Handbook on the Economics of Foreign Aid
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Handbook on the Economics of Foreign Aid

Edited by B. Mak Arvin and Byron Lew

It would be fair to say that foreign aid today is one of the most important factors in international relations and in the national economy of many countries – as well as one of the most researched fields in economics. Although much has been written on the subject of foreign aid, this book contributes by taking stock of knowledge in the field, with chapters summarizing long-standing debates as well as the latest advances. Several contributions provide new analytical insights or empirical evidence on different aspects of aid. As a whole, the book demonstrate how researchers have dealt with increasingly complex issues over time – both theoretical and empirical – on the allocation, impact, and efficacy of aid, with aid policies placed at the center of the discussion.
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Chapter 21: On the heterogeneous impact of aid on growth: a review of the evidence

Lisa Chauvet


In theory, the impact of aid on growth is ambiguous. Aid is expected to fill the financing gap and relax the capital constraint – low saving and lack of foreign currency – limiting the growth of low-income countries (Chenery and Strout, 1966). In addition, the poorest countries may be stuck in a low-level equilibrium and aid may finance the ‘big push’ which these countries need to reach a higher equilibrium and get out of the poverty trap (Rosenstein-Rodan, 1943). However, related to the concept of ‘big push’ is that of absorptive capacity: countries may encounter limits to the amount of aid they can absorb in an effective way, and this depends on their level of development (Rosenstein-Rodan, 1961). If this limit is reached, aid may then adversely impact the situation of developing countries. The two main theoretical adverse effects of aid which have been highlighted in the literature are: the macroeconomic (Dutch disease) effect and the governance (political curse) effect. Aid may induce the Dutch disease if the increase in demand caused by the inflow of money leads to an increase in the prices of non-tradable goods relative to the prices of tradable goods (which are set internationally), hence an appreciation of the real exchange rate and a loss of competitiveness. The political curse is linked to the fact that aid has a deteriorating impact both on political institutions (financing dictators) and economic institutions (inducing corruption and rent-seeking activities).

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