Foreign aid, policy and Growth

Is economic growth affected positively by foreign aid? And when this is the case, what role does a good policy environment play? This is a heavily debated topic. While Burnside and Dollar (1997) show that foreign aid only contributes to growth if recipient governments have good policies, others disagree with this result and show that aid always contributes to economic growth and that a good policy environment has no effect. This paper presents another analysis on the already large literature of the aid-growth nexus. It proposes new variables that might affect the relationships that exist between foreign aid, government policies and economic growth. This paper produces OLS and TSLS regressions for eight panels of four-years covering 107 countries between 1970-2001 while taking into account more data that has become available through the years. After controlling for the possibility of aid endogeneity, this paper shows that foreign aid positively affects economic growth. However, the policy environment did not empirically contribute to this positive effect. In addition, this paper examines the effects of the domestic savings rate interacted with foreign aid and the results were very promising, producing highly significant coefficients. The final hypothesis examined, was whether aid works in good policy environments when taking diminishing returns on aid into account. Results show that even when diminishing returns are added, the policy environment did not have any affect.