Aid for trade and inflation: Exploring the trade openness, export product diversification and foreign direct investment channels

Abstract

AbstractDrivers of inflation have been extensively investigated in the literature. However, little attention has been paid to the effect of official development assistance flows, let alone the part of this aid allocated to the trade sector (the so‐called Aid for Trade [AfT] flows) on inflation in the recipient‐countries. This paper explores the effect of AfT flows on inflation in recipient‐countries, using a set of 126 countries over the period 1995–2015, and the two‐step system generalised methods of moments technique. Results have shown that AfT flows contribute to reducing inflation, with the magnitude of this negative effect being higher than that of NonAfT flows (that is, other development aid flows than AfT flows). Interestingly, AfT flows tend to exert a higher negative effect on inflation in countries that enjoy a greater export product diversification, higher FDI inflows, greater trade policy liberalisation and trade openness. These findings show that a scale up of AfT flows (ideally not at the expense of NonAfT flows) by donor‐countries can contribute to greater macroeconomic stability, including through lower inflation rates in recipient‐countries.