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Does Foreign Aid Effects Gdp

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Introduction
The impact of Foreign Aid on the growth and development of less Developed Countries (LDCs) is a matter of strategic importance for the policy makers of these countries in framing their future economic programs and strategies. There has been a significant increase in the flow of foreign aid in the developing countries (Figure 1&2).According to Alberto Alesina, foreign aid is determined by political condition, economic needs and policy considerations of recipients. Despite the advancement of technology and infrastructure, a large number of developing countries still face the acute shortage of basic amenities of life such as Food and shelter. Thus, the influx of foreign aid can be a crucial factor to address these issues.

Figure 1

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Figure 2 The economic theory suggests positive effects of investment on the national income of the country. John Maynard Keynes in his most famous book The Theory of Employment, Interest and Money, argued that the national income of the country increase by more than the amount of investment by a phenomenon known as the MULTIPLER EFFECT. The qualitative effects of the investment such as Foreign Aid include the inflow of new technology, alleviation of poverty and establishment of infrastructure in the host economy. Thus, the increase of Foreign Aid is a positive sign for the future growth of a developing economy. The main objective of this empirical project is to analyze the effects of Foreign Aid on the growth rates of LDCs and to investigate whether Foreign Aid alone or there are some other factors too that have contributed to the development of LDCs in the past four decades. The main motivation behind this project is to find these factors and to suggest the government of Pakistan for concentrating on these factors for their future economic plans. The

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distinguishing factor of this project is that we have analyzed data of nine LDCs over a large time span of four decades. The subsequent sections of the paper are structured as follows. Section 2 depicts Literature review, Section 3 presents summary of the data set, Section 4 presents Econometric Analysis and the final Section 4 represents the Conclusion remarks and sheds light on the policy implications and future research ideas on the growth rate of the LDCs.

Literature Review
There has been a great debate amongst the researchers around the globe on the effect and relationship of the Foreign Aid on growth rates and a large amount of empirical literature has been produced on this issue. Alberto, Mark and Cecilia (2009) explore the effects of foreign aid on income inequality and poverty during the period 1971-2002. The author concentrates on dynamic panel data techniques, allowing simultaneity heterogeneity issues. The author founds out that foreign investment and founds some evidence that foreign aid contributes to improvement in the distribution of income if the quality of institutions is taken into account. The study conducted by Abdiweli and Hodan (2007) analyzes the effect of foreign aid and trade on the income of 150 countries over the period 1975-2000. The study explored simultaneity of international trade, foreign aid and economic performance using a threestage least squares approach. The results of their paper showed that Foreign Aid and trade are determinants of GDP per worker but in opposite direction. Rahim M. Quazi analyzes the effects of foreign aid on GDP, growth and fiscal behavior of Bangladesh over the 1973-1999 period. The results of his case study revealed that aid has marginal effects on GDP growth, however, the segmentation of aid into loans and grant shows that loans have a large effect on GDP growth whereas grants do not have it. The author further contends that foreign grants are invested low productive civil projects while loans are invested in public investment projects that stimulate growth in GDP.

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A study conducted by Salahuddin and Rabiul Islam (2008) examines the factors affecting investment in developing countries comprising a period 1973-2003. The results of this paper have shown that investment decisions depend on growth, domestic savings, trade openness and so on. The study contends that aid is a significant factor that contributes the investment decision and raises the need for developing countries to capitalize on this factor. Muhammad Arshad and Ayaz analyzed the aid growth connection in Pakistan for the period 1972-2006. The empirical research focused ARDL cointegration approach. The results of the paper showed that domestic investment ,exports growth and inflows of Foreign Direct Investment are important factors in generating economic growth in Pakistan.

Data and Procedure:
Specification of Model This section discusses the model used throughout our research to study the links between Official Development Aid (which is representative of AID) and per capita GDP growth. After checking the feasibility of various model systems, the final relationship was tested through panel data. The model is derived from the basic production function, which states that a country’s GDP is determined by a combination of i. ii. iii. Labor Capital (which includes Technological advancements) Foreign aid which acts as input to the previous two variables.

