Foreign aid

Question 1

What is aid?

Answer 1

Development assistance, as defined by the DAC (Development Assistance Committee)

Question 2

What is then official development assistance (ODA) flows?

Answer 2

Official development assistance (ODA) flows are defined as those flows to countries and
territories on the DAC List of ODA Recipients and to multilateral development
institutions which are:

i. provided by official agencies, including state and local governments, or by their
executive agencies; and

ii. each transaction of which:
a. is administered with the promotion of the economic development and welfare of
developing countries as its main objective; and
b. is concessional in character (DAC statistics).

Question 3

What is concessionality?

Answer 3

The degree by which a loan or trade reduces the lender’s or one trading partner’s returns in comparison with what they would get at full market rates.

Question 4

What is the grant element of and ODA loan?

Answer 4

The grant element of an Official Development Assistance (ODA) loan is calculated to measure the concessionality of the loan. It represents the difference between the loan amount (F) and the present value of the repayments (P) made over time, which are discounted using a specified discount rate (r).

G=F−∑(P_t /(1+r)^t)

Where:

G is the grant element.
F is the face value of the loan.
T is the maturity of the loan (the number of years over which the loan will be repaid).
P_t is the payment made in year t.
r is the discount rate.

The discount rate is used to calculate the present value of future payments, taking into account the time value of money. A higher discount rate will reduce the present value of future payments, and therefore, increase the grant element of the loan.

This calculation is used to assess the “softness” of a loan, meaning how generous or lenient the loan conditions are compared to a standard market-based loan. If the grant element is above a certain threshold, the loan can be considered as part of a country’s ODA. According to the slide, before 2018, a loan could be recorded as ODA as long as the grant element was above 25% of the loan. After 2018, only the grant component is included in ODA.

The “Net ODA” mentioned refers to the ODA that remains after deducting repayments on earlier loans. This would include only new loan disbursements less the repayments, rather than the full face value of the loan.

Question 5

How is ODA constrained?

Answer 5

The boundary of ODA has been carefully delineated in many fields,
including:

Military aid: No military equipment or services are reportable as ODA. Anti-
terrorism activities are also excluded. However, the cost of using donors’ armed forces to deliver humanitarian aid is eligible.

Peacekeeping: Most peacekeeping expenditures are excluded in line with the exclusion of military costs. However, some closely-defined developmentally relevant activities within peacekeeping operations are included.

Nuclear energy: Reportable as ODA, provided it is for civilian purposes.
Cultural programmes: Eligible as ODA if they build the cultural capacities of
recipient countries, but one-off tours by donor country artists or sportsmen, and activities to promote the donors’ image, are excluded.

Question 6

How big a part of US investment was ODA flows in 2017?

Answer 6

15% (6,7% of US GDP)

In constrast is foreign direct investments (FDI) on 41%

But you can not compare this two flows directly.

Question 7

What is FDI, and why can you not compare them.

Answer 7

FDI, Remittances and Aid
* Are from different actors:
Firms, Households and States
* And to different actors:
Firms, Households and States
* Are driven by different motives:
Profit, Income/Insurance, Policy
* And have different impacts

Direct comparisons of the sizes of the
flows does not make much sense, because the actors are different, because of motives.

Question 8

Who gives aid?

Answer 8

Bilateral donors
* Donor country –> Recipient
country
* 22 OECD Countries gathered in
DAC,
* The OPEC countries,
* The former Soviet Bloc,
* China, India, Thailand,..

Multilateral donors
* International Financial Institution –> Recipient
country
* Donor country –> International Financial
Institution –> Recipient country
* The World Bank group
* The World Bank (IBRD) gives OOF
* The international Development Association
(IDA) gives ODA
* The Regional Development Banks
* AFDB, ADB, IADB, (AIIB)
* IMF (mainly OOF)
* The UN Agencies
* UNDP, UNFPA, WHO, FAO, IFAD, WFP, UNHCR

Question 9

What is the UN 0.7% aid target?

