Impact of Foreign Aid on Economic Growth

Impact of orthogonal instigate on Economic festeringAbstractThe massive expenditures on unconnected supporter programs by developed nations and transnational institutions, in conclave with the perceived lack of results from these disbursements, raise important questions as to the actual military capability of monetary assistance to less(prenominal) developed countries (LDCs). In this analytic thinking, I focus on 119 start- and medium-development countries, and measure the affect that unlike supporter has on their growth rank of gross domestic product, victimization shut up variables for geography and bout in a geometric lock model.The results indicate that impertinent concern donations do pay a positive repair on the stinting growth of the recipient nation. The exit is extremely modest, however, and new(prenominal) factors such as gird conflict and geography ignore easily mitigate this violation, in some cases to the extent that unknown tutelage becomes prejudicial to scotch growth. Further analysis of the results indicate that this jar is apace felt, with half of the total allude of contradictory countenance felt in approximately six months.Key Words inappropriate countenance, stinting growth, scotch development1. IntroductionOver the last half century, remote financial maintenance has emerged as a dominant strategy for alleviating p everywherety in the third knowledge base. Not coincidentally, during this time period major international institutions, such as the United Nations, World Bank, and International Monetary Fund gained prominence in ball-shaped economical affairs.1Yet it seems that sixty familys later, the lesser developed countries (LDCs) of the world continue to suffer from economic hardship, raising questions of whether orthogonal incite is a worthwhile and legal approach to boosting growth and development in recipient economies. Research on the depicted object has attempted to draw an empirical c onnection amid foreign aid and economic growth. Despite these efforts, however, on that point is no solid consensus among scholars on the actual hard-hittingness of foreign aid inflows.2The term foreign aid pile imply a number of different activities, ranging from humanistic support in the wake of natural disasters to military assistance and arms donations.3For the purposes of this analysis, however, I refer to the measurement definition of moroseicial development assistance, or aid that is aimed at increasing economic development, and has a give component of at least 25% of the total aid package.4Critics of development assistance cite a variety of reasons why it is a poor strategy for combating global p everyplacety. Some argue that it groundwork m early(a) corruption, weaken accountability, and cause government to become excessively large.5Nonetheless, as researchers Hansen and Tarp (2000) write, it is neither analytically defendable or empirically credible to argue from the outset that aid never works.6Indeed, a number of studies go for shown a positive relationship between foreign aid and economic growth, especially in countries which create responsible economic policies regarding share, inflation, and other macroeconomic concerns.The purpose of this analysis is to charter the effects of foreign aid inflows on real gross domestic product growth rates. It differs from existing research in ii key ways. First, I utilize a geometric lag model to capture the continued move of foreign aid inflows for historic period after its initial introduction into the economy.7Second, I incorporate several dummy variables for geography, political stability, and development to chance their rundownal impact on foreign aid effectiveness in growing gross domestic product.2. Literature ReviewThere argon twain contrasting sides to this debate one which argues that aid has a positive effect on economic growth, with even more impact in countries with proceed ec onomic and trade policies and a nonher which contends that foreign aid causes corruption, encourages rent-seeking behavior, and erodes bureaucratic institutions. A renewed interest in explaining cross-country economic growth emerged in the early 1990s, with numerous studies attempting to answer the foreign aid question. To date, however, in that location is no consensus among scholars as to the actual effects of foreign aid on economic growth.There invest been several prominent studies which find a causal link between foreign aid and economic growth. Perhaps the most well-known of these was per stocked by two researchers for the World Bank, Craig Burnside and David Dollar (1997). They found that foreign aid enhances economic growth, so long as good fiscal policies are in place. These policies abide include maintaining small budget deficits, controlling inflation, and being open to global trade.8Durbarry, et. al. (1998) also found a positive association between foreign aid and ec onomic growth, and confirmed Burnside and Dollars finding of conditionality on good economic policy. The study also concluded, however, that the degree to which aid impacts gross domestic product depends largely on other factors