Attracting foreign investment: Optimal ODA policy with trade liberalization

Abstract

This paper presents a theoretical framework for analyzing the efficient use of foreign aid (ODA) in attracting foreign direct investment, based on the variant of recent economic geography models. A salient result is that recipient countries with less trade openness should direct ODA towards social infrastructure, whereas it should be aimed toward developing economic infrastructure if the target country is a sufficiently open economy. The second result is that, in spite of optimal ODA policy, capital might outflow temporarily from less-developed countries at the beginning of trade liberalization. These results are consistent with empirical observations of 74 recipient countries for the time period 1991 – 2001.