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Over the past few decades international workers' remittances have significantly contributed to the foreign exchange reserves of the developing countries. While these household level remittance flows have often been associated with poverty alleviation, positive welfare gains and even as an alternate source of development finance, a detailed study of the effects of these flows on a remittance-dependent small developing economy, however shows counterintuitive results. The paper applies the Dutch Disease theory to explain the effects of remittances on the economy and introduces a micro–macro framework to establish channels of transmission of remittances through the economy. The paper shows that international remittances, by altering the household budget constraint, have a direct impact on the micro level household decision making, primarily with respect to the consumption and labor supply decisions. These when aggregated give rise to significant adjustments in the macro level production functions and consumption behaviors, leading to a decline in the output, particularly of the trading sector and an adverse impact on the external sector of the economy.

The past few decades has witnessed a surge in international capital flows into the developing countries. This has motivated extensive research on examining the impact of these flows on these economies. While on the one hand these flows aid in economic advancements by cushioning balance of payment deficits, they also impart a sense of dependency in the economies, making them vulnerable to external shocks and crises. The studies on international capital flows often adopt a broad macroeconomic framework to explain the economic consequences of these flows on the recipient economies. Reinhart and Reinhart (2008) study the impact of capital inflow ‘bonanzas’ in both advanced and emerging economies during 1980–2007 for 181 countries and 1960–2007 for a subset of 66 economies from all regions. They found that such ‘bonanzas’ in developing countries are often associated with pro-cyclical fiscal policies and attempts to curb or avoid an exchange rate appreciation, and very likely contributing to economic vulnerability. In all the cases exchange rate appreciation turns out to be the most prominent outcome of international capital flows. High levels of capital inflows result in higher levels of domestic absorption, which bring about an appreciation in the exchange rates (Athukorala and Rajapatirana, 2003). One of the important sources of foreign exchange for the developing countries is the International Workers' Remittances. In the last two decades international remittances to the developing countries have increased by more than 300%. While the earlier literature on remittances mostly looked at the social development and welfare improvement effects of remittances, given its large scale, studies are now more focussed on the macroeconomic impact of these flows. This has paved the way for extensive research on the macroeconomic implications of remittances. In recent times, given the magnitude of remittances received by the developing countries vis-a-vis the GDP of the countries, researchers are skeptical about the developmental impact of remittances. The increasing magnitude of remittances causes a boom in the foreign exchange receipts of the country, which is similar to the ‘resource boom’ phenomena, giving rise to ‘Dutch Disease’ type of effects, i.e., increased remittances leading to real exchange rate appreciation, causing the tradable sector of the economy to collapse and hence resulting in a loss of external competitiveness of the country. This paper uses the premises of the ‘Dutch Disease’ Theory and situates itself in the context of developing countries. However, instead of looking at the direct implications of international remittances on the real exchange rate adjustments, the paper establishes the macroeconomic channels through which the effects of remittances get transmitted through the economy. Such an approach is essential while studying the impact of remittances precisely because remittances are household level flows. The macroeconomic effects of remittances primarily stem from two micro-decision making processes. Firstly, on the demand side remittances have a direct impact on the households' consumption behavior and, secondly, on the supply side they alter the labor supply decision of the households. Thus the paper explains the two channels of remittance transmission, i.e., the consumption channel and the labor channel, and eventually their impact on the economic growth. The analysis is divided in two parts. In the first part develops a general equilibrium model in the static framework to explain the transmission process and derives comparative statics for the decision variables with respect to a change in remittance inflows. In the second part the paper converts the static model into a dynamic model by constructing a dynamic stochastic general equilibrium (DGSE) model of the transmission mechanism and solves it for a small open remittance-dependent economy. The simulation results indicate that remittances give rise to Dutch Disease type of effect through two channels – the consumption channel and the inter-sectoral labor adjustment channel. In an economy with two-sectors, traded and non-traded, an increase in remittances leads to an increase in the consumption levels in both the sectors, this leads to an increase in the relative price of the non-traded sector, thus causing the labor to reallocate from the traded sector into the non-traded sector. This eventually leads to a fall in the output of the traded sector, causing the traded sector to contract and thus the country losing its external competitiveness. The paper is organized in seven sections. Section 2 explains the concept of resource boom and Dutch Disease in the context of international remittance flows. Section 3 provides the theoretical background of the model and explains the channels of transmissions in a static framework. Section 4 formulates the model in the dynamic framework and constructs a DSGE model, which is then simulated for the Bangladesh economy. The choice of Bangladesh as a reference country is motivated by two factors. Firstly, being one of the top ten remittance receiving countries, it fits into our framework of a small open economy, with remittances as an important source of foreign exchange transfers. Secondly, apart from being a small economy, Bangladesh economy is also quite homogenous in terms of the industries. This makes it possible to distinctly divide the economy into traded and non-traded sectors, and increases the generalizability of the model across all developing countries with similar dependence on remittances. Section 5 highlights the role of international remittances in Bangladesh economy. Section 6 then estimates the model using Bayesian calibration method and generates the impulse response functions of the macro parameters to a shock in the remittances. Section 7 summarizes the paper and highlights the policy conclusions for managing and absorbing international remittance flows.

