How should donors give foreign aid? Project aid versus budget support
AbstractWe develop a theoretical model to compare the two major foreign aid modalities: project aid and budget support. These two modalities have a different impact on the production of 'developmental goods'. Firstly, conditionality can be associated with budget support, but only a subset of the developmental expenses - the observable ones - can be subject to conditionality. Secondly, when using project aid, the donors control the overall allocation of the aid resources. However, we consider that, because of limited harmonisation and coordination, project aid can be associated with a cost of imperfect fit. We develop a unified framework to compare these two modalities where we allow the simultaneous utilisation of both instruments. We show that all the aid should be given via budget support, no matter whether conditionality is used or not. Furthermore, we show that the optimal use of conditionality depends on the recipient's developmental preferences, the productivity of the inputs and the level of aid compared to the recipient's budget: when these parameters are relatively high, conditionality should be enforced. Otherwise, the optimal aid allocation is such that all the aid is given through unconditional budget support. We conclude that conditionality does not always improve the aid effectiveness.
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Date of creation: 2008
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conditionality - foreign aid - optimal contract;
Other versions of this item:
- Izabela Jelovac & Frieda Vandeninden, 2008. "How should donors give foreign aid? Project aid versus budget support," Working Papers, Groupe d'Analyse et de ThÃ©orie Economique (GATE), Centre national de la recherche scientifique (CNRS), UniversitÃ© Lyon 2, Ecole Normale SupÃ©rieure 0813, Groupe d'Analyse et de Théorie Economique (GATE), Centre national de la recherche scientifique (CNRS), Université Lyon 2, Ecole Normale Supérieure.
- Izabela Jelovac & Frieda Vandeninden, 2008. "How Should Donors Give Foreign Aid? Project Aidversus Budget Support," CREPP Working Papers 0804, Centre de Recherche en Economie Publique et de la Population (CREPP) (Research Center on Public and Population Economics) HEC-Management School, University of Liège.
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- F35 - International Economics - - International Finance - - - Foreign Aid
- O19 - Economic Development, Technological Change, and Growth - - Economic Development - - - International Linkages to Development; Role of International Organizations
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