as well, such as geography.9Ali and Isse (2005) further confirmed the findings of Burnside and Dollar. The study also demonstrated, though, that aid is subject to decreasing marginal returns, indicating a threshold beyond which development assistance can become detrimental to economic growth.10Not all research has shown a positive relationship to exist between aid and growth. Even before Burnside and Dollars monumental findings, a study by Peter Boone (1994) found that aid-intensive African countries experienced zero per capita economic growth in the 1970s and 80s, despite foreign aid real increasing (as measured by share of GDP).11Additionally, Knack (2001) found that extravagantly levels of foreign aid can erode bureaucratic and institutional quality, tr iggering corruption, and encouraging rent-seeking behavior.12There is also narrate that the effects of foreign aid can be mitigated by other non-economic factors. Situations of state failure, such as social conflict, racial extermination or politicide, and revolution can all potentially influence the extent to which aid impacts growth. George Mason Universitys political Instability Task Force (PITF) created a binary selective informationset indicating in which countries and during what years these events take place. According to the PITF, an heathenish conflict requires the clash of two separate ethnic, religious, or nationalistic factions, and also moldiness meet two threshold criteria 1,000 people must be mobilized for gird conflict, and at least 1,000 people per year must have died as a drive result of this conflict. Similarly, revolutions are defined as episodes of violent conflict between political groups in hopes of overthrowing the current regime, and must meet the comp arable threshold criteria as ethnic wars. Finally, genocide and politicides are defined in a slightly different manner. These events occur when the group in power carries out sustained policies that target ethnic, religious, or political rivals, ultimately resulting in the deaths of a straightforward portion of one of those groups.13Easterly and Levine (1997) studied the effects of high ethnic fractionalization on economic growth. By fractionalization, they mean the probability that two randomly chosen people from a population allow for be of different ethno-linguistic backgrounds. Easterly and Levine conclude that movement from heterogeneity to homogeneity (decreasing fractionalization) results in better schooling, more streamlined infrastructures, and more developed financial systems and foreign exchange markets.14According to their findings, then, it is entirely possible that ethnic conflict, in its attempt to move away from ethnic diversity and towards ethnic homogeneity, re sult rattling improve economic growth. Despite their findings, however, the instability of the regime could still negatively impact the degree of aids effectiveness.Not a lot of attention is paid to genocide, politicide, and revolution and their effects on growth in the literature. Moreover, there has been close to no research performed on this question as it concerns the effectiveness of aid. It is reasonable to believe, though, that resources (including foreign aid) are siphoned off by the dominant party and utilise for individual benefit rather than for economically efficient activities, as intended.Furthermore, out of respect for state sovereignty, these events are not belike to prompt a major international response, which would perhaps eliminate local control over resources and allow them to be used productively. heathenish conflict, on the other hand, typically ignores state boundaries. One study by Gurr (1993) estimated that over two-thirds of identified ethnic communal groups in the world have kindred in another country. The spread across state borders allows other states to intervene without violating state sovereignty, which could positively impact how resources are used, and ultimately, economic growth.Additionally, a countrys geographic location can influence economic performance nations that are landlocked, for instance, are at a natural disadvantage in global trade. Sachs and Warner (1996) write,Landlocked countries, in particular, face very high costs of shipping, since they must pay roadway transport costs across at least on international boundary in addition to sea freight costs. Although air shipments can help overcome many of these problems, only certain goods can be economically shipped by air, and most countries still import and export the majority of goods by the sea.15A report by the UN Economic and Social Commission for Asia and the Pacific (1999) specifically mentions the positive relationship between aid and growth in landlocke d countries, noting that they are at a disadvantage for these reasons, as well.16 referable to their geographical position, then, landlocked countries could potentially benefit from foreign assistance, as it may fill the gap in trade that they experience relative to countries with easy access to international trade.3. Methodology3.1 DataI direct the focus of this analysis to low- and medium-development countries as defined by the