Financing Public Investment through Foreign Aid: Consequences for Economic Growth and Welfare*

Abstract

Abstract The paper develops a theoretical framework for understanding the mechanism through which foreign aid affects macroeconomic performance. The authors find that the long‐run impact of an aid program and the nature of the transitional dynamics it generates depend crucially on (i) the elasticity of substitution in production, (ii) whether the aid flow is tied to investment activity or not, (iii) how the recipient government chooses to react to the flow of external assistance, and (iv) whether the aid program is permanent or temporary. Structural characteristics of the recipient are important in determining the extent to which external assistance can aid growth and welfare.

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