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Where Has All the Money Gone? Foreign Aid and the Quest for Growth

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Author Info
Santanu Chatterjee () (University of Georgia)
Paola Giuliano () (International Monetary Fund, Harvard University and IZA)
Ilker Kaya () (University of Georgia)

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Abstract

This paper examines fungibility as a possible explanation for the "missing link" between foreign aid and economic growth. The composition of aid plays a crucial role in determining the composition of government spending and, consequently, the magnitude of fungibility and its impact on growth. Embedding fungibility as an equilibrium outcome in an endogenous growth framework, we show that the substitution away from domestic government investment is higher than from government consumption. This leads to a reduction in domestic productive public spending and completely offsets any positive impact that aid might have on growth. The main predictions of the model are tested using a panel dataset of 67 countries for 1972-2000. We find strong evidence of fungibility at the aggregate level: almost 70 percent of total aid is fungible in our sample. We also find that investment aid is more fungible than other categories of aid. In the presence of fungibility, there is no statistically significant relationship between foreign aid and economic growth.

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Paper provided by Institute for the Study of Labor (IZA) in its series IZA Discussion Papers with number 2858.

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Length: 37 pages
Date of creation: Jun 2007
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Handle: RePEc:iza:izadps:dp2858

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Related research
Keywords: foreign aid economic growth fungibility fiscal policy

Find related papers by JEL classification:
E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
F3 - International Economics - - International Finance
F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
O1 - Economic Development, Technological Change, and Growth - - Economic Development

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  1. Tavares, Jose, 2003. "Does foreign aid corrupt?," Economics Letters, Elsevier, vol. 79(1), pages 99-106, April. [Downloadable!] (restricted)
  2. C-J. Dalgaard & H. Hansen, 2001. "On Aid, Growth and Good Policies," The Journal of Development Studies, Taylor and Francis Journals, vol. 37(6), pages 17-41, August. [Downloadable!] (restricted)
  3. Svensson, Jakob, 2000. "Foreign aid and rent-seeking," Journal of International Economics, Elsevier, vol. 51(2), pages 437-461, August. [Downloadable!] (restricted)
  4. Alesina, Alberto & Wacziarg, Romain, 1998. "Openness, country size and government," Journal of Public Economics, Elsevier, vol. 69(3), pages 305-321, September. [Downloadable!] (restricted)
  5. Craig Burnside & David Dollar, 2000. "Aid, Policies, and Growth," American Economic Review, American Economic Association, vol. 90(4), pages 847-868, September. [Downloadable!] (restricted)
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  6. C. S. Adam & S. A. O'Connell, 1999. "Aid, Taxation and Development in Sub-Saharan Africa," Economics and Politics, Blackwell Publishing, vol. 11(3), pages 225-253, November. [Downloadable!] (restricted)
  7. Pack, Howard & Pack, Janet Rothenberg, 1990. "Is Foreign Aid Fungible? The Case of Indonesia," Economic Journal, Royal Economic Society, vol. 100(399), pages 188-94, March. [Downloadable!] (restricted)
  8. Feyzioglu, Tarhan & Swaroop, Vinaya & Zhu, Min, 1998. "A Panel Data Analysis of the Fungibility of Foreign Aid," World Bank Economic Review, Oxford University Press, vol. 12(1), pages 29-58, January.
  9. Chatterjee, Santanu & Sakoulis, Georgios & Turnovsky, Stephen J., 2003. "Unilateral capital transfers, public investment, and economic growth," European Economic Review, Elsevier, vol. 47(6), pages 1077-1103, December. [Downloadable!] (restricted)
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  10. Devarajan, Shantayanan & Swaroop, Vinaya & Heng-fu, Zou, 1996. "The composition of public expenditure and economic growth," Journal of Monetary Economics, Elsevier, vol. 37(2-3), pages 313-344, April. [Downloadable!] (restricted)
  11. Barro, Robert J, 1990. "Government Spending in a Simple Model of Endogenous Growth," Journal of Political Economy, University of Chicago Press, vol. 98(5), pages S103-26, October. [Downloadable!] (restricted)
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  12. Sajal Lahiri & Pascalis Raimondos-Møller, 2004. "Donor Strategy under the Fungibility of Foreign Aid," Economics and Politics, Blackwell Publishing, vol. 16(2), pages 213-231, 07. [Downloadable!] (restricted)
  13. Pack, Howard & Pack, Janet Rothenberg, 1993. "Foreign Aid and the Question of Fungibility," The Review of Economics and Statistics, MIT Press, vol. 75(2), pages 258-65, May. [Downloadable!] (restricted)
  14. William Easterly, 2003. "Can Foreign Aid Buy Growth?," Journal of Economic Perspectives, American Economic Association, vol. 17(3), pages 23-48, Summer. [Downloadable!] (restricted)
  15. Boone, Peter, 1996. "Politics and the effectiveness of foreign aid," European Economic Review, Elsevier, vol. 40(2), pages 289-329, February. [Downloadable!] (restricted)
  16. Swaroop, Vinaya & Jha, Shikha & Sunil Rajkumar, Andrew, 2000. "Fiscal effects of foreign aid in a federal system of governance: The case of India," Journal of Public Economics, Elsevier, vol. 77(3), pages 307-330, September. [Downloadable!] (restricted)
  17. Alexander Pivovarsky & Benedict J. Clements & Sanjeev Gupta & Erwin Tiongson, 2003. "Foreign Aid and Revenue Response: Does the Composition of Aid Matter?," IMF Working Papers 03/176, International Monetary Fund.
  18. Easterly, William, 1999. "The ghost of financing gap: testing the growth model used in the international financial institutions," Journal of Development Economics, Elsevier, vol. 60(2), pages 423-438, December. [Downloadable!] (restricted)
  19. Chatterjee, Santanu & Turnovsky, Stephen J., 2007. "Foreign aid and economic growth: The role of flexible labor supply," Journal of Development Economics, Elsevier, vol. 84(1), pages 507-533, September. [Downloadable!] (restricted)
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