Does Foreign Aid Increase Foreign Direct Investment?

Pablo Selaya and Eva R. Sunesen
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Eva R. Sunesen: Department of Economics, University of Copenhagen

No 08-04, Discussion Papers from University of Copenhagen. Department of Economics

Abstract: The notion that foreign aid and foreign direct investment (FDI) are complementary sources of capital is conventional among governments and internationalcooperation agencies. This paper argues that the notion is incomplete. Within the framework of an open economy Solow model we show that the theoretical relationship between foreign aid and FDI is indeterminate. Aid may raise the marginal productivity of capital by financing complementary inputs, such as public infrastructure projects and human capital investment. However, aid may also crowd out productive private investments if it comes in the shape of physical capital transfers. We therefore turn to an empirical analysis of the relationship between FDI and disaggregated aid flows. Our results strongly support the hypotheses that aid invested in complementary inputs draws in foreign capital while aid invested in physical capital crowds out FDI. The combined effect of these two types of aid is small but on average positive.

Keywords: foreign aid; foreign direct investment (FDI); open economy Solow model (search for similar items in EconPapers)
JEL-codes: F21 F35 H40 O19 (search for similar items in EconPapers)
Pages: 17 pages
Date: 2008-02
New Economics Papers: this item is included in nep-dev
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Citations: View citations in EconPapers (14)

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Journal Article: Does Foreign Aid Increase Foreign Direct Investment? (2012)
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