Foreign Aid and Economic Growth in Developing Countries: An Instrumental Variables Approach

Abstract

There is little consensus on the capacity for foreign aid to cause economic growth in developing countries. This is due in large part to the fact that foreign aid recipients are selected by donors, confounding identification. This paper proposes an identification strategy that exploits exogenous variation in foreign aid receipts generated by participation in Human Rights Treaties at the UN to identify an average causal effect of aid on growth. Our approach allows for heterogeneous effects of aid on growth across recipients for unobservable reasons, and we thus identify a Local Average Treatment Effect (LATE). Further, we normalize aid with respect to population as opposed to the more commonly used GDP for the purposes of identification and show that this choice has important implications for the identification and interpretation of the effect of aid. Our estimates imply that a percentage point increase in aid as a fraction of GDP causes the annual average growth rate in a recipient country to increase by about 0.6 percentage points. Though LATE's are instrument specific and thus subject to concerns about external validity, we provide evidence suggesting that our estimate is indeed externally valid. The estimated effect is explained almost entirely by an expansion of the service industry, accompanied by a large increase in household consumption, with no evidence that aid causes Dutch disease. We conclude that aid increases growth by inducing a structural change in household demand for services.