Thus, following is the basic formula derived explaining the relationship between the four variables.

y l k a where the lower case letters indicate growth rates of GDP, Labor, Capital, Aid respectively. While the GDP Growth rates of countries are available easily, the last three variables are

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researched on a proxy-basis. Production growth acts as a proxy for Labor growth, yearly Gross Capital Formation (as a percentage of GDP) for Capital Growth and yearly Net Official Development Aid (per capita) for Foreign Aid Growth. After taking this into consideration, we derived our final model: GDP growthit = β0 + β1 Warit + β2 Investmentit + β3 FDI/GDPit + β4 AIDit + β5 debtserit + β6 Exportsit + β7 Importsit + β8 Inflationit + β9 AIDi(t-1) + β10 AID i(t-2) + β11 AID i(t-3) + β12 AID 2 i(t-4) + β13 (AID)it + β14 AID*Inv it + β15 AID*FDI it + β16 popgrowth it + € Following are the expected co-efficient signs of the variables in the above model: Positive Negative Unsure

β2, β3, β4, β6, β9 – β16 β 1, β5, β7 β8

Variable Descriptions and Data Sources:
Almost all the data used in the regression has been taken from the official website of World Bank Data, which gives data for 1287 indicators of 214 countries from 1960 to 2012. The statistics for War and mass unrest has been taken from Historyguy.com. The countries chosen have been done so after an extensive thought process, taking into account the subsequent efficiency that would come into play if we selected just 9 countries. The countries (listed later) are from a diverse background and geographical representation, nullifying area based effects. These countries have developed well over the past decade (like India, Brazil, Indonesia, Malaysia and Turkey), thus selecting them is a reasonable step. GDP growthit = β0 + β1 Warit + β2 Investmentit + β3 FDI/GDPit + β4 AIDit + β5 debtserit + β6 Exportsit + β7 Importsit + β8 Inflationit + β9 AIDi(t-1) + β10 AID i(t-2) + β11 AID i(t-3) + β12 AID 2 i(t-4) + β13 (AID)it + β14 AID*Inv it + β15 AID*FDI it + β16 popgrowth it + €

War is a dummy variable which takes the value of 1 if the country was in the state of war or mass violence at the time, Investment is actually Gross Capital Formation as a percentage of GDP, FDI/GDP is the Foreign Direct Investment as a percentage of GDP, Aid is Official

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Development Aid received, Debtser is the interest payments made on prior loans taken, Inflation is represented by the GDP Deflator and exports and imports are taken as a percent of GDP.

Empirical Results:
The model mentioned above has been analyzed through a panel data method in order to analyze the effect of aid on the growth rate. After rigorously going through the models available within the panel data, the random effects method was found out to be more compatible with this data structure in terms of its statistical properties (through Hausman Test). Hence, the results found out through random effects model has been tabulated in the Table1 shown below. Table 1 Variable Constant Investment Population growth Exports Imports Inflation War FDI (% of GDP) AID AIDt-1 AIDt-2 AIDt-3 1970-1979 -1.074366 (5.139193) 0.2179969 (0.205847) 1.002825 (1.553618) 0.04000196 (0.121475) 0.1608622 (0.1897812) -0.0215201 (0.006394) -1.622447 (1.307017) -1.072933 (0.9639739) 0.006241 (0.5623024) 0.0732274 (0.3253695) 0.2290722 (0.2925029) -0.404 (0.127) 1980-1989 -3.709 (3.579) 0.2527 (0.1237) 1.962 (0.3864) 0.1104 (0.0727) 0.1104 (0.1312) -0.0021 (0.0006) -0.5428 (2.5011) -2.356 (1.073) -0.1689 (0.2843) -0.03 (0.0557) 0.0808 (0.1158) -1.1702 (0.0754) 1990-1999 -2.931 (2.944) 0.486 (0.0889) -0.467 (1.279) -0.112 (0.111) 0.0845 (0.149) -0.00176 (0.00081) 2.585 (1.272) -0.00755 (0.315) 0.175 (0.234) -0.0286 (0.0595) 0.0654 (0.0376) -0.0860 (.0494) 2000-2011 1970-2011 0.977 (0.494) 0.231 (0.0598) 0.660 (0.682) -0.00619 (0.0891) 0.0146 (0.125) -0.00252 (0.000857) 0.977 (0.494) 0.103 (0.284) -0.0664 (0.0939) -0.0188 (0.0368) 0.101 (0.0463) -0.0924 (0.0390)

0.414 (0.172) 0.235 (1.457) 0.0297 (1.577) -0.515 (0.214) -0.283 (0.0317) -- * 0.0265 (0.536) 0.5039 (0.5806) -0.0569 (0.129) 0.194 (0.0961) -0.114 (0.0699)

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AIDt-4 AID^2 AID*Investment AID*FDI Debt Service R-sqr

