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Does Foreign Aid Increase Foreign Direct Investment?

Author

Listed:
  • Pablo Selaya

    (Department of Economics, University of Copenhagen)

  • Eva R. Sunesen

    (Department of Economics, University of Copenhagen)

Abstract

The notion that foreign aid and foreign direct investment (FDI) are complementary sources of capital is conventional among governments and internationalcooperation agencies. This paper argues that the notion is incomplete. Within the framework of an open economy Solow model we show that the theoretical relationship between foreign aid and FDI is indeterminate. Aid may raise the marginal productivity of capital by financing complementary inputs, such as public infrastructure projects and human capital investment. However, aid may also crowd out productive private investments if it comes in the shape of physical capital transfers. We therefore turn to an empirical analysis of the relationship between FDI and disaggregated aid flows. Our results strongly support the hypotheses that aid invested in complementary inputs draws in foreign capital while aid invested in physical capital crowds out FDI. The combined effect of these two types of aid is small but on average positive.

Suggested Citation

  • Pablo Selaya & Eva R. Sunesen, 2008. "Does Foreign Aid Increase Foreign Direct Investment?," Discussion Papers 08-04, University of Copenhagen. Department of Economics.
    • Handle: RePEc:kud:kuiedp:0804
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    More about this item

    Keywords

    foreign aid; foreign direct investment (FDI); open economy Solow model;
    All these keywords.

    JEL classification:

    • F21 - International Economics - - International Factor Movements and International Business - - - International Investment; Long-Term Capital Movements
    • F35 - International Economics - - International Finance - - - Foreign Aid
    • H40 - Public Economics - - Publicly Provided Goods - - - General
    • O19 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - International Linkages to Development; Role of International Organizations

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