This paper surveys the theoretical economic literature on foreign aid—in particular, the aid donor–recipient relationship. Economic theory, especially new institutional economics, can be very helpful in understanding foreign aid relationships—especially the incentive problems involved—and in designing institutions to improve aid effectiveness. In particular, it helps in understanding the chain of principal–agent relations inherent in the aid delivery system and the resulting potential for agency problems. The survey shows that economic theory can improve the design of cooperation modalities by aligning the incentives of donors and recipients for poverty reduction, but that, in order to address the problems, policy analysis must take into account the constraints faced by stakeholders in the aid relationship. The aid ‘contract’ should thus seek to improve the agents’ incentives to use aid effectively, given the circumstances of the developing country.
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