Answer 9

UN sets a target, that a country should use 0.7% of their gross national income (GNI) on ODA

Bonus info, Denmark accomplishes this goal in 2017, but are still behind Norway and Sweden.

United States uses only 0,2%

Question 10

What motives is there for aid donations?

Answer 10

Foreign Policy, Political Alliances
and National Security
* The Cold War
* The Middle East
* The War on Terror
* Diplomatic Visibility/Influence

Historical (political) Motives
* Former colonies

Economic Motives
* Trade
* Subsidies in donor countries

Humanitarian motives
(Income levels and poverty)
* We have an obligation to help worse
off people
* Humanitarian aid (disaster relief)

Less obvious motives
* Democracy
* Country size

Question 11

What levels are we assessing aid on?

Answer 11

At the project level: Project Evaluations
* Cost-Benefit, Cost-Effectiveness and Impact Evaluations

At the sector level: Program Evaluations
* Benefit-incidence and Contribution Evaluations

At the macro level: Country Performance
* Tables and statistical analyses

Question 12

In the lecture we looked at macro level country perfomance. What did it show?

Answer 12

Simple tabulation shows that not all countries are caught in the
aid trap: More exits than entries

But this does not show if Foreign Aid can buy Growth

Question 13

What are the 4 main ideas on aid (often) works

Answer 13

1. Aid augments saving, finances investment, and adds to the capital stock. (The recipients are constrained)
2. Aid might increase (long-term) worker
   productivity through investments in health or education
3. Aid provides a channel for the transfer of technology or knowledge from rich countries to poor countries
4. Aid improves efficiency (through investments and/or institutions)

Question 14

What are the 5 main ideas on aid does not Work or is Harmful

Answer 14

1. Aid flows can reduce domestic saving, both private saving and government saving
2. Aid undermines private sector incentives for investment or to improve productivity.
3. Aid can cause the currency to appreciate, undermining the profitability of the production of all tradable goods (known as Dutch disease)
4. Aid helps keep bad governments in power, thus helping to perpetuate poor economic policies and postpone reform
5. Aid encourages corruption

Question 15

Why is the impact of aid on growth so difficult to assess?

Answer 15

1. The growth model is complicated
2. The aid countries and projects has a strong selection bias: We give aid to Tanzania, not Norway
3. Aid is fungible: We give aid to build schools, but may finance the military
4. Data is dirty (Recall problems and measurement error in GDP)
5. We cannot experiment: It is difficult to design a control group

Question 16

What may we expect of aids impact on growth?

Answer 16

Assuming a Cobb-Douglas production function, we can calibrate some
numbers

• A 1% increase in the aid-to-GDP ratio for equipment investment should –
  at best- raise the long-run level of GDP per capita by 0.5-0.67% - but it
  may be 0
• Investment in human capital also holds clear potential to increase GDP per
  capita. But the effects will only materialize very slowly over time
• A 1% increase in the aid-to-GDP ratio for infrastructure investments could
  raise the long-run level of GDP per capita by 0.23-0.45%

Question 17

Is there a lot of different results on aid has a postive impact on growth?

Answer 17

Yes, there are several papers saying it has a positive effect and several papers which argues for a negative or no effects.

Question 18

Papper:

The effect of aid on growth:
evidence from a Quasi-experiment

by Sebastian Galiani · Stephen Knack · Lixin Colin Xu · Ben Zou

outline the key arguments

Answer 18

A study using an exogenous event finds aid to have a positive impact on
growth. But this is one study of many [The one the lecturer finds most
convincing]

The lecturer is a proponent of one view, but you may disagree

Question 19

Please give three different motives for providing foreign aid?

Answer 19

Political motives: Foreign Policy, Political Alliances
and National Security, Democracy (globalization)

Humanitarian motives
(Income levels and poverty)

Economic motives

For large downers political and economic motives appear to dominate.

