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Table of Content 1

1 Introduction 2

2 Literature Survey 3

2.1 Econometric Models in Earlier Studies 4

2.2 The Pro Foreign Aid Views: Foreign Aid May Undermine Economic Growth in Developing Countries 5

2.3 The Anti Foreign Aid Views: Foreign Aid May Undermine Economic Growth in Developing Countries 6

2.4 Gaps in Existing Literature Studies 7

3 Theoretical Arguments and Regression Analysis 7

3.1 The Data Survey 7

3.2 Theoretical Argument 8

3.3 Regression and Data Analysis 9

4 Conclusion 11

4.1 Summary 11

4.2 Recommendations 11

4.3 Limitations and Further Research 12

5 Reference 12

It was just after the Second World War that the concept “foreign aid” was created, when the United States pumped in billions into the European economy, in order to help the economy to recover (Sogge, 2002). Since then, foreign aid is has been regarded as a way to directly benefit the economy of the country that receives the aid. The majority of the foreign aid givers donate foreign aid to other countries have strong belief of such association (World Bank, 1998). A number of earlier literature studies have used different approaches to examine whether or not foreign aid is capable of meeting such goal in reality. In other words, these literature studies aim to find out whether or not foreign aid is actually able to stimulate economic growth in developing countries based on empirical evidence. Despite of the rapid political, economical and social changes in the world since the Second World War, how foreign aid impacts economic growth in developing countries remains as an important and heated topic.

Therefore, an empirical analysis of how foreign aids affect economic development in developing countries is essential in testing the effectiveness of foreign aid. Institutively, the research title of the study is:

How Foreign Aid Impacts on Economic Development of Developing Countries

The remaining parts of this research paper is structured in the following way. The second section is the literature survey, which analyses the existing literature studies regarding to the influence of foreign aid on economic development in developing countries. The third section outlines the empirical results, by displaying the results of the data survey and presenting theoretical arguments. The final section summarizes the findings of the analysis and discussion, where recommendations, discussions of limitations and further researches will also be presented.

In this section, a literature survey is conducted. The section focuses on critical analysis of existing literature studies of the following topics:

There are two main types of econometric models that have been applied in analyzing the relationship between foreign aid and economic growth (McMillan, 2011), namely the “Two Gap Model” (Chenery and Strout, 1966) and the “Poverty Trap Model” (Nelson, 1956).

The Two Gap model contains two components, where the first component is the relationship between foreign aid and economic growth, whereas the second component regards the relationship between savings level and economic growth. The fundamental rationality of the model believes that foreign aid is able to increase investment level in the economy, which in turn drives economic growth. The aim of the model is to find the optimal investment level in order to obtain a target economic growth level (Devarajan et al., 2002). There are a number of drawbacks of this model, where most of the criticisms focus on its assumptions (McMillan, 2011). For example, Harms and Lutz (2004) criticized that the “Two Gap Model” neglected the other drivers of economic growth (such as health care, education level, utilities development, research and development level), by assuming that investment is the only driver of economic growth. In addition, Harms and Lutz (2004) pointed out that it was not necessarily the case that recipient countries of foreign aids invest the entire amount of foreign aid into the economy. As a result, foreign aid may not only impact on economic growth of a country in the form of investment. Meanwhile, corruption in developing countries is also another obstacle that prevents foreign aids from turning into investments.

On the other hand, the Poverty Trap Model has more theoretical features than econometric features, comparing to the Two Gap Model. The fundamental rationality of the model is that it believed that economic growth is constrained by poverty traps, which result from a number of different determinants including high population, low savings as well as low productivity level. The injection of foreign aid into the economy is believed to be able to lift the economy out of the poverty traps, and therefore initiate faster economic growth. However, the model also has its limitations. Harms and Lutz (2004) pointed out that it was way more complicated and difficult for a country to get out of poverty traps than what was stated in the Poverty Trap Model. More specifically, they believed that despite of the importance of initial capital injection for a developing economy to takeoff, other factors such as governance and private investment should play roughly equally important roles.

The literature surveyed in this section mostly argue that foreign aid has a positive influence over the economic development in developing countries. Early scholars such as Papenek (1973) and Levy (1988) believed that foreign aid had a positive impact over economic development, as it was able to stimulate savings, investment as well as increase capital. In addition, they also argued that by providing help in the form of foreign aid, developed countries were also able to transfer more advanced knowledge and technology to developing countries (Papenek, 1973; Levy, 1988). On the other hand, later empirical studies examined the topic in a more rigorous manner, through the application of the “diminishing return hypothesis” (Durbarry et al., 1998; Dalgaard and Hansen, 2000; Hadjimichael, et al., 1995; Hansen and Tarp, 2000; Lensink and White, 2001; Dalgaard et al., 2004). More specifically, these studies argued that that positive impact that foreign aid had over economic growth in developing countries is only valid up to a certain level.

On the other hand, a number of research studies have found negative relationship between foreign aid and economic growth. In other words, these literature studies have found a negative relationship between the two. Friedman (1958) and Bauer (1972) believed that foreign aid is unnecessary for a country to achieve high economic growth. In addition, they pointed out the danger of aiding foreign governments that are corrupted. Griffin and Enos (1970) used empirical analysis to conclude a negative correlation between foreign aid and economic growth. In addition, Bauer (1991) argued the damage that foreign aid causes in developing countries, as he believed that governments that received foreign aid were also entitled with more power and resources relative to the rest of the society.

Overviewing the existing literature studies in the topic, it has been observed that most of the studies were produced in the 90s and early 2000. In contrast, there lacks studies that examines how foreign aid impact on economic growth after 2005. As a result, in order to fill in such research gap, this research paper will produced a more up-to-date understanding of the issue, by using more recent data for the empirical analysis.

