The Effectiveness of Foreign Aid on Economic Growth

The effectiveness of foreign aid on economic growth is a topic that is widely disputed. There is extensive and compelling literature that argues for and against its effectiveness. There are significant policy implications for... [ view full abstract ]

The effectiveness of foreign aid on economic growth is a topic that is widely disputed. There is extensive and compelling literature that argues for and against its effectiveness. There are significant policy implications for donor governments when making allocation decisions for foreign aid. Much of the debate on the effectiveness of foreign aid on economic growth looks at the economic policies in place and the political environment of the receiving countries. This paper analyzes the effect foreign aid has on economic growth in developing countries based on the increase in per capita annual GDP growth. It also examines if economic policies and the political environment inhibit the impact of foreign aid.

The theoretical model for this study is based off of the model used by Mosley (1980). The theory follows that developing countries grow at a rate determined by the country’s marginal propensity to save and its capital-output ratio. The model assumes that countries would experience an increase in growth when aid is added to the equation. The empirical model used for this analysis is based on the models used by Burnside and Dollar (2000) and Ghura and Hadijmichael (1996). The study runs both an OLS regression as well as a fixed effects model. The fixed effects model controls for differences among countries and years. Similar to these studies, this analysis includes an interaction term between policy and aid. The interaction term analyzes the validity of the assumption that the effectiveness of aid in the growth process is directly dependent on the quality of economic policies. The analysis examines the years 1980-2015 and uses data from the World Bank.