All the Conditions of Effective Foreign Aid
D.S. Prasada Rao,
Derek Headey () and
No WP042004, CEPA Working Papers Series from University of Queensland, School of Economics
The conclusion that foreign aid will promote economic growth only when allocated towards good policy regimes has been the subject of considerable debate. Aid effectiveness researchers have variously sought to falsify this result or to find other individual conditions of aid effectiveness. However, economic theory suggests that any factor which influences the expected returns to investment may influence the effect of aid on growth even when aid is partly diverted to consumption. To investigate this hypothesis, ï¿½allï¿½ of the hypothesized conditions of aid effectiveness are individually tested in a cross-country growth specification. From these tests the most significant and robust individual interactions are simultaneously modeled, thereby deriving multiple conditions of aid effectiveness. The paper concludes that aid is more effective in economies experiencing economic shocks or recovering from war, and less effective in countries which are geographically disadvantaged or at war. We also find a previously unidentified condition of aid ineffectiveness: the inflow of foreign direct investment. This finding renews a justified interest in the policy-aid-growth nexus, insofar as domestic policy determines the distribution of aid and FDI flow, which appear to act as substitutes in the growth process.
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