An Empirical Analysis of the Effect of Aid on Growth

The fact that so many countries register low per capita income after receiving enormous amounts of foreign aid questions its effectiveness as a tool for economic growth and consequently as an instrument of poverty alleviation. The impact of foreign aid on economic growth is ultimately an empirical question and one that will be addressed in this paper. The paper uses the most recent data and incorporates most of the salient features of the new growth literature to test the effect of aid on economic growth. Three important conclusions emerged from the empirical analysis of the paper. First, it shows that the effect of aid on growth is nonlinear. The nonlinearity of the relationship indicates a threshold for foreign aid beyond which more aid is detrimental to economic growth. Second, the empirical results of this paper support Burnside and Dollars findings that a good policy environment is important for aid to work effectively. Aid effectiveness can only be sustained in an environment of good economic policy. Finally, using etholinguistic fractionalization as an instrument, the empirical results of the paper indicate that the relationship between AID/GDP and economic growth is sequential. More and more aid leads to lower economic growth.The authors would like to thank W. Mark Crain, G. Chris Rodrigo, Willem Thorbecke, an anonymous referee, and the participants of the 57th International Atlantic Economic Conference held in Lisbon, March 10–14, 2004. This paper is presented to the conference under a different title. Professor Ali would also like to thank the Research Council of Niagara University for their financial help.