How Foreign Aid Impacts on Economic Development of Developing Countries Table of Content Table of Content 1 1 Introduction 2 2 Literature Survey 3 2.1 Econometric Models in Earlier Studies 4 2.2 The Pro Foreign Aid Views: Foreign Aid May Undermine Economic Growth in Developing Countries 5 2.3 The Anti Foreign Aid Views: Foreign Aid May Undermine Economic Growth in Developing Countries 6 2.4 Gaps in Existing Literature Studies 7 3 Theoretical Arguments and Regression Analysis 7 3.1 The Data Survey 7 3.2 Theoretical Argument 8 3.3 Regression and Data Analysis 9 4 Conclusion 11 4.1 Summary 11 4.2 Recommendations 11 4.3 Limitations and Further Research 12 5 Reference 12 Introduction It was just after the Second World War that the concept “foreign aid” was created, when the United States pumped in billions into the European economy, in order to help the economy to recover (Sogge, 2002). Since then, foreign aid is has been regarded as a way to directly benefit the economy of the country that receives the aid. The majority of the foreign aid givers donate foreign aid to other countries have strong belief of such association (World Bank, 1998). A number of earlier literature studies have used different approaches to examine whether or not foreign aid is capable of meeting such goal in reality. In other words, these literature studies aim to find out whether or not foreign aid is actually able to stimulate economic growth in developing countries based on empirical evidence. Despite of the rapid political, economical and social changes in the world since the Second World War, how foreign aid impacts economic growth in developing countries remains as an important and heated topic. Similar to many other debates, scholars that analyze the topic tend to have two types of split views regarding to the actual effectiveness of foreign aid in economic growth in developing countries. Researchers that are against using foreign aid to help developing countries argue that it has an adverse effect over long-term economic growth. In contrast, researchers that support the use of foreign aid to help developing countries believe its effectiveness in lifting a stagnating economy. On the other hand, another more contemporary school of thoughts believe that the effectiveness of foreign aid in economic development in developing countries is dependent on a number of factors, which include characteristics of both donor and recipient countries. Therefore, an empirical analysis of how foreign aids affect economic development in developing countries is essential in testing the effectiveness of foreign aid. Institutively, the research title of the study is: How Foreign Aid Impacts on Economic Development of Developing Countries The remaining parts of this research paper is structured in the following way. The second section is the literature survey, which analyses the existing literature studies regarding to the influence of foreign aid on economic development in developi.

1. How Foreign Aid Impacts on Economic Development of
Developing Countries Table of Content
Table of Content 1
1 Introduction 2
2 Literature Survey 3
2.1 Econometric Models in Earlier Studies 4
2.2 The Pro Foreign Aid Views: Foreign Aid May Undermine
Economic Growth in Developing Countries 5
2.3 The Anti Foreign Aid Views: Foreign Aid May Undermine
Economic Growth in Developing Countries 6
2.4 Gaps in Existing Literature Studies 7
3 Theoretical Arguments and Regression Analysis 7
3.1 The Data Survey 7
3.2 Theoretical Argument 8
3.3 Regression and Data Analysis 9
4 Conclusion 11
4.1 Summary 11
4.2 Recommendations 11
4.3 Limitations and Further Research 12
5 Reference 12
Introduction
It was just after the Second World War that the concept “foreign
aid” was created, when the United States pumped in billions
into the European economy, in order to help the economy to
recover (Sogge, 2002). Since then, foreign aid is has been
regarded as a way to directly benefit the economy of the country
that receives the aid. The majority of the foreign aid givers
donate foreign aid to other countries have strong belief of such
association (World Bank, 1998). A number of earlier literature
studies have used different approaches to examine whether or
not foreign aid is capable of meeting such goal in reality. In
other words, these literature studies aim to find out whether or
not foreign aid is actually able to stimulate economic growth in
developing countries based on empirical evidence. Despite of

2. the rapid political, economical and social changes in the world
since the Second World War, how foreign aid impacts economic
growth in developing countries remains as an important and
heated topic.
Similar to many other debates, scholars that analyze the topic
tend to have two types of split views regarding to the actual
effectiveness of foreign aid in economic growth in developing
countries. Researchers that are against using foreign aid to help
developing countries argue that it has an adverse effect over
long-term economic growth. In contrast, researchers that
support the use of foreign aid to help developing countries
believe its effectiveness in lifting a stagnating economy. On the
other hand, another more contemporary school of thoughts
believe that the effectiveness of foreign aid in economic
development in developing countries is dependent on a number
of factors, which include characteristics of both donor and
recipient countries.
Therefore, an empirical analysis of how foreign aids affect
economic development in developing countries is essential in
testing the effectiveness of foreign aid. Institutively, the
research title of the study is:
How Foreign Aid Impacts on Economic Development of
Developing Countries
The remaining parts of this research paper is structured in the
following way. The second section is the literature survey,
which analyses the existing literature studies regarding to the
influence of foreign aid on economic development in developing
countries. The third section outlines the empirical results, by
displaying the results of the data survey and presenting
theoretical arguments. The final section summarizes the
findings of the analysis and discussion, where
recommendations, discussions of limitations and further
researches will also be presented.
Literature Survey
In this section, a literature survey is conducted. The section

