The Macroeconomic Consequences of Remittances

Remittances play a large and important role in certain economies, where they may exceed 5% or even 10% of GDP. Indeed, remittance flows in certain nations exceed FDI in magnitude. In this paper we study the impact of remittances on a small open economy. Our model is a stochastic limited participation model with cash in advance constraints and costly adjustment of cash holdings. We examine the impact of remittances on the steady state of the economy and on the dynamic response of variables to shocks, including monetary shocks, technology shocks, and remittances shocks. We also examine the impact on dynamic responses to shocks of alternative specifications regarding the initial impact of a remittances shock on the economy. In particular we allow a monetary injection to be in the nature of a helicopter drop on households, thereby loosening the cash in advance constraint, or a helicopter drop on the financial intermediaries, providing an increase in the supply of loanable funds on impact. Remittances are modeled in a similar way, so that they may either flow to households as increased cash for purchases or flow to banks as additional deposits and increased lending potential. We find that a positive remittances shock forces the exchange rate to depreciate and lowers both output and the interest rate in the period of the shock, irrespective of adjustment costs on money balances, but increase output in the subsequent periods while consumption rises on impact. We also show that the positive shock expands the dynamic responses of the nominal interest rate, output and nominal exchange rate, but reduces the magnitude of the consumption response, as we allow for a larger proportion of remittances to go through the financial system for investment.