Why aid is expected to positively influence economic growth

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Explain why aid is expected to positively influence economic growth

1. Introduction
The success of the Marshall plan [officially the European Recovery program (ERP)] in improving economic conditions post World-War II in Western Europe gave birth to the idea that economic aid can improve conditions in developing and poor countries Hogan (1987). The rationale for expecting Aid to positivelyinfluence economic growth stemmed from the fact that aid was seen as an exogenous net increment to the capital stock of the recipient country. Inherent in this perception is the assumption that each dollar of aid will result in one dollar total savings and investment. However, aid to developing and low income countries have been fiercely criticised for not yielding the desired economic growth.Unlike its predecessor ERP which existed for only four years, after which the economy of every participating state had surpassed pre-war levels, aid has been in existence for more than three decades.

There is plenty of evidence of effectiveness of aid in many specific projects. But literatures reviews conducted on the macro-economic impact of aid covering the period up to the end of eighties tella less optimistic story compared to microeconomic project evaluations. This has given rise to the macro-micro paradox.

The aim of this essay is to first, outline the pathways in which aid is understood to impact on growth, then discuss some of the prevalent reasons offered as explanations for disappointing results of aid and conclude.

2. Theoretical underpinnings of the aid and growthrelationship
Aid is exists in a variety of forms and is given for various purposes. Therefore it can potentially impact on economic growth through a variety of complex channels. However, for the purposes of this essay I will focus on the impact of aid on selected macroeconomic variables namely; savings, investment and growth. This approach is in line with Hansen and Tarp (2000). In the firstgeneration of studies aid was not treated as a component of national income adding to both consumption and investment. Fungibility of aid was not allowed for. Aid for consumption was not taken into account. The underlying theoretical framework is based Harrod-Domar model. The thrust of the Harrod-Domar model is the Leontief production function, it assumes excess supply of labour, no substitution amongproduction inputs is possible and output is linearly related to capital the scarce factor of production. The only way in which savings, domestic and foreign (including aid) can have an effect on growth in this model is through the accumulation of physical capital that is investment.

In the early empirical literature the equation below was used to assess the aid-savings relation.
s=α0 + α1a1where α0 is the marginal savings rate and α1 captures the impact of aid inflows (as a share of income) on the savings rate. Hansen and Tarp review of the literature from a period of late sixties to 1998 showed only one study had an estimate α1 significantly greater than zero (out of 47 studies). More than 60% of the studies showed a significant negative coefficient. Two conclusions emerged, firstlyarguments suggesting that the impact of aid on domestic savings is positive were speculative and secondly the negative finding has been viewed to mean aid is harmful to growth. Papanek (1972) argued that the negative α1 parameter is consistent with the aid-impact on total investment as long as α1>-1. Hansen and Tarp (2000) derived the test statistic for this alternative hypothesis for 39 out of41 studies only one study lead to lower total savings, 18 studies had a positive impact on savings and 20 studies aid had no impact on savings. The conclusion from these first generation studies is that aid spurs growth.

The second approach was to focus on the aid, investment and growth relationship Hansen and Tarp (2000) categorise these studies as the second generation studies. In this...