Foreign Aid, External Debt and Governance

This paper presents a theoretical model for governance. Specifically, the Ramsey-Cass-Koopman's growth model has been extended by incorporating governance in an open economy framework. Steady-state and short run analysis show that external debt and foreign aid do not affect the growth rate of consumption but have level impact on consumption. Foreign aid and governance encourage the economic growth but external debt creates a burden on the economy. Both Investment and saving are independent of external debt and thus the current account surplus. Foreign aid does not affect investment directly but it has a direct positive impact on the savings in the economy. Therefore, it is argued that improvements in the quality of governance will stimulate the output and consumption rapidly and it acts like a catalyst.