Evaluating the impact of foreign aid on economic growth: a cross-country study

Abstract

Many studies have tried to assess the effectiveness of foreign aid at the micro and macro level. One branch of the literature attempts to measure the contribution of foreign aid to the growth of developing countries. The micro results are clear and encouraging: foreign aid is beneficial to economic growth. However, the macro results are inconclusive: the impact of foreign aid on growth may be positive, negative, or even non-existent, in statistical terms. This contradiction is known as the ‘micro-macro paradox’. As the findings in this paper will demonstrate, certain methodological and econometric flaws inherent in the assessments being carried out may provide an explanation for the misleading macro results. I have proposed a solution for the shortcomings I have found, using a different set of common econometric tools and the generalised method of moments (GMM) estimator on simple augmentations of cross-country growth specifications. Examining a large sample of developing countries covering a 29-year period, I have found that foreign aid has had a positive impact on economic growth. In light of these findings, I conclude that less importance should be attributed to the ‘micro-macro paradox’ as an overall appraisal of the effectiveness of foreign aid. In terms of magnitude, I have also found that foreign aid has less effect on growth in the short term than in the long term. I also conclude that the time lags in the aid-growth relationship should not be ignored.

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