United Nations outgrowth Programme (UNDP) in its valet de chambre Development Index (HDI).17These nations were selected since they are the most likely to be recipients of foreign aid, whereas high-development nations are the most likely to be donors. I select the HDI as a basis for classification because in addition to income, the ability accounts for life dribbleancy as measured by infant mortality rates, and educational attainment as measured by adult literacy rates and gross enrollment ratios for primary, secondary, and tertiary schools. This provide s for a more stark(a) on a lower floorstanding of a countrys stage of development and a comprehensive measure of quality of life.18In all, 119 countries of the 177 analyze by the UNDP (67%) meet the development criteria and were included in this study.19Due to data availability issues, I trammel the range of this study to the period from 1980 to 2003. With 119 cross sections, there is a potential 2,856 observations over this time span. by and by taking into account missing data for the independent variables included in the model, 1,760 remain, or about 62%. A vast majority of the missing data is a result of the overall lack of education regarding Sub-Saharan Africa and Soviet bloc countries during the early 1980s. Furthermore, I aim to measure the impact of foreign aid on average, across both time and countries. Thus, I employ pooled data analysis.I collect the data in annual format from several sources. Most of the data come from the United Nations Conference on Trade and Deve lopment (UNCTAD)20and the International Monetary Fund (IMF).21 accede 1 below lists the variables included in this study and the source from which they were gatheredTable 1 Data SourcesVariableUnitSource egregious Domestic ProductGrowth vagabondIMFOfficial Development AssistanceMillions $USUNCTAD sept functionGrowth postUNCTADGovernment ExpendituresGrowth RateUNCTADExports*Petroleum ExporterGrowth RateUNCTADImportsGrowth RateUNCTADAgricultural ProductionGrowth RateUNCTADGross Capital FormationGrowth RateUNCTAD pompousnessGrowth RateIMF nudity to Trade22Share of GDPUNCTADEnergy Consumption Per CapitaMillions of BTUsEnergy nurture Agency, U.S. Dept of EnergyMajor Petroleum Exporter keep mum1=Yes, 0=OtherwiseUNCTADNon-tropics Dummy231=Yes, 0=OtherwiseIUCN World Conservation UnionForeign Direct Investment InflowsMillions $USUNCTADEthnic difference Dummy1=Yes, 0=OtherwisePolitical Instability Task Force, University of MarylandGenocide Dummy1=Yes, 0=OtherwisePolitical Instability Ta sk Force, University of MarylandRevolution Dummy1=Yes, 0=OtherwisePolitical Instability Task Force, University of MarylandLandlocked state Dummy1=Yes, 0=OtherwiseUNCTADLow Development Dummy1=Yes, 0=OtherwiseUnited Nations Development ProgrammeData for household consumption, government expenditures, exports, imports, agricultural production, and gross capital formation were only purchasable in share of GDP format. Since I aim to explain growth rates in GDP, however, function changes in the dollar enumerates of each of these variables would be more appropriate. Thus, I transform these numbers into growth rates as well.243.2 Model SpecificationI assume that inflows of foreign aid will continue to impact the economy for years after its initial introduction, but at a decreasing rate. It would therefore be unsuitable to use an ordinary least squares model, since it would only take into account aid inflows in the year they were received and disregard the continued impact that foreign a id has on the economy in the years after its introduction. To in effect capture this rationale, I use a geometric lag model which incorporates an place number of lags for each variable, but weights each lag in a geometrically declining fashion. The general form of this type of model is(1)Note that in the model a weight is attached to each lag (), a value between zero and one that diminishes geometrically as time passes. Mathematically, this model is the same as25(2)This simpler form, however, shows the dependent variable Y on the right side of the equation. Since Y is already shown to have an error component in (1), this simplification introduces a stochastic regressor into the model, requiring two-stage least squares (TSLS) regression. In order to fit the instruments required for TSLS are non-stochastic, I lag each one period. Thus, to the observer at time t, set for instruments at t-1 are fixed. In other words, these instruments are stochastic but predetermined.3.3 Expected Res ultsI expect to find a positive relationship between foreign aid and economic growth on average, as indicated by most prior research on this subject. I further anticipate, however, that aid will have a detrimental effect on low-development countries since they lack efficient infrastructures and institutions which might make foreign aid donations more effective. I expect ethnic conflict, genocide and revolution to negatively influence the effectiveness of foreign aid, but leave open the possibility that ethnic conflict could positively influence aids impact based on Easterlys study. Furthermore, I expect landlocked countries to experience additional positive gains from foreign aid, since they are at a trade disadvantage.4. Results and AnalysisThe results of the TSLS regression are shown below in Table 2Table 2 TSLS Regression ResultsParameterEstimateStd. Errort-StatisticProb.Constant Term0.0910.4000.2280.820GDP(-1) Lambda0.2330.0872.6920.007Household Consumption6.3072.2412.8140.005Go vernment Expenditures4.5051.3053.4520.001Exports*Petroleum Exporter9.8251.8665.2660.000Imports-3.7460.963-3.8910.000Agricultural Production10.9761.9925.5100.000Gross Capital Formation7.2620.8348.7030.000Inflation-0.0010.000-2.2820.023Openness to Trade0.0200.0054.3010.000Energy Consumption-0.0130.004-3.2120.001Energy Cons.