Where Has All the Money Gone? Foreign Aid and the Quest for Growth

Santanu Chatterjee

University of Georgia

Paola Giuliano

University of California-Los Angeles

and

Institute for the Study of Labor (IZA)

Ilker Kaya

University of Georgia

January 2009

ABSTRACT

This paper examines fungibility as a possible explanation for the "missing link" between foreign aid and its effectiveness. The composition of aid plays a crucial role in determining the composition of government spending, thereby affecting any potential growth benefits. Embedding fungibility as an equilibrium outcome in an endogenous growth framework, we show that the substitution away from domestic government investment is higher than from government consumption. This leads to a crowding-out of domestic public investment spending and offsets any positive impact that aid might have on growth. The main predictions of the model are then tested using a panel dataset of 67 countries for 1972-2000. We find strong evidence of fungibility at the aggregate level: almost 70 percent of total aid is fungible in our sample. We also find that investment aid is more fungible than other categories of aid, crowding out about 90 percent of government investment. There is also no statistically significant relationship between foreign aid and private investment, whereas aid has a positive impact on household consumption. These results are significant, since more than two-thirds of all aid flows to the developing world are tied to some form of public investment.

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