The data used for the study is obtained from the World Bank. The economic growth is measured using Gross Domestic Production, whereas the foreign aid data is obtained from World Bank’s “net official development assistance and official aid received (current US$)”. The dummy variable of the “average years of schooling” is extracted from the Human Development Reports produced by the United Nations Development Programme. The time period covered in the empirical analysis is between 1994 and 2013. In total, twenty countries are included in the analysis, chosen using random sampling method. More specifically, these countries are: Afghanistan, Brazil, Thailand, China, Egypt, Ethiopia, Croatia, Pakistan, Iraq, Kenya, Nigeria, Nepal, Malaysia, Philippines, Tunisia, Turkey, Uganda, Vietnam, South Africa and Zimbabwe.

The model used for this study is adapted from the Solow’s Economic Growth Model. The use of Solow’s Model in analyzing the role of foreign aid plays in economic growth is rationalized as follows.

More specifically, the Solow’s Economic Growth Model states that:

In which is the GDP level, is the level of capital, is labor available in the economy.

By taking first derivatives of K(t) and H(t), we get:

More specifically, is the proportion of output that is turned into investment rather than consumption, is the proportion of output that is regarded as the cost to improve human capital which is measured as the average school years completed, d is regarded as the depreciation of the capital.

Furthermore, following definitions are set:

In addition, let be the “GDP per capita”, be “foreign aid per capita” and be “human capital per capita”. As a result, we get:

By solving the above three equations, an optimal level of GDP per capita is:

Following construction of the theoretical model as well as solving relevant equations, a logarithm regression equation can be obtained:

Where the technology growth rate and depreciation rate is approximated to be 0.05. g is the growth rate of “SCHOOLING”.

Therefore, the hypothesis test tests following null hypothesis:

If the null hypotheses are rejected, the alternative hypotheses will be accepted. More specifically, the alternative hypotheses are:

By running the linear regression analysis on the log values of the variables, following results were found.

The results show that the p-value of the log values of both foreign aid and schooling are nearly 0. This implies that both foreign aid and schooling have significant impact over economic growth in developing countries. However, it is worth noting that the coefficient associated to the log-value of “foreign aid” is negative. Therefore, it implies that foreign aid has a negative impact over economic growth in developing countries. Meanwhile, the adjusted R-square was found to be 0.6151. This implies that the goodness-of-fit of this model is relatively high.

In this research paper, the researcher modifies the Solow’s Economic Growth Model in order to examine the impact of foreign aid over economic growth in developing countries. The empirical analysis finds that foreign aids have significantly negative impact over economic growth in developing countries. This result is consistent to the views of the scholars who are anti foreign aid. This can be explained by a number of factors. For example, many of the developing countries have relatively corrupted political regime. As a result, the foreign aid received is not used effectively.

Based on the results and findings, a number of recommendations can be made correspondingly. First, foreign aid donor countries need to assess the recipient countries before giving out foreign aid. This can be achieve by conducting in-depth economic and market analysis of the target countries. Second, international organizations should supervise and monitor how aid recipient countries use the money received. This will therefore motivate and incentivize developing countries to use foreign aid effectively.

However, there are some limitations of this research paper. First of all, only 20 countries are analyzed in this study. This is a very small proportion of all developing countries in the world. As a result, the results may not be objective enough to be generalized. In order to over come this issue, further research should include in more countries in the analyzed sample. Second, the analysis is only conducted across different countries, whereas timeline analysis is not conducted. In order to over come this issue, further research should take into account of how foreign aid has impacted on economic growth over the years.

Bauer, P. (1972). Dissent on development. Cambridge: Harvard University Press.

Chenery, H. and Strout, A. (1966). Foreign assistance and economic development. American Economic Review. 56: pp679-733.

Dalgaard, C. and Hansen, H. (2000). On aid, growth, and good policies CREDIT Research Paper No. 00/17, Centre for Research in Economic Development and International Trade, University of Nottingham.

Dalgaard, C.; Hansen, H. and Tarp, F. (2004). On the empirics of foreign aid and growth. Economic Journal. 114(496): pp191-216.

Durbarry, R.; Gemmell, N. and Greenaway, D. (1998). New evidence on the impact of foreign aid on economic growth. CREDIT Research Paper No. 98/8, Centre for Research in Economic Development and International Trade. University of Nottingham.

Friedman, M. (1958). Foreign Economic Aid. Yale Review. 47(4): pp501-516.

Hadjimichael, M.; Ghura, D.; Muhleisen, M.; Nord, R. and Ucer, E. (1995). Sub-Saharan Africa: growth, savings, and investment 1986-93. Occasional Paper 118, International Monetary Fund, Washington.

Hansen, H. and Tarp, F. (2000). Aid effectiveness, disputed. Journal of International Development. 12: 375-398.

Harms, P. and Lutz, M. (2004). Aid and growth regressions. Journal of Development Economics. 64: pp547-570.

Lensink, R. and White, H. (2001). Are there negative returns to aid? Journal of Development Studies. 37(6): pp42-65.

Levy, V. (1988). Aid and growth in sub-Saharan Africa: the recent experience. European Economic Review. 32(9): pp1777-1795.

McMillan, L. (2011). Foreign aid and economic development. School of Doctorial Studies Journal. 2011: pp158-164.

Nelson, R. (1956). A theory of the low-level equilibrium trap in underdeveloped economies. American Economic Review. 46: pp894-908.

Papenek, G. (1973). Aid, foreign private investment, savings, and growth in less developed countries. Journal of Political Economy. 81(1): pp120-130.

Sogge, D. (2002). Give and take: what’s the matter with foreign aid? USA: Palgrave McMillan.

World Bank (1998). Assessing aid: what works, what doesn’t and why. USA: Oxford University Press.

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