The Economics of Foreign Aid Lecture 1 Aid and Growth

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The Economics of Foreign AidLecture 1 Aid
and Growth

• Justin Sandefur
• Weeks 7 8, HT 2006
• Economics of Developing Countries Option

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Overview of Lectures

• Introduction
• Quantities
• Modalities
• Motivations
• Aid Growth
• Models
• Empirical Evidence
• Next week Political Economy of Aid

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Quantities

• To support the changes that have begun in
  Africa, we call for an additional US25 billion
  per year in aid, to be implemented by 2010.
  Donor countries should commit immediately to
  provide their fair share of this. Subject to a
  review of progress then, there would be a second
  stage, with a further US25 billion a year to be
  implemented by 2015.''
• Report of the Commission for Africa, p. 16

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Quantities Donor Perspective
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Quantities Recipient Perspective
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Modalities

• Program/Project Aid. Dams, roads, energy
  provision, industrial production.
• Technical Assistance knowledge transfer,
  consulting, provision of personnel and concrete
  problem solving
• Social Sector Support primary education, basic
  health, HIV/AIDS programs, etc.
• Food Aid subsidized, imported grain.

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Motivations Who gives to whom?

• Alesina Dollar (2000), differences in aid
  receipt across countries mostly explained by
• Colonial loyalties
• Strategic considerations (UN voting patterns)
• Over time, aid tends to benefit democratization,
  less so trade openness
• Poverty is a significant determinant, but
  sensitivities vary by donor.

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Part II Aid and Growth

• Harrod Domar model and the financing gap
• Solow model and decreasing returns
• Empirical evidence on aidgtinvestmentgtgrowth
  links.
• Aid x Good Policies Growth?

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Simple algebra of Harrod-Domar

• Output is proportional to capital by a constant
  (the ICOR)
• which yields a growth equation in terms of
  investment
• Note the absence of labor, human capital

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Harrod-Domar algebra

• Investment composed of savings, private foreign
  inflows, and aid.
• Plug this into our growth equation to get

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Harrod-Domar algebra

• We can rearrange our growth equation to find aid
  requirements
• A made up example 7 growth target for Ghana 6
  savings ICOR 3.5 9b GDP
• (7 x 3.5 x 9b) (6 x 9b) 1.6b AID

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Harrod-Domar Suspect assumptions

• There is a stable, short run, proportional
  relationship between investment and growth.
• (this relationship is constant over time and
  invariant to the level of investment no
  decreasing returns to capital)
• Aid increases investment one-for-one

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Aid in the Solow model

• Departure from Harrod-Domar in the very first
  line decreasing returns
• Continuity with Harrod-Domar in that the focus is
  still on capital. Aid still matters only in that
  it contributes to investment.

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Solow model with aid preparing to meet the data

• Solve out for growth following MRW (see Hansen
  and Tarp on reading list)
• We claimed that aid enters as investment, so test
  this as well
• Combine to get

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Empirical Results

• See Hansen Tarp (2000) for a nice summary.
  According to most published empirical
  cross-country work
• Does aid crowd out savings?
• Yes, but not completely
• Does aid increase investment?
• Yes, but less than one-for one
• Does aid increase growth?
• Yes, but estimates of how much differ. Strong
  evidence of decreasing returns.

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The interaction of aid policies

• Burnside Dollar (2001) ask to what extent the
  failures of aid effectiveness are due to bad
  policies?
• Regress growth on aid, policies, and the
  interaction between the two
• Good policies defined as low inflation,
  deficit, and trade openness.

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Raw correlation b/n aid growth
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Marginal effect of aid (1GDP) on growth in
varying policy environ.
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Reason for doubt about DB
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Taking Burnside Dollar seriously

• If aid only works in a good policy environment,
  how should we allocate aid?
• Collier Dollar (2002) compute a poverty
  efficient aid allocation on the basis of the
  Burnside Dollar (2001) results
• Selectivity allocate aid to poor countries (as
  opposed to allies, etc.) with good policies
  already in place (as opposed to funding reform
  efforts).

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Poverty-efficient aid allocation
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Poverty-efficient aid allocation
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Key assumptions underlying Collier Dollar
allocation

• Impact of aid on growth depends on the policy
  environment
• Aid is fungible
• Conditionality doesnt work
• Growth is good for the poor (and policies which
  are good for growth are good for poverty
  reduction)
• Reasonable assumptions? Come back next week