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

  • Amegashie, J. Atsu
  • Ouattara, Bazoumanna
  • Strobl, Eric

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 Library of Munich, Germany in its series MPRA Paper with number 3158.

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Date of creation: 12 Apr 2007
Date of revision: 06 May 2007
Handle: RePEc:pra:mprapa:3158
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