Foreign aid Flashcards

Question

Based on Table 3 in Galiani, Knack, Xu and Zou (2017), reproduced below, please explain how the authors interpret the regression coefficients for the variable “Aidis-1” in Table 3? see review

Answer 1

Regressions (1) and (2) are OLS regressions; fixed effects and first difference OLS, respectively. Both show a significant positive effect of aid on GDP growth. The elasticity is around 0.01. The estimated association with an increase in aid/GNI from 0.09 to 0.1 is thus (0.01/0.09) = 0.12 percentage points. Regression (3) is a Fixed effects 2SLS regression using the crossing event as an instrument for aid. The regression shows a significant positive effect which is quite a lot higher than the OLS estimates: (0.028/0.09) = 0.31 percentage points. The following four regressions are 2SLS regressions with variations in the instrument and the transformation of the panel data. They all show even higher estimates (the student need not comment on these).

Answer 2

a. The three rival views of how aid seems to influence economic growth, which are highlighted in the textbook, are: (i) That aid does not work; (ii) That aid only works in the presence of sufficiently sound policies (or conditional on other structural characteristics); (ii) that aid is subject to “diminishing returns”. All three views seek evidence by using regression analysis. Whereas view (i) focuses on a linear effect of aid on growth, both (ii) and (iii) allow for nonlinearities; (ii) adopts a specification where aid is interacted with e.g., policy indices (aside from entering linearly), whereas (iii) allows for a squared term. Identification problems means that it is unresolved which (if any) of the three views are a better description of the historical record. b. The key identification problem is that aid is endogenous. That is, poor (slow growing) countries are likely to receive more aid. Therefore, the correlation between aid and growth (which often is negative) may mean that aid hampers growth; that slow growth leads to more aid inflows; that factors that hamper growth also influences (positively) how much aid a country receives.

Answer 3

The Feldstein-Horioka puzzle is that there exist a very strong link, nearly 1:1, between domestic savings and domestic investments within the OECD area. Accordingly, despite the fact that capital can move across countries you see a pattern, which would fit a collection of closed economies. This finding suggests that international capital markets are not functioning very efficiently. The Lucas paradox approaches a similar issue from a different angle. In essence Lucas starts by noting differences in capital per worker is quite large between rich and poor countries. If factor markets are competitive, to a first approximation, the real rate of return in a country should equal the marginal product of capital. In light of the vast differences in capital per worker, one would expect huge differences in rates of return between, say, the US and India, implying capital should flow from capital abundant US to India where capital is scarce. In practice, this does not happen. So why doesn’t capital flow to poor countries? One possibility, of course, is that international capital markets are not functioning very well. That is, perhaps there are large frictions. Lucas, however, pursues a different idea. Namely, that the US is abundant in another production faction that is complementary to capital: human capital. In order to close the apparent gap in returns, based on observed differences in capital-labor ratios, however, Lucas have to assume sizeable human capital externalities, which are hard to validate independently empirically. Absent a good explanation, then, for observed capital (apparently in the opposite direction of where it should go based on theory), the Lucas paradox also suggests capital markets are not functioning very well.

Answer 4

C&F make the point that if international capital markets are well functioning an inflow of foreign aid will not matter much. The argument is (i) that aid can be viewed as a transfer of physical capital, and, (ii) that international capital markets ensure real rates of return are equalized. In this setting, the capital-labor ratio is pinned down by the world real rate of interest, which means an inflow of capital will be accompanied by an equal

Answer 5

The World Bank has an income threshold for countries that are eligible for ODA from IDA. The threshold was set in 1987 to limit the number of countries eligible for IDA funds. 35 countries crossed the threshold between 1987 and 2010. Crossing the income threshold does not imply that the countries stop receiving ODA, but they start negotiating with the World Bank on different terms, moving from IDA (ODA) to IBRD (OOF). Thus, the crossing is an exogenous event (a natural experiment) that can be used to identify the effect of aid. The crossing of the threshold should have no independent impact on growth, thus if there is an effect it is because of the drop in aid. The authors show that the crossing is a relevant instrument as ODA drops by (1-exp(-0.88)) = 59% in the periods following the crossing--on top of what we would expect if aid was determined by country fixed factors, year factors, GDP per capita and population size.

Answer 6

In order for a transfer to be considered official development assistance (ODA) it needs to fulfil three criteria. The flow comes from official development agencies (national government agencies or multinational agencies); the flow has “promotion of economic development and welfare” as main objective (military expenditures are generally not accepted as ODA); the flow has a grant element of at least 25%.

Answer 7

Between the 1960s and today (DAC) ODA as a fraction of (DAC) GNI has declined from about 0,5% to roughly 0,4%.

Answer 8

The micro-macro paradox observes that a whole host of micro-level studies find large positive returns on aid funded investments, whereas it seems hard to find a positive impact of aid on growth.

Answer 9

They do not. The simplest way to see this is by noting that even if aid – on impact- serves to increase income (say by funding infrastructure) the longer run impact can be zero if population growth responds in keeping with the Malthusian mechanism. This example serves to illustrate that growth regressions do not identify the (macro) return to aid, since the growth effect also convolutes behavioural responses (or general equilibrium effects). The student may also bring up that a recent study by Dalgaard and Hansen (2017, JDS) provides a method to identify the macro return. DH do not find that the macro returns are at variance with the micro returns. This suggests that if aid has a limited effect on growth it is unlikely to be caused by aid is being misused. Instead, mechanisms such as the Malthusian one, or perhaps political-economy effects whereby the return to aid is channelled into counterproductive uses (or simply send out of the country), may represent countervailing forces that leaves the net impact on growth insignificant.

Answer 10

On the other hand opponents of foreign aid programs, argue that domestic savings decline as a result of aid-induced increased consumption. The effect on savings: If we believe in the argument that poor people can not save due to their voluntary choices. The decision to save rather than to consume represents a choice between current and future satisfaction, so a person who does not care much about the future will not save. If people value the present more because they are uncertain about the future, aid does not induce greater levels of savings because, at least in the short run, it cannot change the incentives people face when choosing consumption today over consumption tomorrow and people respond to incentives. In this context, foreign aid ends up being consumed by recipient governments rather than saved to be enjoyed in the future. The effect on investment: Economic agents invest in the future when they get a high return to their investments. If these agents expect returns to be low or uncertain, they will not invest. Instead aid will be consumed. The effect on consumption and national income: As we have seen, we would expect the population to increase their consumption when receiving foreign aid when we have assumed a poverty trap. Consumption C is defined as national income less saving; equivalently consumption is national product less investment: C = Y - S = Y - I Therefore an increase in consumption will increase Y. Again we have assumes a high population which will lead to consumption having a smaller effect on y. The graph: As the neoclassical model predicts, the main determinant of per capita income growth is capital accumulation, which sustain long term constant growth, but higher consumption can have a short run increase in GPD pr capita. In this case we will see a short run effects in the solow model, but decline due to no savings or investments which would have raised capital accumulation. see graph

Foreign aid Flashcards

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