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Does Foreign Aid Increase Foreign Direct Investment?

  • Pablo Selaya

    (Department of Economics, University of Copenhagen)

  • Eva R. Sunesen

    (Department of Economics, University of Copenhagen)

The notion that foreign aid and foreign direct investment (FDI) are complementary sources of capital is conventional among governments and internationalcooperation agencies. This paper argues that the notion is incomplete. Within the framework of an open economy Solow model we show that the theoretical relationship between foreign aid and FDI is indeterminate. Aid may raise the marginal productivity of capital by financing complementary inputs, such as public infrastructure projects and human capital investment. However, aid may also crowd out productive private investments if it comes in the shape of physical capital transfers. We therefore turn to an empirical analysis of the relationship between FDI and disaggregated aid flows. Our results strongly support the hypotheses that aid invested in complementary inputs draws in foreign capital while aid invested in physical capital crowds out FDI. The combined effect of these two types of aid is small but on average positive.

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Paper provided by University of Copenhagen. Department of Economics in its series Discussion Papers with number 08-04.

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Length: 17 pages
Date of creation: Feb 2008
Date of revision:
Handle: RePEc:kud:kuiedp:0804
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