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The effects of foreign aid on economic growth in developing countries

Author

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  • Masha Rahnama
  • Fadi Fawaz
  • Kaj Gittings

    (Texas Tech University, USA
    University of South Florida, USA)

Abstract

Decades of research regarding the effect of foreign aid on economic growth in less developed countries have produced inconclusive results. Research in this literature has been plagued by a variety of empirical impediments. Among them, measurement and endogeneity issues, sparse sets of control variables that may be correlated with both foreign aid and economic growth such as institutional quality, and disagreements regarding the appropriate econometric methodology. This paper highlights a further issue: the heterogeneous effects of foreign aid on growth across less developed countries. Previous studies have pooled all of the developing countries together, treating them as homogenous, despite that developing countries are vastly different across both observable and unobservable dimensions. Developing countries differ in their stages of development, per capita income, socio-economic, financial, and political characteristics. For this reason, the World Bank (2012) broadly classifies the developing countries into two categories: low income developing countries (LIDCs) and high income developing countries (HIDCs) based on per capita income. Our hypothesis is that the relationship between foreign aid and economic growth should be different among LIDCs and HIDCs. For this reason, we analyze the relationship between foreign aid and economic growth separately for LIDCs and HIDCs, producing estimates using samples which are more likely to be homogenous. Integrating the fullest set of control variables thus far in the literature such as unemployment rate, capital formation, government budget surplus, inflation rate, degree of trade openness, and corruption, and using GMM methodology in a dynamic setting we find that foreign aid has positive effects on growth in high-income developing countries and negative effects on growth in low-income developing countries. We also find that higher unemployment rates, higher inflation, and higher levels of corruption reduce economic growth in both LIDCs and HIDCs. Additionally, higher level of capital formation, a larger budget surplus, and higher degrees of trade openness contribute positively to economic growth in both LIDCs and HIDCs. We do not find any evidence that time trends in the data affect our results. The result remains after accounting for endogeneity concerns and when a measure of institutional quality proxied by corruption. The finding implies that foreign aid has beneficial effects in high-income developing countries which are at latter stages of development. This suggests that countries need to gain some "traction" before foreign aid can help.

Suggested Citation

  • Masha Rahnama & Fadi Fawaz & Kaj Gittings, 2017. "The effects of foreign aid on economic growth in developing countries," Journal of Developing Areas, Tennessee State University, College of Business, vol. 51(3), pages 153-171, July-Sept.
  • Handle: RePEc:jda:journl:vol.51:year:2017:issue3:pp:153-171
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    Citations

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    Cited by:

    1. Akame, Afuge & Mavrotas, George, 2024. "The differential effects of foreign aid to sub-Saharan Africa," IOB Discussion Papers 2024.01, Universiteit Antwerpen, Institute of Development Policy (IOB).
    2. Muhammad Azam & Yi Feng, 2022. "Does foreign aid stimulate economic growth in developing countries? Further evidence in both aggregate and disaggregated samples," Quality & Quantity: International Journal of Methodology, Springer, vol. 56(2), pages 533-556, April.
    3. Boateng, Elliot & Agbola, Frank W. & Mahmood, Amir, 2021. "Foreign aid volatility and economic growth in Sub-Saharan Africa: Does institutional quality matter?," Economic Modelling, Elsevier, vol. 96(C), pages 111-127.
    4. Tefera, Mamo G & Odhiambo, Nicholas M, 2022. "The impact of foreign aid on economic growth in Africa: Empirical evidence from low-income countries," Working Papers 29830, University of South Africa, Department of Economics.
    5. Hervé Nenghem Takam & Roger Tsafack Nanfosso, 2024. "Importance of official development assistance in improving the economic cycles of Economic and Monetary Community of Central Africa countries," SN Business & Economics, Springer, vol. 4(7), pages 1-22, July.
    6. Tim Röthel, 2023. "Budget support to the health sector—The right choice for strong institutions? Evidence from panel data," Review of Development Economics, Wiley Blackwell, vol. 27(2), pages 735-770, May.

    More about this item

    Keywords

    foreign aid; economic growth; high-income developing countries; low-income developing countries; capital formation; corruption;
    All these keywords.

    JEL classification:

    • C30 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - General
    • F00 - International Economics - - General - - - General
    • F01 - International Economics - - General - - - Global Outlook
    • O1 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development

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