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How should donors give foreign aid? Project aid versus budget support

  • Izabela Jelovac

    (GATE - Groupe d'analyse et de théorie économique - CNRS - UL2 - Université Lumière - Lyon 2 - Ecole Normale Supérieure Lettres et Sciences Humaines)

  • Frieda Vandeninden

    (MGSoG - Maastricht Graduate School of Governance - Universiteit Maastricht)

We develop a theoretical model to compare the two major foreign aid modalities: project aid and budget support. These two modalities have a different impact on the production of 'developmental goods'. Firstly, conditionality can be associated with budget support, but only a subset of the developmental expenses - the observable ones - can be subject to conditionality. Secondly, when using project aid, the donors control the overall allocation of the aid resources. However, we consider that, because of limited harmonisation and coordination, project aid can be associated with a cost of imperfect fit. We develop a unified framework to compare these two modalities where we allow the simultaneous utilisation of both instruments. We show that all the aid should be given via budget support, no matter whether conditionality is used or not. Furthermore, we show that the optimal use of conditionality depends on the recipient's developmental preferences, the productivity of the inputs and the level of aid compared to the recipient's budget: when these parameters are relatively high, conditionality should be enforced. Otherwise, the optimal aid allocation is such that all the aid is given through unconditional budget support. We conclude that conditionality does not always improve the aid effectiveness.

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Paper provided by HAL in its series Post-Print with number halshs-00293130.

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Date of creation: 2008
Date of revision:
Publication status: Published in Working paper GATE 2008-13 ; CREPP Working paper (Research Center on Public and Population Econom.. 2008
Handle: RePEc:hal:journl:halshs-00293130
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  1. Hefeker, Carsten, 2004. "Project Aid or Budget Aid? The Interests of Governments and Financial Institutions," HWWA Discussion Papers 309, Hamburg Institute of International Economics (HWWA).
  2. Svensson, Jakob, 2003. "Why conditional aid does not work and what can be done about it?," Journal of Development Economics, Elsevier, vol. 70(2), pages 381-402, April.
  3. Alesina, Alberto & Dollar, David, 2000. " Who Gives Foreign Aid to Whom and Why?," Journal of Economic Growth, Springer, vol. 5(1), pages 33-63, March.
  4. Arvind Subramanian & Raghuram Rajan, 2005. "What Undermines Aid’s Impact on Growth?," IMF Working Papers 05/126, International Monetary Fund.
  5. Boone, Peter, 1996. "Politics and the effectiveness of foreign aid," European Economic Review, Elsevier, vol. 40(2), pages 289-329, February.
  6. Finn Tarp, 2006. "Aid and Development," Discussion Papers 06-12, University of Copenhagen. Department of Economics.
  7. Svensson, Jakob, 1998. "Foreign aid and rent-seeking," Policy Research Working Paper Series 1880, The World Bank.
  8. Burnside, Craig & Dollar, David, 1997. "Aid, policies, and growth," Policy Research Working Paper Series 1777, The World Bank.
  9. Hansen, Henrik & Tarp, Finn, 2000. "Aid and Growth Regressions," MPRA Paper 62288, University Library of Munich, Germany.
  10. Tito Cordella & Giovanni Dell'Ariccia, 2007. "Budget Support Versus Project Aid: A Theoretical Appraisal," Economic Journal, Royal Economic Society, vol. 117(523), pages 1260-1279, October.
  11. Collier, Paul & Dollar, David, 2002. "Aid allocation and poverty reduction," European Economic Review, Elsevier, vol. 46(8), pages 1475-1500, September.
  12. William Easterly, 2003. "Can Foreign Aid Buy Growth?," Journal of Economic Perspectives, American Economic Association, vol. 17(3), pages 23-48, Summer.
  13. Raghuram G. Rajan & Arvind Subramanian, 2005. "What Undermines Aid's Impact on Growth?," NBER Working Papers 11657, National Bureau of Economic Research, Inc.
  14. Torsvik, Gaute, 2005. "Foreign economic aid; should donors cooperate?," Journal of Development Economics, Elsevier, vol. 77(2), pages 503-515, August.
  15. Azam, Jean-Paul & Laffont, Jean-Jacques, 2003. "Contracting for aid," Journal of Development Economics, Elsevier, vol. 70(1), pages 25-58, February.
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