Week 10 - Foreign Aid

Question 1

What is the technical term for foreign aid?

Answer 1

ODA - official development assistance

Question 2

What does and doesn’t count as ‘official’ aid?

Answer 2

ODA only counts aid originating from donor governments, excludes private assistance from NGO’s and charities e.g. Oxfam

Question 3

In what forms can foreign aid come in?

Answer 3

Mix of financial flows, technical assistance and commodities

Question 4

What is the main objective of foreign aid?

Answer 4

to promote development and welfare. e.g. military aid is excluded

Question 5

What does it mean when aid has to be a kind of ‘assistance’

Answer 5

needs to actually help them, in the forms of grants and/or subsidised loans

Question 6

What is net ODA?

Answer 6

Gross ODA minus repayment of loan principles

Question 7

what is the difference between bilateral and multilateral aid?

Answer 7

Bilateral aid is when a country gives aid to a recipient country directly. Multilateral is when aid is given indirectly e.g. through an institution such as the IMF

Question 8

What other ‘less noble’ motivations also play a role in foreign aid? (3)

Answer 8

• Tied aid: have to use aid to buy from donor country firms
• food aid bought from donor country farmers and transfereed on donor country ships
• Geopolitical motives - aid used during cold war to buy allegience

Question 9

How can we work out the effect of foreign aid on a recipient country?

Answer 9

Take some of the growth models we talked about earlier and plug foreign aid in and then work through the implications of increasing it.

Question 10

what does it mean if aid is transformative?

Answer 10

It can actually increase growth and lead to development. This is heavily debated

Question 11

What are the key assumptions of the financing gap model and how does this relate to foreign aid?

Answer 11

1. aid will go 1 for 1 into investment
2. there is a fixed linear relationship between investment and growth.

Harrod-domar therefore predicts that investment leads to growth. Aid allows poor country to invest.

Question 12

How can aid be inserted into the neo-classical growth model?

Answer 12

endogenise the investment/savings rate (Ramsey growth Model)

Question 13

Describe the main features of this theoretical neoclassical growth model with aid (3)

Answer 13

1. Representative agent in recipient country. They choose to divide income between savings/investment and cons, with the aim of maximising discounted lifetime utility
2. There’s a pay-off to investment: more production in future (depending on the marginal product of capital), so more income and more future consumption and utility, but obviously less consumption now
3. This consumption in the future is discounted via subjective discount rate rho

Question 14

Where is the steady state of this model? What is it determined by?

Answer 14

Where these two forces balance out. The steady state level of capital in the model is determined by what we call deep or structural paramters, especially MPk and rho

Question 15

How does aid affect this steady state?

Answer 15

Most likely doesn’t affect these deep parameters much, meaning aid does not affect the steady state level of capital.

Question 16

If a recipient country is at the steady state, what will happen then?

Answer 16

Nothing, aid cannot be used to build up capital since they’re already at their steady state due to the agents consumption/investment decision. Aid cannot be used for investment so it all will be used for consumption

Question 17

What if the recipient country is below the steady state?

Answer 17

Agent uses a permanent increase in aid is partly used to build physical capital and speed up transition to steady state.

Question 18

True or false - the size of the effect of aid depends on the type of model

Answer 18

True - in particular whether or not we have diminishing returns to capital (Harrod domar vs solow swan

Question 19

So why might aid be mostly consumed?

Answer 19

Since the the level of capital and income per capita on balanced growth path is determined by structural parameters of economy, which aid might not be able to influence much. Aid will mostly be consumed and not much impact on growth

Question 20

What does bauer (1976) say to challenge the idea that aid increases growth via investment?

Answer 20

If conditions for development are in place (e.g. well functioning market economy, good institutions etc) and only capital is lacking, then it will come either domestically or abroad. Therefore there is no need for aid. But if such conditions are not in place, then aid will be ineffective

Question 21

What are 4 counter arguments to bauer?

Answer 21

1. poverty traps
2. virtuous cycles
3. bindings constraints on growth
4. complementary inputs

Question 22

Briefly explain the poverty trap

Answer 22

Underdeveloped countries, very poor, low savings rate, little capital, to poor to invest in public infrastructure

Question 23

How could aid help a country which is poor because of poverty traps?

Answer 23

The general idea of a poverty trap is that a country is stuck in a low income equilibrium - aid can help push country into a better equilibrium. This ‘big push’ in key (public) investments will rapidly boost productivity, financed by aid.

Question 24

How could aid help even if there is a single equilibrium, through virtuous cycles

Answer 24

there may be virtuous cycles so that if aid finances investment into physical capital which can lead to a bit of growth, which can trigger chain reactions of further changes that are beneficial to the economy and further increase income per capita e.g. better institutions and policies, a more diversified economy.

Question 25

What idea is this like in a previous growth model

Answer 25

Romers AK model where the effect of investment is amplified because it leads to the creation of knowledge

Question 26

Why might we get underinvestment even in the presence of these virtuous cycles?

Answer 26

Individual investors do not internalise these positive externalities when they invest. Aid can provide the public sector with the necessary funds to correct this market failure (underinvestment)

Question 27

Why might aid work in the context of binding constraints?