Question 20

Please explain how donations of food to a country can hurt local farmers by
undermining the incentives for them to produce food?

Answer 20

Aid undermines private sector incentives for investment pr to improve productivity. If one “just” get extra food, then why use time and money on becoming more productive?

Aid can cause the currency to appreciate, undermining the profitability of the production of all tradable goods (known as Dutch disease)

A currency appreciates if it takes more of another currency to buy it, and depreciates if it takes less of another currency to buy it.

When a country experiences a large influx of foreign currency, its currency tends to appreciate.
This appreciation makes other sectors of the economy, such as manufacturing and agriculture, less competitive on the global market because their goods become more expensive for foreign buyers.

Finale the answer from the exam with graph, see review.

This is explained in PRLB (Box 14-5, p. 528). If all food is produced locally (no imports), then
an increase in food from aid donations can shift out the supply curve for food and drive down
food prices, benefitting consumers but hurting farmers. This is shown in the panel (a) of Figure
14-6, given below.

Question 21

Please explain and present graphically the three views on aid and growth given in
PRLB chapter 14 ?

Answer 21

See review for graphs

(a) View 1: Aid has a positive impact on growth with diminishing returns after controlling for the impact of other variables.

The majority of studies conclude that, after controlling for these variables (geography, political conflict, policies, and institutions) and allowing for diminishing returns, a positive relationship between aid and growth emerges, albeit with important variance around the trend line. This view is captured by Figure 14–5a. But as we shall see, other research reached different con- clusions, so the debate about the relationship between aid and growth remains open.

(b) View 2: Aid has little or no impact on growth and may have a negative impact.

One simple way is if most of it simply is wasted. If donors build large bureaucracies or spend the money on expensive technical experts from their home country that write reports no one reads, aid will not help growth. Aid that winds up in the personal off-shore bank accounts of government officials or finances a fleet of expensive cars for members of parliament creates little stimulus to growth.

More insidious, if aid breeds corruption, government officials and their cronies spend their time plotting about how to siphon aid money to their own bank accounts rather than increasing output

One of the strongest critiques of aid and how it might undermine development is that it can prop up malevolent dicta- tors and support political regimes that further impoverish rather than help the poor. U.S. aid to the Marcos regime in the Philippines during the 1970s and 1980s, for example, may have helped support an anticommunist ally but probably also length- ened the time in which his corrupt regime remained in power. The same argument can be made about aid in the 1970s and 1980s to the Central African Republic, Haiti, or Zaire.

(c) View 3: Aid has a positive impact on growth in some circumstances (circles) but no impact in others (squares).

If aid builds a road but provides no funds for maintenance, there may be an initial burst of output, but this could be followed by a decline back to previous levels as the road deteriorates. Because donors typically like to finance capital costs of new projects but not maintenance, this is a common problem.

Question 22

Please sketch or draw two simple versions of the Solow growth model in which a
temporary inflow of foreign aid may have permanent effects on the level of income
per capita. [Hint: Think of low-income traps generated by low savings rates and
high population growth rates].

Answer 22

If low income trap is the same as poverty trap, then it is defined as mechanism where it is almost impossible to escape poverty because people are not able to save up money.

If we first assume a temporary inflow of foreing aid have permanent effects on the income level per capita. Then we would expect to end up in a new higher steady state, because foreign aid is assumed to facilitate and accelerate the process of development by
generating additional domestic savings and investments as a result of the higher growth rates that it is presumed to induce. The assumed large population growth rates will have a negative effect on the increase , due to the need of capital per worker to sustain a constant steady state growth.

See review for graph, showing a higher long run steady state due to permanent effect on income level per capita.

Other case, population growth is reduced on the long run due to the higher income, better nutrition and healthcare.

This will lower the straight line (n + delta)*k, which would increase capital per worker and output per work. With the lower population we will have less capital dilution.

se review for graph.

