Aid, Budgetary Policies, and the Macroeconomy: Growth, Inflation, and Welfare

Abstract

This paper examines the macroeconomic effects of foreign aid transfers in a small open recipient economy. The focus, however, is not on the impact of foreign aid per se but rather on aid’s influence conditional upon the different budgetary financing policies under the discretion of the recipient government. We compare the effects of an aid transfer tied to investment in a public good from a pure aid transfer, under income-tax and/or inflation-tax financing of government expenditures. The effects of each form of aid under each type of public financing are examined with respect to the economic growth rate, the rate of inflation, and the percentage change in welfare of the recipient economy. The economy is analyzed numerically and specific policy recommendations are provided for individual recipient countries.