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Which countries receive aid as insurance and why? A theory of optimal aid policy

Ryan Banerjee

No 667, 2010 Meeting Papers from Society for Economic Dynamics

Abstract: Empirical evidence shows that developing countries with opaque institutions receive procyclical Official Development Aid (ODA) while developing countries with transparent institutions receive acyclical or countercyclical ODA. This paper provides a dynamic equilibrium model of optimal aid policy that quantitatively accounts for this fact. In the model, the donor wants to (a) encourage actions by the aid receiving government that increase output and (b) smooth out economic fluctuations. The transparency of institutions in the country affects the donor's ability to distinguish downturns caused by exogenous shocks, from those caused by government actions. The solution to the donor's mechanism design problem is dependent on the transparency of government actions. If the donor has good information about government actions, aid policy is countercyclical and aid acts as insurance. However, if the donor is unable to perfectly infer the cause of the downturn, aid policy is procyclical to encourage unobservable good actions. The model predicts a similar pattern for ODA commitments for the following year which is supported by the data. For countries with opaque institutions procyclical aid is the result of optimal policies given the information constraints of donors.

Date: 2010
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