Aid and Growth Revisited: Policy, Economic Vulnerability and Political Instability

This paper revisits the relationship between aid and growth, adding new assumptions to the standard Burnside-Dollar model, where aid effectiveness depends only on policy: 1) policy itself depends on aid, which involves a dynamic formulation of the standard model, 2) aid effectiveness (positively) depends on structural economic vulnerability, 3) it depends (negatively) on political instability. An augmented model including these assumptions is estimated on 5-year subperiods from 1965 to 1999 for 59 developing countries, using the Arellano-Bond GMM estimator and new composite indicators of policy, economic vulnerability, political instability. None of the previous assumptions is rejected. It follows that an "efficient" allocation of aid has to consider not only the quality of the present policy, but also its potential improvement, the economic vulnerability faced by the recipient country (more aid needed), and its political instability as well (aid less effective).