The impact of foreign aid on growth and savings in developing countries
Developing countries have received foreign aid and other forms of capital flows for a long time, although they have been subject to some fluctuations. The key question is whether these flows have helped them in achieving their objectives? Aid has been evaluated at two levels: micro and macro. While micro evaluations have found that in most cases aid 'works' (for example Cassen et al., 1986), those at the macro-level are ambiguous. This thesis is predominantly concerned with the macroeconomic impact of foreign aid. There have been considerable efforts to improve both the theoretical and empirical literature on aid effectiveness, both suffer from serious weaknesses and shortcomings. At the theoretical level, there are not many models which capture the full potential of foreign aid within a consistent, fully specified, growth framework, while existing empirical studies are flawed by model mispecification, questionable sample composition and size, and inappropriate econometric techniques. This has led to inconclusive and often misleading results in assessing the effectiveness of foreign aid. This thesis attempts to address some of these deficiencies. The impact of aid is mainly assessed on growth and savings in developing countries. Before testing its impact, aid is introduced into some growth models. Cases are analysed where an economy, after initial aid flows, can become independent of aid and experience sustained growth through its ability to raise labour efficiency. On the empirical front, two techniques are used: a preliminary statistical analysis is performed, followed by an econometric analysis. The former allows a better understanding of the geographical distribution of aid, the link and any correlation between the macro variables: aid, growth, savings and investment. Since aid flows have been influenced by major international shocks (e. g. oil price shocks, debt crises, etc.), a simple taxonomy is used to indicate how these events have influenced the effectiveness of aid. Using a macroeconometric model from Fischer-Easterly to control for the recipients' macroeconomic environment (previously overlooked in the literature), a positive and significant impact of foreign aid on growth is found. This result is confirmed using both cross-section and panel data for the period of 1970-1993. We make use of Hall's (1978) life cycle/permanent income hypothesis, but do not find evidence that current aid flows leak into consumption, hence rejecting the fungibility hypothesis. Although much further work concerning the developmental effectiveness of aid remains to be carried out, it is hoped that this study will stimulate improved techniques and methods used in testing the effectiveness of aid in future work.