Foreign Aid and Its Effect on Per-Capita Income (Growth) in Recipient Countries: Pitfalls and Findings from a Time Series Perspective

In this paper we investigate the effectiveness of development aid in recipient countries. Specifically, we analyze the relationship between per-capita income and foreign aid for a maximum of 131 recipient countries over the 1960 to 2006 period. We employ annual data and 5-year averages and, contrary to the previous literature, carefully examine the time-series properties of the data. The previous literature overlooks the non-existence of a long-run relationship between aid and growth and the presence of autocorrelated error terms. To address those problems, we apply panel time-series techniques (panel unit-root tests, panel cointegration tests, and panel dynamic feasible generalized least-squares estimation [DFGLS]). Estimations with DFGLS show that aid has an insignificant or minute negative significant impact on per-capita income. This holds for countries with both above- and below-average aid-to-GDP ratios, for different levels of human development, different income levels and different regions of the world. We also find that aid has a significantly positive (although small) impact on investment, but a significant negative impact on domestic savings (crowding out) and the real exchange rate (appreciation).