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 23: Does real exchange rate appreciation undermine aid effectiveness? Evidence from sub-Saharan Africa

David Fielding and Fred Gibson


In their survey of the aid effectiveness literature, Doucouliagos and Paldam (2009) suggest a number of reasons for the lack of robust, consistent evidence for a positive effect of foreign aid on recipient country gross domestic product (GDP). One possible reason is that aid has a Dutch disease effect: the extra income from aid is spent at least partly on goods and services that are not internationally tradable. This causes the price of these goods and services to rise relative to the price of internationally tradable goods; that is, there is a real exchange rate appreciation. Correspondingly, the domestic production of non-tradable goods expands and the production of tradable goods contracts. Under certain conditions – for example, if there are positive externalities in the production of some tradable goods, or if factors of production are unemployed during the resource reallocation following a relative price change – then the appreciation will be associated with a reduction in resource efficiency. However, it is important to stress that a real exchange rate appreciation does not necessarily lead to lower aggregate productivity. In a simple neoclassical model with no externalities and flexible goods and factor prices, the relative price change just entails a movement around the production possibility frontier.

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