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

Revised

October 2010

ABSTRACT

This paper examines the link between the composition of foreign aid and that of government spending. Two questions are addressed: (i) does foreign aid crowd out government spending in aid-recipient countries, and (ii) are certain categories of aid more fungible than others? Embedding foreign aid, its allocation, and government spending in a simple endogenous growth model we characterize scenarios where aid might crowd out government spending on investment (say, on infrastructure), thereby mitigating any positive impact on growth. The model is estimated 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. Aid does not affect private investment, but has a strong positive impact on household consumption. The results are also robust to checks for causality. These findings are significant, since more than two-thirds of all aid flows to developing countries are tied to some form of public investment.

The paper can be downloaded from SSRN or by clicking here.