The role of institutions in shaping the growth-aid relationship

Abstract

Empirical evidence on the relationship between aid and economic growth is mixed and inconclusive. This paper proposes a theory to explain these contradictory findings. We build an endogenous growth model with a productive public good and homogeneous agents who allocate their time to both work and the appropriation of public resources. Aid increases public resources, raising the provision of the productive public good, but promotes rent-seeking. As recent empirical evidence suggests, a hump-shaped relationship between aid and growth emerges: too much aid is counterproductive for growth, particularly when institutions are weak. Aid transmits growth from the donor to the recipient country but harms income convergence and even prevents convergence among ex-ante identical countries when aid exceeds a certain threshold. Institutional improvements raise such a threshold. Thus, countries with lower income and lower institutional quality should receive less aid, unless an institutional reform is taken as a previous step to receive that aid.