this version 09/06/2011
Recent research yields widely divergent estimates of the cross-country relationship between foreign aid receipts and economic growth. We propose and test two reasons for this divergence, both of which relate to the timing of effects between aid and growth.
First, these studies have insufficiently considered the lag with which aid might affect growth, particularly certain kinds of aid. Second, they have sought to reduce the bias from contemporaneous reverse causation with the use of instrumental variables that appear to be invalid, weak, or both. We reanalyze data from the three most influential published aid-growth studies, strictly conserving their regression specifications, adding sensible assumptions about timing and avoiding questionable instruments.
With these changes, the research designs from all of these studies yield one finding: that increases in aid have been followed on average by modest increases in investment and growth. The most plausible explanation is that aid causes some degree of growth in recipient countries, though the magnitude of this relationship is modest, varies greatly across recipients, and diminishes at high levels of aid.