Foreign aid: is it all consumed?

Recent studies have found evidence to suggest that aid's effectiveness on growth has improved. Yet the debate on aid and domestic savings is still inconclusive and aid fungibility continues to be particularly contentious. One of the problems with much of the earlier literature examining the relationship between aid and savings (or aid-consumption) is that the relationship is not well embedded in a convincing theoretical framework. Although recent developments in fiscal response models have been made, the methodology applied when testing the model empirically is still not convincing. In this paper we use an alternative theoretical setting and start from a 'normal income' perspective that consumption and savings are driven by life cycle|permanent income factors. Using a panel setting, the model is tested on a sample of developing countries. We found limited support for life cycle|permanent income drivers but did find that changes in the policy environment, for instance stabilisation programmes, may have been influential. The hypothesis that aid has been fungible in the pre-1980 era could not be rejected. However, for the post 1980 period, where policy reforms were common, aid inflows did not seem to have leaked to finance consumption contrary to the views of both the right and the left questioning the utility of foreign aid. Copyright © 2004 John Wiley & Sons, Ltd.