*Low Dev.-0.0520.014-3.8220.000Less than Half of Land in Tropics (1=Yes)0.7420.3262.2750.023Foreign Direct Investment0.0000.0002.1240.034Foreign Aid0.0010.0003.2330.001Foreign Aid*Ethnic Conflict0.0010.0002.2020.028Foreign Aid*Genocide*Low Dev.-0.0170.009-1.9480.052Foreign Aid*Revolution-0.0010.000-2.7310.006Foreign Aid*Landlocked0.0020.0011.8470.065Foreign Aid*Landlocked*Low Dev.-0.0030.001-2.3200.021R-squared0.415S.E. of regression4.535Adjusted R-squared0.408Durbin-Watson stat2.069The model can be written as in general terms as follows(3)WhereGDP = Gross Domestic Product Growth Rate (for country i at time t)ODA = Official Development Assistance (for country i at t ime t)DUMMY = transmitter for Dummy Variables (for country i at time t)Z = Vector for All Other Variables (for country i at time t)The results of the regression indicate that approximately 42% of the variation in GDP growth rates is explained by the variables included in the model, as attest by the R-squared value. Further, each coefficient estimate is of import at the 0.05 level, with the exception of a few borderline cases and the continual term. These coefficients are also consistent with my expectations, however the coefficient for the ethnic conflict dummy did turn out to be in harmony with Easterlys study of ethnic fractionalization.The Durbin-Watson statistic fails to conclusively determine the presence of serial correlation. Further analysis of the residuals, however, indicates that it is not a statistically significant problem.26The model was also tested for the presence of heteroskedasticity, both across time and cross sections using the Breusch-Pagan Test. The results o f this test fail to show statistically significant evidence of heteroskedasticity.27Multicollinearity was investigated using a correlation matrix of the regressors, but no major evidence of this anomaly was detected, either.28The results provide brain wave as to foreign aids effectiveness in a number of ways. Most obvious is that it is has a positive, though modest effect on economic growth, significant at the 0.01 level. Increasing foreign aid by $1 million US will result in an increase in GDP of approximately 0.001%, ceteris paribus. According to the data, the average annual amount of official development assistance received over all years and countries is approximately $570 million US. In this case, aid is estimated to increase growth in GDP by approximately 0.6%.As shown in Table 3, however, this impact can be greatly little by other factors, in some cases to the point where aid actually becomes detrimental to growth. Using the baseline case of a country with no ethnic confli ct, revolution, or genocide, which is not landlocked, and does not suffer from low development, I estimate the additional impacts of any of those circumstances on economic growth. Those factors with N/A listed under Impact were not statistically significant at the 0.05 level.29Table 3 chemical elements Influencing Aid EffectivenessFactorImpactOverall Impact of Aid + Additional Factor(s) on GDPEthnic Conflict0.0010.002Ethnic Conflict in Low Development CountriesN/AN/AGenocide/PoliticideN/AN/AGenocide/Politicide in Low Development Countries-0.017-0.016Revolution-0.0010.000Revolution in Low Development CountriesN/AN/ALandlocked Country0.0020.003Landlocked Country with Low Development-0.003-0.002The model indicates that foreign assistance actually becomes detrimental to growth in situations where there is genocide or politicide in low development nations, as predicted. I attribute this to the fact that resources are typically controlled by the dominant party in genocidal conflicts, and it is likely that aid dollars are siphoned off and used for their own benefit instead of productive and efficient activities. Revolutionary conflict eliminates entirely the impact aid has on the economy, resulting a net effect of about zero. I argue that this is the case because the institutions required to effectively utilize foreign assistance are in jeopardy during a major transfer of power, decrease their ability to act efficiently and distribute aid dollars according to the countrys best interests. Interestingly, ethnic conflict actually increases the effectiveness of aid. This finding is consistent with Easterlys study of ethnic fractionalization and its impact on economic growth.In landlocked countries, aid is particularly effective, tripling the extent to which it impacts economic growth. As Sachs and Warner pointed out, landlocked