0.211 (0.334) 0.0187 (0.009) -0.046 (0.0342) 0.0744 (0.0966) 0.1679 (0.4471) 42.65%

0.1517 (0.072) 0.003 (0.0097) -0.0038 (0.0091) 0.0705 (0.05) -0.367 0.167 48.92%

0.0122 (0.0300) -0.00127 (0.000698) -0.00343 (0.00817) 0.0136 (0.0338) -0.462 (0.123) 51.3%

0.0961 (0.0919) -0.0174 (0.0157) -0.0122 (0.0214) 0.0321 (0.0347) 0.199 (0.147) 29.36%

0.0353 (0.0249) -0.000672 (0.000432) 0.00491 (0.00244) -0.0173 (0.0120) -0.275 (0.0589) 27.88%

* Data does not contain any war in this era, hence this could not be estimated As table 1 shows, the model was estimated for five different time periods: 1970-1979, 1980-1989, 1990-1999, 2000-2011 and the final one was for the whole range: 1970-2011. The 10 period spans can be thought of as short run whereas the 40 period span can be a thought of estimating an impact on long run. Although the signs of the variables are as predicted, however, they are mostly insignificant. The overall R-squared vary from as low as 27.9% to 51.3%. These values can be considered low, however they are consistent with the other studies relating to this topic and are acceptable in panel data sets. The coefficient of Investment is positive as predicted earlier and is also statistically significant in all eras except 1970-1979 (investment depicts the confidence people have in the economy; increase in investment would almost always result in good GDP Growth). The coefficient of inflation is negative in all cases and these are also significant in all eras except 2000-2011. Similarly, as experienced by developing countries, debt service as a percentage of GDP effects GDP growth negatively since its coefficient is significant and negative in all eras. These results are as expected and in complete harmony with traditional economic theory. Surprisingly, the war dummy and population growth does not seem to effect the GDP growth since they are shown as insignificant in all eras except one (1990-1999 for war and

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1980-1989 for population growth). Similarly Exports and Imports as a percentage of GDP are insignificant in all eras. Moreover, Foreign Direct Investment as a percentage of GDP also does not seem to influence GDP growth since its coefficients are insignificant in almost all eras. These results are somehow contradictory to the traditional economic theory which suggests that these variables affect the GDP growth. Now let’s analyze the effect of AID on GDP growth rate. There seems to be no impact propensity of AID since AID is isignificant in all eras. Similarly there is no lagged effect of AID in one year after AID since its coefficient is also insignificant in all eras. However, lagged effects of AID two, three and four years after the AID is received predict some effect. The AIDt-2 is positive and significant in recent era 2000-2011 and in the long run (19702011). Similarly, AIDt-3 is negative significant in eras 1970-79, 1980-89, 1970-2011. AIDt-4 is positive significant in the era 1980-89. In the long run (1970-2011), the lagged effects of AID 2 and 3 years after received are significant, however with opposite signs. The long run propensity in this era is (0.101-0.0924) is 0.0086. Hence we can conclude that overall AID acts positively to GDP growth rate. However, we cannot find evidence of opposite effects of aid in two and three year lagged from economic theory. The AID square variable is insignificant in all eras except 1970-1979 suggesting no quadratic relationship between AID and GDP growth. Similarly, the AID effect on GDP seems to be same at all levels of FDI since the interaction AIDFDI is insignificant in all periods. However, AID effect do differ at different levels of Investment (Gross Capital Formation) since the interaction AIDINV is positive significant in the long run (1970-2011). This is what developing countries need to take into account. AID coupled with Investment has more beneficial effect on GDP rather AID alone.

Concluding Remarks:
We have tried to gauge the effect of AID on the development of its economy through the use of regression analysis. We have used a diverse list of countries to eliminate regional or income differences (list in Appendix) and have divided the data for the forty years into four sets of ten each to see if there was a particular time when AID affected the economy more than other times.

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What we have concluded is extremely interesting. Although the AID is not effective in determining the growth of GDP in that specific year, it is significant in explaining the GDP Growth of two and three years after that disbursement. The effect of Aid on GDP Growth in the second year is positive, but for the next year it has a negative impact on the economy. Further rigorous analysis needs to be done on this to explicate the cause of such statistical behavior, and this paper might be an important milestone in discovering this behavior. The second interesting thing is the effect Aid coupled with Investment in the economy has on it. This is an excellent finding that leads us to think that a country that is only dependent on aid is not such a good example of a well-run country. However, if people are investing in the country, alongside international aid agencies, that pays off well for the country. Participation of the people in the betterment of the country is important for it. Some weakness of this analysis needs to be presented in order to overcome the short comings the next time anyone attempts this data analysis. A more direct variable needs to be introduced/used as a proxy for labor force growth than population growth. More data on more countries is required to see area based effects of aid disbursement. This would be a very good addition in the present analysis. Other variables could be introduced to improve the adjusted-R2 of the regression and find interesting relationships. Taking these factors will be vital if further research is to be conducted in this area.

