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Foreign Aid, Incentives and Efficiency: Can Foreign Aid Lead to Efficient Level of Investment?

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Abstract

This paper develops a two-period-two-country model in which an altruistic donor faces Samaritan's Dilemma to address two important policy questions: (i) whether foreign aid can lead to efficient level of capital investment in the recipient country and (ii) how do the form (e.g. budgetary transfers, capital transfer) and the timing of aid affect the incentives of the recipient? It finds that the capital transfer makes financial savings more attractive relative to the capital investment for the recipient and exacerbates the free rider problem. The capital transfer can lead to efficient level of capital investment. But in this case, it completely crowds out the recipient's own capital investment. In the absence of capital transfer, by using multi-period budgetary transfers the donor can achieve not only the efficient level of capital investment by the recipient, but also the allocation which arises when the donor can commit to its transfer policy. By tying its hands in the sense of forgoing capital transfer, the donor can give aid more efficiently.

Suggested Citation

  • Alok Kumar, 2014. "Foreign Aid, Incentives and Efficiency: Can Foreign Aid Lead to Efficient Level of Investment?," Department Discussion Papers 1406, Department of Economics, University of Victoria.
  • Handle: RePEc:vic:vicddp:1406 Note: ISSN 1914-2838
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    References listed on IDEAS

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    1. Lindbeck, Assar & Weibull, Jorgen W, 1988. "Altruism and Time Consistency: The Economics of Fait Accompli," Journal of Political Economy, University of Chicago Press, vol. 96(6), pages 1165-1182, December.
    2. Pedersen, Karl R, 1996. " Aid, Investment and Incentives," Scandinavian Journal of Economics, Wiley Blackwell, vol. 98(3), pages 423-438.
    3. Izabela Jelovac & Frieda Vandeninden, 2008. "How should donors give foreign aid? Project aid versus budget support," Post-Print halshs-00293130, HAL.
    4. Svensson, Jakob, 2003. "Why conditional aid does not work and what can be done about it?," Journal of Development Economics, Elsevier, vol. 70(2), pages 381-402, April.
    5. Torsvik, Gaute, 2005. "Foreign economic aid; should donors cooperate?," Journal of Development Economics, Elsevier, vol. 77(2), pages 503-515, August.
    6. Svensson, Jakob, 2000. "When is foreign aid policy credible? Aid dependence and conditionality," Journal of Development Economics, Elsevier, vol. 61(1), pages 61-84, February.
    7. Raghuram G. Rajan & Arvind Subramanian, 2008. "Aid and Growth: What Does the Cross-Country Evidence Really Show?," The Review of Economics and Statistics, MIT Press, vol. 90(4), pages 643-665, November.
    8. Hagen, Rune Jansen, 2006. "Samaritan agents? On the strategic delegation of aid policy," Journal of Development Economics, Elsevier, vol. 79(1), pages 249-263, February.
    9. Collier, Paul & Dollar, David, 2002. "Aid allocation and poverty reduction," European Economic Review, Elsevier, vol. 46(8), pages 1475-1500, September.
    10. Hansen, Henrik & Tarp, Finn, 2001. "Aid and growth regressions," Journal of Development Economics, Elsevier, vol. 64(2), pages 547-570, April.
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    12. David Dollar & Craig Burnside, 2000. "Aid, Policies, and Growth," American Economic Review, American Economic Association, vol. 90(4), pages 847-868, September.
    13. Tito Cordella & Giovanni Dell'Ariccia, 2007. "Budget Support Versus Project Aid: A Theoretical Appraisal," Economic Journal, Royal Economic Society, vol. 117(523), pages 1260-1279, October.
    14. William Easterly, 2003. "Can Foreign Aid Buy Growth?," Journal of Economic Perspectives, American Economic Association, vol. 17(3), pages 23-48, Summer.
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    Cited by:

    1. Alok Kumar, 2014. "Samaritan's Dilemma, Time-Inconsistency and Foreign Aid: A Review of Theoretical Models," Department Discussion Papers 1405, Department of Economics, University of Victoria.

    More about this item

    Keywords

    Foreign Aid; Capital Investment; Efficiency; Budgetary Transfers; Capital Transfer; Samaritan's Dilemma;

    JEL classification:

    • F35 - International Economics - - International Finance - - - Foreign Aid
    • O12 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Microeconomic Analyses of Economic Development
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance
    • O19 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - International Linkages to Development; Role of International Organizations

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