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Does Foreign Aid Increase Foreign Direct Investment?

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Author Info

  • Pablo Selaya

    (Department of Economics, University of Copenhagen)

  • Eva R. Sunesen

    (Department of Economics, University of Copenhagen)

Abstract

The notion that foreign aid and foreign direct investment (FDI) are complementary sources of capital is conventional among governments and internationalcooperation agencies. This paper argues that the notion is incomplete. Within the framework of an open economy Solow model we show that the theoretical relationship between foreign aid and FDI is indeterminate. Aid may raise the marginal productivity of capital by financing complementary inputs, such as public infrastructure projects and human capital investment. However, aid may also crowd out productive private investments if it comes in the shape of physical capital transfers. We therefore turn to an empirical analysis of the relationship between FDI and disaggregated aid flows. Our results strongly support the hypotheses that aid invested in complementary inputs draws in foreign capital while aid invested in physical capital crowds out FDI. The combined effect of these two types of aid is small but on average positive.

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Bibliographic Info

Paper provided by University of Copenhagen. Department of Economics in its series Discussion Papers with number 08-04.

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Length: 17 pages
Date of creation: Feb 2008
Date of revision:
Handle: RePEc:kud:kuiedp:0804

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Keywords: foreign aid; foreign direct investment (FDI); open economy Solow model;

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Citations

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Cited by:
  1. T. Bhavan & Changsheng Xu & Chunping Zhong, 2011. "Growth effect of foreign aid and volatility in South Asia," International Journal of Development Issues, Emerald Group Publishing, vol. 10(3), pages 204-213, September.
  2. Andreas Fuchs & Axel Dreher & Peter Nunnenkamp, 2012. "Determinants of Donor Generosity: A Survey of the Aid Budget Literature," Kiel Working Papers 1789, Kiel Institute for the World Economy.
  3. Henri Bezuidenhout, 2009. "A regional perspective on Aid and FDI in Southern Africa," Working Papers 147, Economic Research Southern Africa.
  4. Kang, Sung Jin & Lee, Hongshik & Park, Bokyeong, 2011. "Does Korea follow Japan in foreign aid? Relationships between aid and foreign investment," Japan and the World Economy, Elsevier, vol. 23(1), pages 19-27, January.
  5. Carro, Martha & Larrú, José María, 2010. "Flowing Together or Flowing Apart: An Analysis of the Relation between FDI and ODA Flows to Argentina and Brazil," MPRA Paper 25064, University Library of Munich, Germany.
  6. Katarína Čulková & Katarína Teplická, 2013. "Contribution Of Foreign Direct Investment For The Region Development," Annals - Economy Series, Constantin Brancusi University, Faculty of Economics, vol. 1, pages 19-27, February.

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