On the heterogeneous impact of aid on growth: a review of the evidence

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In theory, the impact of aid on growth is ambiguous. Aid is expected to fill the financing gap and relax the capital constraint – low saving and lack of foreign currency – limiting the growth of low-income countries (Chenery and Strout, 1966). In addition, the poorest countries may be stuck in a low-level equilibrium and aid may finance the ‘big push’ which these countries need to reach a higher equilibrium and get out of the poverty trap (Rosenstein-Rodan, 1943). However, related to the concept of ‘big push’ is that of absorptive capacity: countries may encounter limits to the amount of aid they can absorb in an effective way, and this depends on their level of development (Rosenstein-Rodan, 1961). If this limit is reached, aid may then adversely impact the situation of developing countries. The two main theoretical adverse effects of aid which have been highlighted in the literature are: the macroeconomic (Dutch disease) effect and the governance (political curse) effect. Aid may induce the Dutch disease if the increase in demand caused by the inflow of money leads to an increase in the prices of non-tradable goods relative to the prices of tradable goods (which are set internationally), hence an appreciation of the real exchange rate and a loss of competitiveness. The political curse is linked to the fact that aid has a deteriorating impact both on political institutions (financing dictators) and economic institutions (inducing corruption and rent-seeking activities).

Chauvet L. (2015) "On the Heterogenous Impact of Aid on Growth. A Review of the Evidence." Chapter 21 in  Arvin M. and Lew B. (eds.), Handbook on the economics of foreign aid, Edward Elgar Publishing