How Should Donors Give Foreign Aid? Project Aid Versus Budget Support

GATE Working Paper No. 08-13

29 Pages Posted: 4 Jun 2008 Last revised: 15 Apr 2011

See all articles by Izabela Jelovac

Izabela Jelovac

University of Lyon 2 - Groupe d'Analyse et de Théorie Economique (GATE)

Frieda Vandeninden

Maastricht Graduate School of Governance

Date Written: April 1, 2008

Abstract

We develop a theoretical model to compare the two major foreign aid modalities: project aid and budget support. These two modalities have a different impact on the production of 'developmental goods'. Firstly, conditionality can be associated with budget support, but only a subset of the developmental expenses - the observable ones - can be subject to conditionality. Secondly, when using project aid, the donors control the overall allocation of the aid resources. However, we consider that, because of limited harmonisation and coordination, project aid can be associated with a cost of imperfect fit. We develop a unified framework to compare these two modalities where we allow the simultaneous utilisation of both instruments. We show that all the aid should be given via budget support, no matter whether conditionality is used or not. Furthermore, we show that the optimal use of conditionality depends on the recipient's developmental preferences, the productivity of the inputs and the level of aid compared to the recipient's budget: when these parameters are relatively high, conditionality should be enforced. Otherwise, the optimal aid allocation is such that all the aid is given through unconditional budget support. We conclude that conditionality does not always improve the aid effectiveness.

Keywords: conditionality, foreign aid, optimal contract

JEL Classification: D82, F35, O19

Suggested Citation

Jelovac, Izabela and Vandeninden, Frieda, How Should Donors Give Foreign Aid? Project Aid Versus Budget Support (April 1, 2008). GATE Working Paper No. 08-13, Available at SSRN: https://ssrn.com/abstract=1139811 or http://dx.doi.org/10.2139/ssrn.1139811

Izabela Jelovac (Contact Author)

University of Lyon 2 - Groupe d'Analyse et de Théorie Economique (GATE) ( email )

93, chemin des Mouilles
Ecully, 69130
France

Frieda Vandeninden

Maastricht Graduate School of Governance ( email )

Keizer Karelplein 19
PO Box 616
Maastricht, 6200MD
Netherlands

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