countries are limited in their ability to engage in global trade. Thus, it seems reasonable that foreign aid positively impacts growth in these areas since their capacity to engage in trade is restricted. However, in low-development countries that are landlocked, this relationship no longer holds. This indicates that whatever benefits aid has in landlocked countries is reversed in low-development countries, possibly due to poor institutional quality, corruption, or other factors.As for other variables besides foreign aid, the model shows the effect of foreign direct investment (FDI) on economic growth is surprisingly small an increase of only 0.00003% in GDP for every $1 million US invested. In contrast, foreign aid boosts GDP by 0.001% with the same amount of money. This indicates that foreign aid has a substantially greater impact on growth than foreign direct investment, all else equal. According to the model, being open to trade seems to be a much more effective strategy in growing the economy, even more so than foreign aid and FDI. It is important to note, however, that since desolation to trade is measured as a sh are of GDP, the impact is not directly comparable that of foreign aid or FDI, since economies included in this study vary greatly in size.To quantify how quickly foreign aid impacts the economic growth of a country, I calculate the median lag as outlined by Davies and Quinlivian (2006).30This measure estimates how quickly half of the impact of foreign assistance is felt, and is calculated as followsMedian Lag = = 0.477 (4)A median lag of 0.477 indicates that in approximately 5.7 months, half of the entire impact of foreign aid on GDP growth will be realized. Half of the remaining impact is then felt in another 5.7 months, and so on, as the cumulative impact of the aid asymptotically approaches 100%. This phenomenon is illustrated in Chart 1 below.Graph 1 Cumulative Impact of Foreign Aid on GrowthThe median lag indicates that aid can quickly impact an economy, but for a relatively short amount of time. After only two years of circulation in the recipient economy, over 95% of the tota l impact of foreign aid is experienced.5. Conclusions and Suggestions for Future ResearchThe purpose of this analysis was to determine the effects of development assistance on economic growth. The model developed in this paper provides evidence supporting the contention that foreign aid positively impacts economic growth in the developing world. Therefore, it is not in the interest of developed countries and international bodies to discontinue aid programs. Moreover, as Gunning (2004) points out, it would be extremely catchy for a donor country to stop aid since it would be seen by both the domestic and foreign populations as punishing an already poor country.31The model also shows, however, that the effects of aid on economic growth are modest, and buying economic growth through foreign aid would be fabulously inefficient and expensive. For instance, using foreign aid alone to increase GDP by 1% in a country would require a foreign aid package of approximately $1 one thousand mi llion US. With almost 120 countries identified as low- and medium-development, spurring economic growth in developing world to desirable levels would be an enormous expenditure. This also assumes that the negative effects of conflict and geography shown to be significant in the model do not apply, and ignores the potential problems of aid dependence, corruption, and bureaucratic erosion that research has associated with high levels of foreign aid.The aforementioned studies by Burnside and Dollar (1997) and others have shown aid to be more effective in salutary economic policy environments. Thus, donor governments and multilateral institutions should continue to push economic reforms and trade liberalization on recipient governments. Not only will this improve the effectiveness of foreign aid according to these studies, but it will also result in less aid being required.The armed conflict dummies indicate, with the exception of ethnic conflict, that state failure and political insta bility reverse the positive effect of aid, even making it detrimental to economic growth in some cases. Therefore, donor governments should be advised of the political situations in recipient countries, and work with international bodies to ensure as much stability as possible. Further, since geography is essentially fixed, foreign aid donations to landlocked countries should be designed to facilitate improvements in exaltation infrastructures, which increase their capacity to engage in trade.Future research should further explore the role of sound economic policies and good governance in aid effectiveness. Scholars should also explore other ways of quantifying climate, tropical geography, and governance to provide for additional testing of potential impacts on the effectiveness of foreign aid. Finally, future study of foreign aid should also investigate its effects on economic development, instead of growth. Doing so will shed light on the question of whether aid actually improve s the quality of life in lesser developed countries.