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

  • J. Atsu Amegashie

    ()

    (University of Guelph; Department of Economics.)

  • Bazoumana Ouattara

    (Swansea University; Department of Economics.)

  • Eric Strobl

    (Ecole Polytechnique; Department of Economics)

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 of Guelph, Department of Economics and Finance in its series Working Papers with number 0702.

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Length: 44 pages
Date of creation: 2007
Date of revision:
Handle: RePEc:gue:guelph:2007-2
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