Is the Relationship Between Aid and Economic Growth Nonlinear?

Abstract

In this paper, we investigate the relationship between foreign aid and growth using recently developed sample splitting methods that allow us to uncover evidence for the existence of heterogeneity and nonlinearity simultaneously. We also implement a new methodology that allows us to deal with model uncertainty in the context of these methods. We find some evidence that aid may have heterogeneous effects on growth across two growth regimes defined by ethnic fractionalization. In particular, countries that belong to a growth regime characterized by levels of ethnic fractionalization above a threshold value experience a negative partial relationship between aid and growth, while those in the regime with ethnic fractionalization below the threshold experience no growth effects from aid at all. Nevertheless, there exists substantial model uncertainty so that attempts to pin down the typology of these growth regimes as being decisively characterized by ethnic fractionalization remain inconclusive. When we account for model uncertainty, we find no evidence to suggest that the relationship between aid and growth is nonlinear. Overall, our results suggest that the partial effect of aid on growth is very likely to be negative although we cannot reject the hypothesis that aid has no effect on growth. In this sense, our findings suggest that aid is potentially counterproductive to growth with outcomes not meeting the expectations of donors.

Keywords: Economic Growth, Aid, Threshold Regression, Regression Trees, Bayesian model averaging

JEL Classification: C11, C14, C45, F35, O11, O40