Answer 27

A lack of growth may be due to a potentially small number of binding constraints. If donors identify these and direct aid flows at relaxing them then aid could have a big impact. Will also improve aid effectiveness.

Question 28

How can complementary inputs help aid?

Answer 28

Some inputs relevant to the private sector might not be adequately provided by the market e.g. infrastructure, electricity. If aid can finance improvements in these complementary inputs, then MPk goes up and private investment will increase

Question 29

Most of the literature doesn’t find much effect of aid on development, but why is it still not useless?

Answer 29

Aid could still have value if it does stuff like help children attend schools, supplies vaccines, pays for infrastructure

Question 30

Which sector has aid had a very big impact on

Answer 30

Health e.g. eradication of smallpox, hiv crisis, anti-malerial bendets.

The value for money i.e. how much money has been invested in health aid, is extremely good compared to how many lives its saved.

Question 31

What is the set up for dutch disease effect?

Answer 31

Think of a recipient country as a small open economy, with 2 sectors: traded (exports and imports) and non-traded (e.g. haircuts).
Aid will increase demand for both.
Price for tradeables is fixed on the world market, but increasing demand for domestic non-tradeables increases the price

Question 32

What happens if the domestic non-tradeables increase their price?

Answer 32

the price of non-tradeables rises compared to that or tradeables - exchange rate appreciation.
Leads to a transfer of resources: tradeable sector contracts to allow non-tr sector to expand

Question 33

How does this work?

Answer 33

Increase demand for inputs in non-t sector (e..g for skilled labour). This drives up the price of skilled labour, so those in t sector face higher costs. At the margin, some producers will go bust, freeing up skilled labour to move to non-traded sector, where production expands.

Question 34

Why is this bad?

Answer 34

Because the tradable sector is the sourse of some positive externality, for instance that it is the driver of economy wide productivity growth.

Question 35

What is fungibility?

Answer 35

Aid is fungible if the net effect of aid is different from its intended purpose.

Question 36

How could earmarked aid be fungible?

Answer 36

if it is transformed into a pure revenue or income augmenting resource that can be spent whichever way the recipient government chooses.

Question 37

Why is fungibility a bad thing?

Answer 37

What is optimal for the recipient government might not be optimal for the poor citizens of the country. Aid aimed at benefiting poor people ends up financing military spending, vote-buying or limo’s for ministers

Question 38

What is an example of why we don’t observe full fungibility?

Answer 38

Donor conditionality - earmarking aid is automatically accompanied by a certain type of conditionality: that aid leads to a full increase in expenditure in the targeted sector. If a donor can observe fiscal policy choices of the recipient government and can enforce conditionality, then fungibility can be reduced

Question 39

Suppose a donor uses health aid to build a hospital, but why might aid in this instance actually not be successful?

Answer 39

If the government was planning on building that hospital anyway, now uses the freed resources to buy limos. At the margin, this means that the donors health aid has financed the purchase of these limos

Question 40

How can we test for the degree of fungibility

Answer 40

Run a cross-country regression of the following type: HEXPi = B0 + B1 Haid + xi + u
With HEXP as public health expenditure, HAID health aid, and X a vector of controls.

Question 41

What does it mean is B1 was close to 1 and 0

Answer 41

Close to 1: no fungibility
close to 0: Lots of fungibillity

Question 42

What is a problem with this approach?

Answer 42

Theres a non-negligible fraction of aid which is off budget and is not recorded on recipient gov’t budget
- arises from the direct provision of goods and services by donors instead of going through gov’t

Question 43

what is the impact of this?

Answer 43

It won’t be picked up in the recipient govt;’s budget and health expenditure. So the off-budget health aid leads to low beta1 even though there is no fungibility since we can see 1 more hospital (e.g.) but no more public spending. Therefore this standard assessment will exaggerate the degree of fungibility.

Question 44

What is governance?

Answer 44

Quality of institutions

Question 45

What is the liquidity effect of aid?

Answer 45

Aid provides funds to improve bureaucracy and the legal system e.g. by training people, raising salaries for civil servants, building the capacity to tax

Question 46

Why is the act of taxation important for a state to develop?

Answer 46

Creates a social contract between state and citizens.

Question 47

How could aid help reform of a gov’t?

Answer 47

Help governments committed to reform stay in power as it bears the cost of reform. Compensate those that lose out to the reform.

Question 48

What is a counter argument to this?

Answer 48

Could lead to a moral hazard: why reform to increase taxes, attract FDI and boost income if aid plugs the gap.

Question 49

How could aid worsen governance?

Answer 49

By increasing rent seeking and corruption. More money under control of the government means more opportunities for corruption and rent seeking.
More extreme manifestation: aid increases the value of being in power, so higher risk of coups, political instability and civil conflict

Question 50

Explain conditionality of aid

Answer 50

Aid often comes with demands to change policies and improve governance.

Question 51

How could aid be a useful commitment technology to overcome time inconsistency problems?

Answer 51

If people think that the government keen on reform won’t keep their promises or undo what they initially do. Conditional aid increases cost of reneging on reform, making the time inconsistency problem less severe

Question 52

Why do most economists see conditionality as a failure?

Answer 52

Donors care about reducing poverty, so even when conditions are not met they find it hard to stop disbursing aid. Recipient gov’t anticipate this, so do not reform.