Aid econometrics: Lessons from a stochastic growth model

Abstract

This paper evaluates the standard empirical methods employed in the study of foreign aid, when the data generating process is a calibrated stochastic growth model in which aid recipients make optimal investment and consumption decisions. When recipients receive a stochastic flow of aid and wish to smooth consumption, standard methods fail to distinguish between the response to transient and permanent aid shocks, and hence yield misleading results concerning the object of interest to policy makers: the long-run impact of aid.

Virtuous Circles and the Case for Aid

“…The standard intuition is that they must. But a formal analysis calls this belief into question: in the neoclassical growth model, an amplification effect 21 Gimbel (1976) discusses the wide range of objectives that have been attributed to the Marshall Plan. 22 For an informal discussion of this role for aid, see Rogerson (2011).…”

“…It can easily handle infinite-horizon problems, of the type we analyze here. We could have chosen to solve a discrete-time version of the model using recursive methods, as in the aid study by Carter (2015), but for our purposes, the relaxation algorithm is faster, and easier to implement.…”

“…Another is that definitions of success vary: they might relate to much wider goals, such as securing the political stability of postwar Europe. 21 Well-designed, large-scale aid programmes can have benefits which extend beyond their effects on investment and productivity. Related to this argument, in the models considered in this paper, the potential effects of aid are sharply circumscribed.…”