Examples of aid
- The UK’s $8 billion Climate Investment Funds supports climate action in lower and middle income countries.
- The Brazil Prosperity Fund programme invests £56 million over three years. The money includes supporting solar power projects and events to promote trade.
Effects of aid on recipient country
- Higher AD (either through G if given to government or through C and I if given to consumers or businesses).
- Raises growth but also inflation.
- Aid can create a multiplier effect. The one-off increase in AD resulting from aid can lead to an even greater increase in AD.
- Shift right in LRAS if aid goes toward a supply-side policy. This means increasing productivity or productive capacity e.g. building a hospital or school or infrastructure.
- Can crowd out domestic funds.
- Suppose the aid goes to the government who then spends the money.
- This raises demand for inputs like labour, raw materials and also loanable funds.
- As a result, these inputs rise in price. This increases business costs, reducing profits and the ability of firms to invest. So private investment falls.
- Can encourage aid dependence.
- Aid reduces the need for businesses to innovate to survive or make profits. This may reduce private sector investment.
- Aid can come with conditions. The conditions can be beneficial or harmful for the recipient economy. A typical condition may be that the recipient economy has to engage in supply-side, anti-corruption and fiscal reforms to receive the aid. Organisations like the International Monetary Fund have used this kind of condition for countries such as Ecuador.
- This incentivises the recipient government to reform its economy. This can include reducing the budget deficit, encouraging transparency to prevent corruption, privatisation of state owned assets.
- But such reforms can increase inequality and can lead to other undesirable outcomes. Indeed there were anti-IMF protests in Ecuador as a result of IMF conditions to aid. Cuts to the health service due to IMF deficit reduction recommendations contributed to Ecuador’s health service being underprepared for the health consequences of the Covid pandemic.
Other evaluation points
The effectiveness of aid depends on:
- Where aid is allocated – government bureaucracy vs schooling.
- Suppose aid ends up not being used for a productive project like schooling but is used on government bureaucracy.
- If aid is allocated to businesses to invest, this is more likely to boost the long run growth rate through investments in capital.
- [Note allocating aid to households can boost long-run growth too, particularly where a households use aid to fund education or small business activity].
- The level of corruption. Higher corruption means a greater fraction of the aid is likely to be wasted, all else equal. For example, wasted aid may go to projects with low returns or just to the pockets of politicians or firm managers.
- The skill level of the country’s workers.
- Suppose the country’s workers do not have the skills required to use the aid in the intended way. For example, they do not have the construction skills necessary to build a train line.
- Then a construction project may be more likely to use labour from abroad, which means a greater leakage from the circular flow of income when this money returns abroad.
- Size of the multiplier or position of the economy on the Keynesian LRAS (for AD shifts).
- Time lags for long run projects.
- Depends on the nature of any conditions on aid. This includes whether there are conditions or not. See the aid effects point above for more on the effects of aid conditions.
Aid from the perspective of donor countries
What are the benefits and costs of aid for the developed economy giving aid?
Benefits:
- Reduced global inequality and poverty as a benefit in its own right.
- Increased economic growth in the recipient country. This increases demand for the donor country’s exports.
- Friendlier relations between countries may increase trade flows boosting exports or leading to cheaper imports.
- Conditions of aid may increase aid benefit for donor economy. For example, aid given via loans may allow the donor economy to profit from the aid. Alternatively, conditions to use some of the aid to buy donor country’s exports may boost the donor country’s AD.
- Greater geopolitical influence. Later on, the donor country could leverage this, for example for more preferable trade or other deals.
Costs:
- Monetary cost of aid.
- Opportunity cost of aid. By funding aid, another alternative is left unfunded.
- Conditions on aid may have a negative effect on relations between the donor and recipient countries.
- Corruption and dependency can mitigate a lot of the benefits of aid.
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