Foreign Aid and Economic Growth: The Role of Flexible Labor Supply

Abstract

This paper examines the link between foreign aid, economic growth, and welfare in a small open economy. External transfers impinge on the recipient's macroeconomic performance by affecting resource allocation decisions and relative prices. The endogeneity of the labor-leisure choice and the adjustment of the real wage rate play a crucial role in the propagation of foreign aid shocks. Another crucial determinant of the efficacy of foreign aid is externalities associated with the public good that the aid helps finance. The impact of tied and untied aid on the recipient government's intertemporal fiscal balance is also considered. Finally, the transitional adjustment to a foreign aid shock is shown to depend crucially on the elasticity of substitution in production and the relative importance of the labor-leisure choice in utility.

Keywords: Foreign aid, International transfers, Endogenous labor, Economic growth, Public investment

JEL Classification: E6, F4, O1