help build infrastructure when the recipient country could have used their own money to build it? $\endgroup$
    – Meraki
    Oct 20 at 15:31
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    $\begingroup$ @Meraki 1. From whoever is producing food, preferably if the recipient government is smart from whoever is producing it at lowest cost, no matter whether at home or abroad. 2. Foreign aid money is not necessarily newly created money but might be money gathered via taxation. If central banks adds more money to circulation that, ceteris paribus, lowers value of money. Just taxing some people and transferring that money to other, ceteris paribus, does not. 3. Even if that foreign aid money is fully just created by central bank out of nothing, that will lower value of the money but not to zero $\endgroup$
    – 1muflon1
    Oct 20 at 17:07
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    $\begingroup$ I will grossly oversimplify here, but value of money is determined by money market equilibrium which in many 101 econ textbooks is described as MV=PY. Now this is oversimplification for undergraduates in reality the equilibrium is more complex, but generally speaking value of money which is inverse of price level P will decrease when money supply M or velocity of money V increases and decreases when real output Y increases (you can see this by solving for P=MV/Y - and remember value of money is inversely proportional to P). Now if developing country like Argentina would try to increase M $\endgroup$
    – 1muflon1
    Oct 20 at 17:11
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    $\begingroup$ To pay for all these programs, given their output Y is very low and V is hard to control in short run, Argentinian pesos would quickly loose a lot of value. Their value would still not be zero so Argentina could fund some programs but then resulting inflation would have negative effect on the economy. However, for a country like USA, real output Y is so incredibly high that even creating 1 billion USD is literally drop in the bucket. Yes it will lower value of USD a tiny bit so in real terms the recipient country does not get full real value of 1 billion but in grand scheme of things that’s $\endgroup$
    – 1muflon1
    Oct 20 at 17:14
  • $\begingroup$ Not a big deal, and it would not result in damagingly high levels of inflation for the economy. But as explained previously even within fiat system there is no need for aid to be done with newly created money, if you are taxing and transferring inflation won’t be directly affected. 4. It does not make any difference whether countries have fiat money or commodity money or something else. That is completely inconsequential to this topic. Any money even gold money has its value determined by money market equilibrium the difference between let’s say gold and fiat is who controls the supply of $\endgroup$
    – 1muflon1
    Oct 20 at 17:19

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