Foreign Aid, Public Investment, and the Informal Economy

40 Pages Posted: 17 Sep 2020

See all articles by Santanu Chatterjee

Santanu Chatterjee

University of Georgia - C. Herman and Mary Virginia Terry College of Business - Department of Economics

Mark Kelly

Baylor University

Stephen J. Turnovsky

University of Washington - Institute for Economic Research; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: July 27, 2020

Abstract

This paper uses a two-sector open economy model to examine the dynamic absorption of foreign aid in the presence of both formal and informal production. Calibrating the model to yield a long-run equilibrium consistent with sample averages for 72 aid-recipient developing countries for the period 1990-2017, we show that an increase in foreign aid impacts the sectoral composition of the recipient economy, driving resources into the informal sector, and away from the formal sector. Further, if aid is untied (say, provided for general budget support), then the expansion of the informal sector can lead to a contraction of the aggregate economy through the Dutch Disease effect. If the recipient government’s objective is to drive an economic expansion by increasing the share of formal production, then re-allocating existing aid to public investment is more effective than an increase in the aggregate level of aid.

Keywords: Foreign Aid, Official Development Assistance, Informal Sector, Real Exchange Rate, Dutch Disease, Capital Mobility, Labor Mobility, Public Investment, Infrastructure

JEL Classification: E2, E6, F2, F3, F4

Suggested Citation

Chatterjee, Santanu and Kelly, Mark and Turnovsky, Stephen J., Foreign Aid, Public Investment, and the Informal Economy (July 27, 2020). Available at SSRN: https://ssrn.com/abstract=3661581 or http://dx.doi.org/10.2139/ssrn.3661581

Santanu Chatterjee (Contact Author)

University of Georgia - C. Herman and Mary Virginia Terry College of Business - Department of Economics ( email )

Department of Economics
University of Georgia
Athens, GA 30602
United States
706-542-1709 (Phone)

HOME PAGE: http://https://sites.google.com/view/schatterjee/home

Mark Kelly

Baylor University ( email )

P.O. Box 98003
Waco, TX 76798-8003
United States

Stephen J. Turnovsky

University of Washington - Institute for Economic Research ( email )

Seattle, WA 98195
United States
206-685-8028 (Phone)
206-543-5955 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

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