Question 23

Please explain how Galiani et al. (2017) identifies exogenous changes in foreign aid
to 38 recipient countries.

Answer 23

Today we would call the crossing
an event and look at an event
study (a natural experiment)

The World Bank has an income threshold for countries that are eligible for ODA from IDA. The
threshold was set in 1987 to limit the number of countries eligible for IDA funds. 35 countries
crossed the threshold between 1987 and 2010.
Crossing the income threshold does not imply that the countries stop receiving ODA, but they
start negotiating with the World Bank on different terms, moving from IDA (ODA) to IBRD
(OOF). Thus, the crossing is an exogenous event (a natural experiment) that can be used to
identify the effect of aid. The crossing of the threshold should have no independent impact on
growth, thus if there is an effect it is because of the drop in aid. The authors show that the
crossing is a relevant instrument as ODA drops by (1-exp(-0.88)) = 59% in the periods following
the crossing–on top of what we would expect if aid was determined by country fixed factors,
year factors, GDP per capita and population size.

Question 24

Discuss why in theory aid may increase growth; why aid may depress growth, or aid may leave GDP per
capita unaffected.

Answer 24

Increase growth. There are several reasons why foreign aid may contribute to increase growth. From
an analytic perspective, a poor country can be viewed as being stuck in a poverty trap. A classical
argument is that the poverty traps may be caused by initially low income itself. If income is very low,
the savings rate is usually low as well (due to the presence of minimum consumption requirement),
which can lead to insufficient capital accumulation that solidifies the initial low level of income. In such
a savings driven poverty trap, a sufficient (once over) infusion of foreign aid may ignite the growth
process by lifting income sufficiently that savings turns positive and ignites the standard income
savings-capital multiplier. Poverty traps can also arise due to initially low levels of human capital
(schooling or health). Low levels of factor intensity may in addition hamper technology transfer. By
stimulating human capital accumulation, growth is stimulated, both directly and possibly indirectly
through technology transfer. In addition, foreign aid via technical assistance may influence barriers to
technology transfer directly. Infrastructure investments in countries that are internationally credit
constrained may also stimulate macroeconomic efficiency.

Decrease growth. The main concern with foreign aid is that it may cause a diversion of resources. A
classical argument (Dutch disease) asserts that a “windfall gain” may push resources into the service
sector, which will (due to relatively low productivity) increase the price level in the economy and thus
lead to a real appreciation that works to further shrink the internationally exposed industrial sector.
Resource diversion may also occur through political-economy mechanisms. For example, aid inflows
may keep corrupt governments in power, which likely lowers over-all productivity (e.g., via resource
allocation).

No effect on growth. In countries that have not undergone the demographic transition aid may lead to
population growth rather than growth in prosperity. The mechanism is the “Malthusian mechanism’’,
which asserts that an increase in prosperity leads to larger families (either because of higher fertility,
lower mortality, or both), which works to lower the land-labor ratio and thereby (average) prosperity.
Hence capital dilution, prompted by ac

Question 25

Based on Table 3 in Galiani, Knack, Xu and Zou (2017), reproduced below, please explain how the authors interpret the regression coefficients for the variable “Aidis-1” in Table 3?

see review

Answer 25

Regressions (1) and (2) are OLS regressions; fixed effects and first difference OLS, respectively.
Both show a significant positive effect of aid on GDP growth. The elasticity is around 0.01. The
estimated association with an increase in aid/GNI from 0.09 to 0.1 is thus (0.01/0.09) = 0.12
percentage points.

Regression (3) is a Fixed effects 2SLS regression using the crossing event as an instrument for
aid. The regression shows a significant positive effect which is quite a lot higher than the OLS
estimates: (0.028/0.09) = 0.31 percentage points. The following four regressions are 2SLS
regressions with variations in the instrument and the transformation of the panel data. They all
show even higher estimates (the student need not comment on these).

