Financing Public Investment through Foreign Aid: Consequences for Economic Growth and Welfare*

Abstract

The paper develops a theoretical framework for understanding the mechanism through which foreign aid affects macroeconomic performance. The authors find that the long-run impact of an aid program and the nature of the transitional dynamics it generates depend crucially on (i) the elasticity of substitution in production, (ii) whether the aid flow is tied to investment activity or not, (iii) how the recipient government chooses to react to the flow of external assistance, and (iv) whether the aid program is permanent or temporary. Structural characteristics of the recipient are important in determining the extent to which external assistance can aid growth and welfare.

Aid Allocation, Growth and Welfare With Productive Public Goods

“…These features make the model well suited to discuss the short‐run and longer‐run effects of aid shocks on the real exchange rate (the so‐called Dutch disease effects) and the allocation of aid among alternative spending categories. The model also departs from existing contributions on aid and growth by Chatterjee and Turnovsky (, 2007) by assuming that private agents cannot borrow internationally and that the government can borrow only at a premium that depends on its collateralizable infrastructure assets.…”

“…As in Chatterjee and Turnovsky (, 2007), installation costs are taken to depend on the ratios of investment in infrastructure and health to their respective capital stocks: where Σ I , Σ H > 0.…”

“…Few studies, however, have attempted to consider jointly the links between foreign aid, public investment, and growth in the type of intertemporal optimizing models that are now commonly used in open‐economy macroeconomics. Exceptions are those of Chatterjee et al () and Chatterjee and Turnovsky (), who analyzed the impact of aid tied to public investment in infrastructure on private capital formation and growth in an open economy. However, despite some important insights, to which we will return later on, these studies suffer from several limitations.…”

Roads out of poverty? Assessing the links between aid, public investment, growth, and poverty reduction

“…Two exceptions are Chatterjee, Sakoulis and Turnovsky (2003) and Chatterjee and Turnovsky (2005) who analyzed the impact of aid tied to public investment in infrastructure on private capital formation and growth in an open economy. However, they did not examine the composition of aid and its links with public investment, or Dutch disease effects, which may alter the long-run impact of aid and public investment on growth.…”

Getting help from abroad: The macroeconomics of foreign direct investment in infrastructure in low‐income countries

“…Second, there is extensive and compelling growth literature on infrastructure provision and financing. The financing instruments used in these studies are either foreign aid (Chatterjee and Turnovsky , Harms and Lutz , Chatterjee and Turnovsky , Agénor et al. ), or taxes and government‐subsidized private provision (Glomm and Ravikumar , Ott and Turnovsky , Chatterjee , Chatterjee and Morshed ).…”