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Moral Hazard and the Composition of Transfers: Theory with an Application to Foreign Aid

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  • Amegashie, J. Atsu
  • Ouattara, Bazoumanna
  • Strobl, Eric

Abstract

The paper presents a theoretical and empirical analysis of a donor’s choice of the composition of unrestricted and in-kind/restricted transfers to a recipient and how this composition is adjusted in response to changes in the moral hazard behavior of the recipient. In-kind or restricted transfers may be used, among others, to control a recipient’s moral hazard behavior but may be associated with deadweight losses. Within the context of foreign aid, we use a canonical political agency model to construct a simple signaling game between a possibly corrupt politician in a recipient country and a donor to illustrate the donor’s optimal choice of tied (restricted) and untied foreign aid. We clarify the condition under which a reduction in the recipient’s moral hazard behavior (i.e., improvement in the level of governance) leads to a fall in the proportion of tied aid. We test the predictions of our theoretical analysis using data on the composition of foreign aid by multilateral and bilateral donors.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 3158.

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Date of creation: 12 Apr 2007
Date of revision: 06 May 2007
Handle: RePEc:pra:mprapa:3158

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Keywords: tied foreign aid; governance; moral hazard; political agency; restricted transfer;

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Cited by:
  1. Paul A. Raschky & Manijeh Schwindt, 2009. "On the Channel and Type of International Disaster Aid," Working Papers 2009-16, Faculty of Economics and Statistics, University of Innsbruck.
  2. David Zetland, 2010. "Save the poor, shoot some bankers," Public Choice, Springer, vol. 145(3), pages 331-337, December.
  3. Raschky, Paul A. & Schwindt, Manijeh, 2012. "On the channel and type of aid: The case of international disaster assistance," European Journal of Political Economy, Elsevier, vol. 28(1), pages 119-131.
  4. Geethanjali Selvaretnam & Kannika Thampanishvong & David Ulph, . "Saving and Re-building Lives: an Analysis of the Determinants of Disaster Relief," CRIEFF Discussion Papers 1202, Centre for Research into Industry, Enterprise, Finance and the Firm.
  5. Gaoussou Diarra, 2011. "Aid unpredictability and absorptive capacity: analyzing disbursement delays in Africa," Economics Bulletin, AccessEcon, vol. 31(1), pages 1004-1017.
  6. Knack, Stephen & Smets, Lodewijk, 2013. "Aid Tying and Donor Fragmentation," World Development, Elsevier, vol. 44(C), pages 63-76.
  7. Tierney, Michael J. & Nielson, Daniel L. & Hawkins, Darren G. & Roberts, J. Timmons & Findley, Michael G. & Powers, Ryan M. & Parks, Bradley & Wilson, Sven E. & Hicks, Robert L., 2011. "More Dollars than Sense: Refining Our Knowledge of Development Finance Using AidData," World Development, Elsevier, vol. 39(11), pages 1891-1906.

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