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Foreign Aid and Macroeconomic Performance in Pakistan: Exploring the Role of Local Financial Sector Development

Author

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  • Luqman, Muhammad
  • Haq, Mairajul
  • Lal, Irfan

Abstract

It is widely recognized that foreign aid may not be used effectively in recipient countries due to a problem of absorptive capacity. This study assesses the role of such capacity in the effective use of foreign aid in Pakistan. To accomplish this, we incorporate domestic financial sector development in our model. The empirical analysis estimates growth equations using time series data of Pakistan over the period 1972-2011. We construct the index of financial sector development using principal component analysis. The ARDL bound testing approach of co-integration was used for empirical analysis. The empirical evidence substantiates the fact that foreign aid is more effective and consequently enhances both long and short run growth process only in the presence of local financial sector development. For instance, our result revealed that absorptive capacity (i.e. interactive term of local financial sector development and foreign aid) is positive and statistically significant. The findings support the claim that ‘local financial sector development plays an important role in the effectiveness of foreign aid’. In addition, the results indicate that foreign aid makes a positive and statistically significant impact on economic growth after allowing nonlinearity between the variables; this, in turn, indicates a diminishing return to foreign aid in case of the Pakistan. Our control variables i.e., physical capital and human capital bear their expected positive signs and are also statistically significant. This indicates that physical capital and human capital also play an important role in the log-run economic growth process of Pakistan.

Suggested Citation

  • Luqman, Muhammad & Haq, Mairajul & Lal, Irfan, 2013. "Foreign Aid and Macroeconomic Performance in Pakistan: Exploring the Role of Local Financial Sector Development," MPRA Paper 106866, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:106866
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    References listed on IDEAS

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    1. Suleiman Abu‐Bader & Aamer S. Abu‐Qarn, 2008. "Financial Development and Economic Growth: Empirical Evidence from Six MENA Countries," Review of Development Economics, Wiley Blackwell, vol. 12(4), pages 803-817, November.
    2. Chaudhry, Mumtaz Anwar & Aman, Sughra, 2010. "Aid effectiveness in education sector of Pakistan," HWWI Research Papers 2-20, Hamburg Institute of International Economics (HWWI).
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    Cited by:

    1. Ghulam Yahya Khan & Salik Mehboob & Lydia Bares Lopez, 2018. "Deindustrialization and Economic Growth: Empirical Evidence from Pakistan," Asian Journal of Economic Modelling, Asian Economic and Social Society, vol. 6(4), pages 462-475, December.
    2. Muhammad Zahid Naeem & Chan Bibi, 2019. "Macroeconomic Determinants of Economic Growth under the Perspective of Monetary Policy in Pakistan: An Empirical Analysis," Bulletin of Business and Economics (BBE), Research Foundation for Humanity (RFH), vol. 8(3), pages 164-176, September.

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    Keywords

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    JEL classification:

    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • F35 - International Economics - - International Finance - - - Foreign Aid
    • G2 - Financial Economics - - Financial Institutions and Services
    • O11 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Macroeconomic Analyses of Economic Development

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