What Do Remittances Do? Analyzing the Private Remittance Transmission Mechanism in El Salvador

Abstract

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.Family remittances are important for El Salvador's economy. This paper analyzes the impact of remittances on El Salvador's economy and the spillover effects on the other Central American countries. A vector autoregression (VAR) model is formulated, consisting of real and monetary variables. The results suggest that in, El Salvador, remittances lead to decreases in economic activity, international reserves, and money supply and increases in the interest rate, imports, and consumer prices. This underscores the need for reorienting economic policy in El Salvador to promote the use of remittances in capital formation activities to maximize the benefit of remittances.

The Macroeconomic Consequences of Remittances

“…These findings are reflected in our model through the liquidity effect. In terms of the effect on the real exchange rate, the dynamics indicate a muted effect on impact (the percent deviations in inflation and the exchange rate are identical) but a real exchange rate appreciation thereafter, as suggested by Amuedo-Dorantes and Pozo [4], Cáceres and Saca [10], and Acosta et al [5].…”

“…However, our results for output, and investment, are more controversial. While most empirical studies find an initial decline in output (Cáceres and Saca [10] and Funkhouser [6]) followed by a temporary recovery (World Bank [36] and Barajas et al [17]), our prolonged drop in output can be explained by the sustained decline in labor; an almost permanent increase in remittances generates a very persistent decline in work effort.…”

“…With regards to the effect on consumption, only microeconomic studies are able to measure the positive contribution to the consumption of the remittances-receiving households (Keely and Tran [32], León-Ledesma and Piracha [33], and De Haas [34]), with macroeconomic studies only suggesting that remittances increase consumption (Ratha [35], Cáceres and Saca [10], and Chami et al [8]). Our paper strengthens this link by showing that remittances channeled for consumption do in fact increase consumption.…”

“…Closing the Model. Since we are modeling a small open economy with international assets freely traded, the noarbitrage condition leads to the uncovered interest rate parity condition (UIP)-by combining (8) and (10). Remittances are modeled to be partially exogenous to better identify the effect of these transfers from abroad on the recipient economy.…”

“…While recent research has shed some light on their potential influence on consumption and inflation (Narayan et al [2] and Vacaflores [3]), on the exchange rate and trade competitiveness (Amuedo-Dorantes and Pozo [4] and Acosta et al [5]), on labor supply (Funkhouser [6], Hanson [7], Chami et al [8], Acosta et al [5] and Jansen and Vacaflores [9]), on economic growth (Cáceres and Saca [10] and Osili [11]), and on policy responses (Chami et al [8], Mandelman [12] and Vacaflores [3]), little attention has been placed on the potentially different effect that remittances shocks can have on the main macroeconomic aggregates depending on the distribution of remittances between consumption and investment, on the relative importance of remittances as a share of GDP, and on its relative importance in terms of income.…”