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Where Has All the Money Gone? Foreign Aid and the Quest for Growth

  • Chatterjee, Santanu

    ()

    (University of Georgia)

  • Giuliano, Paola

    ()

    (University of California, Los Angeles)

  • Kaya, Ilker

    ()

    (University of Georgia)

This paper examines fungibility as a possible explanation for the "missing link" between foreign aid and economic growth. The composition of aid plays a crucial role in determining the composition of government spending and, consequently, the magnitude of fungibility and its impact on growth. Embedding fungibility as an equilibrium outcome in an endogenous growth framework, we show that the substitution away from domestic government investment is higher than from government consumption. This leads to a reduction in domestic productive public spending and completely offsets any positive impact that aid might have on growth. The main predictions of the model are tested using a panel dataset of 67 countries for 1972-2000. We find strong evidence of fungibility at the aggregate level: almost 70 percent of total aid is fungible in our sample. We also find that investment aid is more fungible than other categories of aid. In the presence of fungibility, there is no statistically significant relationship between foreign aid and economic growth.

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Paper provided by Institute for the Study of Labor (IZA) in its series IZA Discussion Papers with number 2858.

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Length: 37 pages
Date of creation: Jun 2007
Date of revision:
Publication status: published as 'Where Has All the Money Gone? Foreign Aid and the Composition of Government Spending' in: B.E. Journal of Macroeconomics, 2012, 12 (1), Article 26
Handle: RePEc:iza:izadps:dp2858
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  1. Barro, R.J., 1988. "Government Spending In A Simple Model Of Endogenous Growth," RCER Working Papers 130, University of Rochester - Center for Economic Research (RCER).
  2. C-J. Dalgaard & H. Hansen, 2001. "On Aid, Growth and Good Policies," Journal of Development Studies, Taylor & Francis Journals, vol. 37(6), pages 17-41.
  3. Svensson, Jakob, 2000. "Foreign aid and rent-seeking," Journal of International Economics, Elsevier, vol. 51(2), pages 437-461, August.
  4. William Easterly, 2003. "Can Foreign Aid Buy Growth?," Journal of Economic Perspectives, American Economic Association, vol. 17(3), pages 23-48, Summer.
  5. Henrik Hansen & Finn Tarp, 2000. "Aid effectiveness disputed," Journal of International Development, John Wiley & Sons, Ltd., vol. 12(3), pages 375-398.
  6. Shantayanan Devarajan & Vinaya Swaroop & Heng-fu Zou, 1996. "The composition of public expenditure and economic growth," CEMA Working Papers 77, China Economics and Management Academy, Central University of Finance and Economics.
  7. Wacziarg, Romain & Alesina, Alberto, 1998. "Openness, Country Size and Government," Scholarly Articles 4553014, Harvard University Department of Economics.
  8. Chatterjee, Santanu & Sakoulis, Georgios & Turnovsky, Stephen J., 2003. "Unilateral capital transfers, public investment, and economic growth," European Economic Review, Elsevier, vol. 47(6), pages 1077-1103, December.
  9. Pack, Howard & Pack, Janet Rothenberg, 1993. "Foreign Aid and the Question of Fungibility," The Review of Economics and Statistics, MIT Press, vol. 75(2), pages 258-65, May.
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  11. Chatterjee, Santanu & Turnovsky, Stephen J., 2007. "Foreign aid and economic growth: The role of flexible labor supply," Journal of Development Economics, Elsevier, vol. 84(1), pages 507-533, September.
  12. C. S. Adam & S. A. O'Connell, 1999. "Aid, Taxation and Development in Sub-Saharan Africa," Economics and Politics, Wiley Blackwell, vol. 11(3), pages 225-253, November.
  13. Easterly, William, 1999. "The ghost of financing gap: testing the growth model used in the international financial institutions," Journal of Development Economics, Elsevier, vol. 60(2), pages 423-438, December.
  14. Swaroop, Vinaya & Jha, Shikha & Sunil Rajkumar, Andrew, 2000. "Fiscal effects of foreign aid in a federal system of governance: The case of India," Journal of Public Economics, Elsevier, vol. 77(3), pages 307-330, September.
  15. Tavares, Jose, 2003. "Does foreign aid corrupt?," Economics Letters, Elsevier, vol. 79(1), pages 99-106, April.
  16. Feyzioglu, Tarhan & Swaroop, Vinaya & Zhu, Min, 1998. "A Panel Data Analysis of the Fungibility of Foreign Aid," World Bank Economic Review, World Bank Group, vol. 12(1), pages 29-58, January.
  17. Boone, Peter, 1996. "Politics and the effectiveness of foreign aid," European Economic Review, Elsevier, vol. 40(2), pages 289-329, February.
  18. Alexander Pivovarsky & Benedict J. Clements & Sanjeev Gupta & Erwin Tiongson, 2003. "Foreign Aid and Revenue Response; Does the Composition of Aid Matter?," IMF Working Papers 03/176, International Monetary Fund.
  19. Sajal Lahiri & Pascalis Raimondos-Møller, 2004. "Donor Strategy under the Fungibility of Foreign Aid," Economics and Politics, Wiley Blackwell, vol. 16(2), pages 213-231, 07.
  20. William Easterly, 2002. "The Elusive Quest for Growth: Economists' Adventures and Misadventures in the Tropics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262550423, June.
  21. Pack, Howard & Pack, Janet Rothenberg, 1990. "Is Foreign Aid Fungible? The Case of Indonesia," Economic Journal, Royal Economic Society, vol. 100(399), pages 188-94, March.
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