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The main motivation of this thesis is to contribute to the literature on the macroeconomic effects of foreign aid flows. It consists of four empirical papers, investigating the two main channels through which aid flows impact the recipient economy: (i) the fiscal sector, and (ii) the real exchange rate. The first paper is concerned with the impact of aid on government expenditure, domestic revenues and borrowing. It uses a traditional fiscal response framework with annual data for Ethiopia. The second paper also focuses on the fiscal sector but uses a recently compiled quarterly fiscal dataset and the cointegrated vector autoregression methodology. The main result arising from both papers is the strong correlation between aid inflows and domestic borrowing, possibly as a strategy to smooth unpredictable and volatile aid inflows. Aid is positively correlated with government expenditures, but there is little evidence of tax displacement. There is also evidence of aid heterogeneity, as grants and loans induce different effects. The third paper assesses the impact of foreign aid on the Ethiopian real exchange rate, which is a common measure of external competitiveness. It uses a quarterly macroeconomic dataset and applies two distinct methodologies: (i) single-equation cointegration models, and (ii) an unobserved components model. The results do not provide support for the ‘Dutch disease’ hypothesis. The fourth paper investigates the extent to which foreign aid is ‘absorbed’ and ‘spent’. The empirical analysis uses a panel of 25 African low-income countries and applies recently developed panel cointegration techniques. The findings suggest that aid is fully spent while absorption is higher than previously estimated.
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