The macroeconomic effects of foreign transfers in the recipient country have been widely debated; however, results attained from empirical studies are quite mixed. The subject that received most attention is whether foreign transfers do have some unintended consequences such as causing the real exchange to appreciate that could result in the contraction of the export sector or whether they intensify inequality. In an effort to contribute to these discussions this dissertation studies a dynamic two-sector developing economy model where the transfer receiving country is assumed to be financially constrained. The government can choose to use the transfer as a means to provide an income support (pure transfers) but also to increase the productivity of either the traded sector or that of the nontraded sector (productive transfers).

Chapter 1 emphasizes the tradeoffs arising between real exchange adjustments, long-run capital accumulation, and economic welfare, associated with alternative forms of transfers. While a pure transfer does not affect the long-run real exchange rate, productive transfers do generate permanent real exchange rate adjustments, given capital is perfectly mobile between sectors. The traded sector shrinks most when in fact the real exchange rate depreciates, the long-run welfare gain of transfers is maximized with pure transfers and long-run capital accumulation is maximized if transfers are used to enhance the productivity of the nontraded sector. Overall the effect of the transfer on the aggregate economic performance depends crucially upon the relative capital intensities of the two productive sectors, the allocation of the transfers across the sectors and access to world financial markets.

Chapter 2 focuses on how foreign transfers influence the distribution of wealth and income. Wealth inequality decreases most when transfers are invested towards the nontraded sector. After-tax income inequality decreases most with pure transfers and it would decrease even further with improving access to world financial markets.

Chapter 3 examines the role of flexible labor supply in explaining the impact of foreign transfers on the macroeconomy. Once accounting for the labor-leisure choice, large variations are found in the responses of key macroeconomic variables, but only with pure transfers.