Does foreign aid affect innovation and institutional quality in middle-income countries?

In this study, we explore the dynamics between innovation, institutional quality, and foreign-aid flows in middle-income countries. Using an appropriate econometric model, we investigate the links between these variables in 79 middle-income countries (MICs) over 2005–2020. The results from our study show that foreign aid, institutional quality, and innovation have strong endogenous relationships. The short-run outcomes show that innovation Granger-causes institutional quality; foreign aid Granger-causes innovation; and quality of institutions Granger-causes foreign aid. The long-run outcomes indicate that institutional quality and innovation significantly affect the flow of foreign aid to the MICs. These results indicate that policy-makers in both foreign aid donor and recipient countries should pursue appropriate policies on foreign aid, quality of institutions, and innovation. For instance, in the short run, planners and evaluators in donor countries can direct their aid to MICs that have persistent challenges in improving their institutions and enhancing their innovative capabilities. In the long run, recipient countries ought to recognize that their institutional quality and innovation have a considerable impact on the inflows of foreign aid to their countries.