Question 26

What does the evidence say regarding the impact of aid on economic growth? The discussion should
address the following issues:

a. Which “three views” on the impact of aid on growth are pervasive in the literature?

b. What identification problem(s) arise when evaluating the impact of aid on growth?

Answer 26

a.
The three rival views of how aid seems to influence economic growth, which are highlighted in
the textbook, are: (i) That aid does not work; (ii) That aid only works in the presence of
sufficiently sound policies (or conditional on other structural characteristics); (ii) that aid is
subject to “diminishing returns”. All three views seek evidence by using regression analysis.
Whereas view (i) focuses on a linear effect of aid on growth, both (ii) and (iii) allow for nonlinearities; (ii) adopts a specification where aid is interacted with e.g., policy indices (aside
from entering linearly), whereas (iii) allows for a squared term. Identification problems means
that it is unresolved which (if any) of the three views are a better description of the historical
record.

b.
The key identification problem is that aid is endogenous. That is, poor (slow growing) countries
are likely to receive more aid. Therefore, the correlation between aid and growth (which often
is negative) may mean that aid hampers growth; that slow growth leads to more aid inflows;
that factors that hamper growth also influences (positively) how much aid a country receives.

Question 27

Consider a small open economy, Assume international capital mobility is perfect. Can foreign
aid, in the shape of a capital transfer, help increase GDP (per capita)? Please, explain why or
why not.

Answer 27

The Feldstein-Horioka puzzle is that there exist a very strong link, nearly 1:1, between domestic
savings and domestic investments within the OECD area. Accordingly, despite the fact that
capital can move across countries you see a pattern, which would fit a collection of closed
economies. This finding suggests that international capital markets are not functioning very
efficiently.

The Lucas paradox approaches a similar issue from a different angle. In essence Lucas starts by
noting differences in capital per worker is quite large between rich and poor countries. If factor
markets are competitive, to a first approximation, the real rate of return in a country should
equal the marginal product of capital. In light of the vast differences in capital per worker, one
would expect huge differences in rates of return between, say, the US and India, implying
capital should flow from capital abundant US to India where capital is scarce. In practice, this
does not happen. So why doesn’t capital flow to poor countries? One possibility, of course, is
that international capital markets are not functioning very well. That is, perhaps there are large
frictions. Lucas, however, pursues a different idea. Namely, that the US is abundant in another
production faction that is complementary to capital: human capital. In order to close the
apparent gap in returns, based on observed differences in capital-labor ratios, however, Lucas
have to assume sizeable human capital externalities, which are hard to validate independently
empirically. Absent a good explanation, then, for observed capital (apparently in the opposite
direction of where it should go based on theory), the Lucas paradox also suggests capital
markets are not functioning very well.

Question 28

Consider a small open economy, Assume international capital mobility is perfect. Can foreign
aid, in the shape of a capital transfer, help increase GDP (per capita)? Please, explain why or
why not.

Answer 28

C&F make the point that if international capital markets are well functioning an inflow of
foreign aid will not matter much. The argument is (i) that aid can be viewed as a transfer of
physical capital, and, (ii) that international capital markets ensure real rates of return are
equalized. In this setting, the capital-labor ratio is pinned down by the world real rate of interest,
which means an inflow of capital will be accompanied by an equal

Question 29

Based on Table 3 in Galiani, Knack, Xu and Zou (2017), reproduced below, please explain
a. How the authors identify exogenous variation in foreign aid?

Answer 29

The World Bank has an income threshold for countries that are eligible for ODA from IDA. The
threshold was set in 1987 to limit the number of countries eligible for IDA funds. 35 countries
crossed the threshold between 1987 and 2010.
Crossing the income threshold does not imply that the countries stop receiving ODA, but they
start negotiating with the World Bank on different terms, moving from IDA (ODA) to IBRD
(OOF). Thus, the crossing is an exogenous event (a natural experiment) that can be used to
identify the effect of aid. The crossing of the threshold should have no independent impact on
growth, thus if there is an effect it is because of the drop in aid. The authors show that the
crossing is a relevant instrument as ODA drops by (1-exp(-0.88)) = 59% in the periods following
the crossing–on top of what we would expect if aid was determined by country fixed factors,
year factors, GDP per capita and population size.

