On the Empirics of Foreign Aid and Growth

This paper takes a fresh look at three issues in the aid effectiveness debate. First, we assess the theoretical case for foreign aid. Using an endogenous growth version of the standard overlapping generations model, we show that aid can be an effective policy tool in spurring growth in poor countries. This model also furnishes a theoretical foundation for the approach taken in many empirical studies. Second, we demonstrate that cross-country data, which underpin traditional cross-section based conclusions about the aid-growth link, are fully consistent with the positive evidence on aid effectiveness that emerge from recent panel-based regressions. Third, we reexamine the case for policy-based conditionality. Our empirical analysis suggests that aid is generally effective, even in “bad” environments. However, the degree to which aid enhances growth depends on climate-related circumstances.