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Appendix A
Variable Investment Population growth Exports Imports Inflation War Description Gross capital formation as a % of GDP Annual Population Growth

Exports for the year as a % of GDP Exports for the year as a % of GDP GDP Deflator A dummy variable that takes on the value of 1 if the particular country was involved in a great internal civil strife, war or violence, and 0 for an otherwise stable year. FDI (% of GDP) Foreign Direct Investment as a % of GDP AID Official Development Aid received during that year AIDt-1 Official Development Aid received during the previous year AIDt-2 Official Development Aid received two years before AIDt-3 Official Development Aid received three years before AIDt-4 Official Development Aid received four years before AID^2 Official Development Aid squared to investigate non-linear impact AID*Investment Interaction term of Official Development Aid and Gross Capital Formation (% of GDP) of that year to see impact of both combined AID*FDI Interaction term of Official Development Aid and Foreign Direct Investment (% of GDP) of that year to see impact of both combined Debt Service Total Interest payment on all prior loans taken by the country in that year

Appendix B
The countries included in our regression model are

India

Brazil

Mexico

Indonesia

Argentina

Pakistan

Turkey

Malaysia

Egypt

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Works Cited
ALESINA, ALBERTO, and DAVID DOLLAR. "Who Gives Foreign Aid to Whom and Why?" Journal of Economic Growth 5.1 (2000): 33-63. JSTOR. Web. 20 May 2013. . Ali, Abdiweli M., and Hodan Said Isse. "Foreign Aid and Free Trade and Their Effect on Income: A Panel Analysis." The Journal of Developing Areas 41.1 (2007): 127-42. Buch, Im. "Proceedings of the Annual Meeting of the Western Society for French History." Google Books. Neicshtein, n.d. Web. 21 May 2013. Chong, Alberto, Mark Gradstein, and Cecilia Calderon. "Can Foreign Aid Reduce Income Inequality and Poverty?" Public Choice 140.1/2 (2009): 59-84. JSTOR. Web. 20 May 2013. . Christos, Neophytou A. "KYPROS-NET - OCCUPIED CYPRUS The BETRAYAL of CYPRUS in 1974." KYPROS-NET - OCCUPIED CYPRUS The BETRAYAL of CYPRUS in 1974. Kypros Net, 21 Aug. 2005. Web. 21 May 2013. < http://www.kypros.org/Occupied_Cyprus/cyprus1974/index.htm> "ECHR : Cyprus v. Turkey Publication : 2001-IV." ECHR : Cyprus v. Turkey Publication : 2001-IV. N.p., n.d. Web. 21 May 2013. Evidence from Pakistan." The Pakistan Development Review 46.3 (2007): 215-40. JSTOR. Web. 20 May 2013. . "Indonesian Confrontation, 1963–66." Home. Australian War Memorial, n.d. Web. 21 May 2013.

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JSTOR. Web. 20 May 2013. . Khan, Muhammad Arshad, and Ayaz Ahmed. "Foreign Aid—Blessing or Curse: Quazi, Rahim M. "Effects of Foreign Aid on GDP Growh and Fiscal Behavior: An Econometric Case Study of Bangladesh." The Journal of Developing Areas 38.2 (2005): 95-117. JSTOR. Web. 20 May 2013. . "Revisiting the Yom Kippur War." Google Books. N.p., n.d. Web. 21 May 2013. Salahuddin, Mohammad. "Factors Affecting Investment in Developing Countries: A Panel Data Study." The Journal of Developing Areas 42.1 (2008): 21-37. JSTOR. Web. 04 May 2013. . "SIPAZ - Servicio Internacional Para La Paz." Important Dates. S!Paz, n.d. Web. 21 May 2013. "Wars of Mexico." Wars of Mexico. History Guy, 20 Feb. 2010. Web. 21 May 2013. "[WorldCat.org]." [WorldCat.org]. N.p., n.d. Web. 21 May 2013.

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