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Foreign Aid, Public Spending, Optimal Fiscal and Monetary Policies, and Long-Run Growth

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Author Info

  • Liutang Gong

    (Guanghua School of Management, Peking University
    Institute for Advanced Study, Wuhan University
    Development Research Group, The World Bank)

  • Yuzhe Zhang

    (Department of Economics, the University of Iowa)

  • Heng-fu Zou

    (Guanghua School of Management, Peking University
    Institute for Advanced Study, Wuhan University
    Development Research Group, The World Bank)

Abstract

This paper presents a group of models showing the strikingly different implications of foreign aid to the private sector and public sector. In the first model, with decentralized decision-making and without optimal choices of fiscal policies on behalf of the government, foreign aid to the private sector has no effect on the long-run capital accumulation and it raises private consumption one to one; whereas foreign aid to the government leads to more public spending and higher private capital accumulation. In another model with optimal choices of both fiscal and monetary policies, foreign aid to the private sector gives rise to higher inflation and income taxation. Although aid to the private sector raises private money holdings and consumption, it reduces capital accumulation. However, when foreign aid is provided to the public sector, the government cuts both the inflation rate and the income tax rate, raises public spending, and provides more incentives for private capital accumulation and money holdings. In the long run, aid to the public sector leads to more private capital accumulation, consumption, money holdings, and welfare.

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Bibliographic Info

Paper provided by China Economics and Management Academy, Central University of Finance and Economics in its series CEMA Working Papers with number 309.

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Length: 28 pages
Date of creation: Mar 2008
Date of revision:
Handle: RePEc:cuf:wpaper:309

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Web page: http://cema.cufe.edu.cn/
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Related research

Keywords: Foreign aid; Capital accumulation; Income taxation; Inflation; Growth;

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References

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  1. Alberto Alesina & Beatrice Weder, 1999. "Do Corrupt Governments Receive Less Foreign Aid?," NBER Working Papers 7108, National Bureau of Economic Research, Inc.
  2. White, Howard & Luttik, Joke & DEC, 1994. "The countrywide effects of aid," Policy Research Working Paper Series 1337, The World Bank.
  3. Azam, Jean-Paul & Laffont, Jean-Jacques, 2003. "Contracting for aid," Journal of Development Economics, Elsevier, vol. 70(1), pages 25-58, February.
  4. Giovannini, Alberto, 1985. "Saving and the real interest rate in LDCs," Journal of Development Economics, Elsevier, vol. 18(2-3), pages 197-217, August.
  5. Wane, Waly, 2004. "The quality of foreign aid : country selectivity or donors incentives?," Policy Research Working Paper Series 3325, The World Bank.
  6. Dollar, David & Alesina, Alberto, 2000. "Who Gives Foreign Aid to Whom and Why?," Scholarly Articles 4553020, Harvard University Department of Economics.
  7. Svensson, Jakob, 2003. "Why conditional aid does not work and what can be done about it?," Journal of Development Economics, Elsevier, vol. 70(2), pages 381-402, April.
  8. Levy, Victor, 1987. "Does Concessionary Aid Lead to Higher Investment Rates in Low-Income Countries?," The Review of Economics and Statistics, MIT Press, vol. 69(1), pages 152-56, February.
  9. van de Walle, Dominique & Cratty, Dorothyjean, 2005. "Do donors get what they paid for? micro evidence on the fungibility of development project aid," Policy Research Working Paper Series 3542, The World Bank.
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