Question 30

Please, define “Official development Assistance” (ODA).

Answer 30

In order for a transfer to be considered official development assistance (ODA) it needs to
fulfil three criteria. The flow comes from official development agencies (national
government agencies or multinational agencies); the flow has “promotion of economic
development and welfare” as main objective (military expenditures are generally not
accepted as ODA); the flow has a grant element of at least 25%.

Question 31

Roughly, how much ODA do the 22 OECD (so-called “DAC”) donors give, as a fraction of
total GNI? From 1960 and today has ODA disbursement been increasing, decreasing or
roughly constant as a fraction of (DAC) donor GNI?

Answer 31

Between the 1960s and today (DAC) ODA as a fraction of (DAC) GNI has declined from
about 0,5% to roughly 0,4%.

Question 32

What is the “micro-macro” paradox?

Answer 32

The micro-macro paradox observes that a whole host of micro-level studies find
large positive returns on aid funded investments, whereas it seems hard to find a
positive impact of aid on growth.

Question 33

Does the literature discussed under b) address the micro-macro paradox? Please,
explain why or why not.

this is question b) Which “three views” on the impact of aid on growth are pervasive in the literature?

Answer 33

They do not. The simplest way to see this is by noting that even if aid – on impact-
serves to increase income (say by funding infrastructure) the longer run impact can
be zero if population growth responds in keeping with the Malthusian mechanism.
This example serves to illustrate that growth regressions do not identify the (macro)
return to aid, since the growth effect also convolutes behavioural responses (or
general equilibrium effects).

The student may also bring up that a recent study by Dalgaard and Hansen (2017,
JDS) provides a method to identify the macro return. DH do not find that the macro
returns are at variance with the micro returns. This suggests that if aid has a limited
effect on growth it is unlikely to be caused by aid is being misused. Instead,
mechanisms such as the Malthusian one, or perhaps political-economy effects
whereby the return to aid is channelled into counterproductive uses (or simply send
out of the country), may represent countervailing forces that leaves the net impact on
growth insignificant.

Question 34

Discuss the idea of a temporary foreign aid having a permanent effect in a country with facing a poverty trap and high population growth. Draw it in a solow model.

Answer 34

On the other hand opponents of foreign aid programs, argue that domestic savings decline as a result of aid-induced increased consumption.

The effect on savings:
If we believe in the argument that poor people can not save due to their voluntary
choices. The decision to save rather than to consume represents a choice between current and
future satisfaction, so a person who does not care much about the future will not save. If people value the present more because they are
uncertain about the future, aid does not induce greater levels of savings because, at least in the
short run, it cannot change the incentives people face when choosing consumption today over
consumption tomorrow and people respond to incentives. In this context, foreign aid ends up
being consumed by recipient governments rather than saved to be enjoyed in the future.

The effect on investment:
Economic agents invest in the future when they get a high return
to their investments. If these agents expect returns to be low or uncertain, they will not invest. Instead aid will be consumed.

The effect on consumption and national income:
As we have seen, we would expect the population to increase their consumption when receiving foreign aid when we have assumed a poverty trap.

Consumption C is defined as national income less saving; equivalently
consumption is national product less investment:

C = Y - S = Y - I

Therefore an increase in consumption will increase Y. Again we have assumes a high population which will lead to consumption having a smaller effect on y.

The graph:

As the neoclassical model predicts, the main determinant of per capita income growth is capital accumulation, which sustain long term constant growth, but higher consumption can have a short run increase in GPD pr capita. In this case we will see a short run effects in the solow model, but decline due to no savings or investments which would have raised capital accumulation.

see graph