The paper examines the macroeconomic effects of remittances in a general equilibrium framework. It uses the Dutch Disease framework and establishes the macroeconomic channels through which the effects of remittances get transmitted through the economy. Unlike the other forms of international capital flows, international remittances, primarily originating at a household level, have indirect effects on the macroeconomic parameters. These indirect effects are channelized into the economy through the consumption and labor supply decisions of the households. The paper proposes that for a small open remittance-dependent developing economy, with two distinct sectors of production – tradables and non-tradables, international remittances create an inflationary pressure on the economy, which is felt mostly by the non-traded sector as the price levels in the non-traded sector go up. However, prices for the traded-sector, being pegged at the world market level, remain the same. Thus an increase in the relative price of the non-traded to traded good causes the labor to move out of the traded sector production towards the non-traded sector production. Hence in the longer term this leads to an expansion of the non-traded sector, while the traded sector contracts. Thus the study, instead of using real exchange rate appreciation as an indicator of Dutch Disease, takes a sectoral approach to explain the underlying mechanism leading to the Dutch Disease effects. The main objective of the study is to introduce the micro-foundations of remittances, in the form of households' decision making, in the general equilibrium model of the remittances. Thus the study uses household consumption optimization framework and explains the effect of remittances on the households' consumption and labor supply decisions, and their impact on the aggregate macroeconomic parameters. The model is developed in both static as well as dynamic framework. The static framework explains the interaction between remittance flows and the various economic decision variables, and also gives us an indication of the direction and type of association between household decision variables to a change in remittances. The dynamic formulation on the other hand, gives the process of transmission and shows how different macroeconomic parameters respond to sudden shocks in remittances. The impulse response analysis highlights the fact that a sudden increase in foreign remittances results in a fall in the labor supply to the traded sector and a decline in the output in the traded sector. The findings from the paper thus present a nuanced view on the effects of remittances on the economy. While it does not disagree with the fact that remittances have a strong positive impact on the current account and instantaneously improve the balance of payment deficit of a country, it also highlights the fact that remittances may lead to real exchange rate appreciation in the country, leading to sectoral production re-allocation. Thus, while the effects of a single shock of remittance increase may converge to equilibrium in the long-run, multiple shocks in remittances may take the economy in a negative growth path, primarily resulting from a weakening of the traded sector and loss in the external competitiveness of the country. To prevent the country from slipping into such a negative growth path, appropriate policy measures are required such that these flows are better absorbed in the economy. Historically, the policies for remittances have primarily targeted towards promoting labor migration and encouraging more remittances through formal channels. However, until there are appropriate avenues for absorption of these flows in the economy, the true potential of the transfers cannot be realized. Thus the policies should also be targeted towards the absorption and utilization of remittances in the economy. The policy framework adopted should encourage a more ‘productive usage’ of remittances by creating a conducive environment for investment in the country. 7.1. Utilization of remittances Utilization of remittances has always been the issue of contention. It is often observed in the case of developing economies that most of the remittances are used towards the purchase of food, clothing, education, health and real estate and very little is targeted towards ‘productive usage’. While the day-to-day spending can also be viewed as investment in human capital and increased future productivity, these positive effects are contingent on continuous flow of remittances over a long period of time. The ‘productive usage’, on the other hand, increases the household income by inducing self sufficiency in the households, either through improving traditional economic activity like agriculture or introducing the households to new business activities. Thus it is important to devise initiatives to target proper channeling of the remittance flows. In the case of a developing country there are various factors which act as hindrance for investments in these countries. By investment here we mean investment in bonds or other saving avenues specifically designed for migrants, or private investment in business and other small and medium scale industries. One of the major factors is lack of promotional support in terms of information, advice and training related to potential areas of investment. In Bangladesh, for example, the lower income diaspora do not invest as remittances mostly cater to their basic financial needs, while high income diaspora lack the knowledge and access to investment possibilities (Bruyn and Kuddus, 2005). Similarly, in the case of the Philippines, most of the remittances are spent on food, followed by housing and children's education, and not much gets into productive investments. Thus the need is, firstly, provide for the basic welfare of the households in order to prevent remittances from being frittered away in day-to-day expresses, and secondly, to create appropriate investment opportunities, specifically catering to the needs of the migrants. One way to do this is by creating more financial awareness within the migrant households such that remittances are invested in financial capital, which can then be channeled into credits for productive investments (UN-INSTRAW, 2008). 7.2. Management and absorption of remittance inflows Banking and other financial services play an important role in managing and absorbing these flows in the economy. An appropriate framework helps in reducing the cost of remitting, encouraging more remittance through official channels. Also different deposit options with banking institutions, specially catering to the needs of the migrant households also promotes saving from remittances, which then can be channelized to productive uses, not only by the migrant households but also the non-migrant households. Apart from banking institutions, public institutions also play a significant role in the absorption process. They promote individual entrepreneurship through orientation programs and training, which lead to human capital formation. They also play a role in modifying structural conditions that may represent obstacles to investment. To sum up, the role of banking institutions and public institutions should primarily be to create alternative income generating opportunities, reduce remittance dependency of the households and hence promoting long term sustainable growth. 7.3. The structure of the economy The structure of the economy also plays an important role in determining the effects of remittances. As suggested by the theoretical model, one of the outcomes of increased remittances is a decline of the traditional sector of the economy, which usually is the export competitive sector. This happens primarily because the traditional sector is usually labor intensive and with increased remittance inflows, labor moves out of this sector, creating a lack of productive capacity in the sector and hence a contraction of the sector. Such an outcome can be avoided by diversification of the tradable sector. If the export basket is more diversified such effects can be mitigated.