3. focuses on critical analysis of existing literature studies of the
following topics:
Econometric Models in Earlier Studies
There are two main types of econometric models that have been
applied in analyzing the relationship between foreign aid and
economic growth (McMillan, 2011), namely the “Two Gap
Model” (Chenery and Strout, 1966) and the “Poverty Trap
Model” (Nelson, 1956).
The Two Gap model contains two components, where the first
component is the relationship between foreign aid and economic
growth, whereas the second component regards the relationship
between savings level and economic growth. The fundamental
rationality of the model believes that foreign aid is able to
increase investment level in the economy, which in turn drives
economic growth. The aim of the model is to find the optimal
investment level in order to obtain a target economic growth
level (Devarajan et al., 2002). There are a number of drawbacks
of this model, where most of the criticisms focus on its
assumptions (McMillan, 2011). For example, Harms and Lutz
(2004) criticized that the “Two Gap Model” neglected the other
drivers of economic growth (such as health care, education
level, utilities development, research and development level),
by assuming that investment is the only driver of economic
growth. In addition, Harms and Lutz (2004) pointed out that it
was not necessarily the case that recipient countries of foreign
aids invest the entire amount of foreign aid into the economy.
As a result, foreign aid may not only impact on economic
growth of a country in the form of investment. Meanwhile,
corruption in developing countries is also another obstacle that
prevents foreign aids from turning into investments.
On the other hand, the Poverty Trap Model has more theoretical
features than econometric features, comparing to the Two Gap
Model. The fundamental rationality of the model is that it
believed that economic growth is constrained by poverty traps,

4. which result from a number of different determinants including
high population, low savings as well as low productivity level.
The injection of foreign aid into the economy is believed to be
able to lift the economy out of the poverty traps, and therefore
initiate faster economic growth. However, the model also has its
limitations. Harms and Lutz (2004) pointed out that it was way
more complicated and difficult for a country to get out of
poverty traps than what was stated in the Poverty Trap Model.
More specifically, they believed that despite of the importance
of initial capital injection for a developing economy to takeoff,
other factors such as governance and private investment should
play roughly equally important roles.
The Pro Foreign Aid Views: Foreign Aid May Undermine
Economic Growth in Developing Countries
The literature surveyed in this section mostly argue that foreign
aid has a positive influence over the economic development in
developing countries. Early scholars such as Papenek (1973)
and Levy (1988) believed that foreign aid had a positive impact
over economic development, as it was able to stimulate savings,
investment as well as increase capital. In addition, they also
argued that by providing help in the form of foreign aid,
developed countries were also able to transfer more advanced
knowledge and technology to developing countries (Papenek,
1973; Levy, 1988). On the other hand, later empirical studies
examined the topic in a more rigorous manner, through the
application of the “diminishing return hypothesis” (Durbarry et
al., 1998; Dalgaard and Hansen, 2000; Hadjimichael, et al.,
1995; Hansen and Tarp, 2000; Lensink and White, 2001;
Dalgaard et al., 2004). More specifically, these studies argued
that that positive impact that foreign aid had over economic
growth in developing countries is only valid up to a certain
level.
The Anti Foreign Aid Views: Foreign Aid May Undermine
Economic Growth in Developing Countries
On the other hand, a number of research studies have found
negative relationship between foreign aid and economic growth.

5. In other words, these literature studies have found a negative
relationship between the two. Friedman (1958) and Bauer
(1972) believed that foreign aid is unnecessary for a country to
achieve high economic growth. In addition, they pointed out the
danger of aiding foreign governments that are corrupted. Griffin
and Enos (1970) used empirical analysis to conclude a negative
correlation between foreign aid and economic growth. In
addition, Bauer (1991) argued the damage that foreign aid
causes in developing countries, as he believed that governments
that received foreign aid were also entitled with more power
and resources relative to the rest of the society.
Gaps in Existing Literature Studies
Overviewing the existing literature studies in the topic, it has
been observed that most of the studies were produced in the 90s
and early 2000. In contrast, there lacks studies that examines
how foreign aid impact on economic growth after 2005. As a
result, in order to fill in such research gap, this research paper
will produced a more up-to-date understanding of the issue, by
using more recent data for the empirical analysis.
Theoretical Arguments and Regression Analysis The Data
Survey
The data used for the study is obtained from the World Bank.
The economic growth is measured using Gross Domestic
Production, whereas the foreign aid data is obtained from World
Bank’s “net official development assistance and official aid
received (current US$)”. The dummy variable of the “average
years of schooling” is extracted from the Human Development
Reports produced by the United Nations Development
Programme. The time period covered in the empirical analysis is
between 1994 and 2013. In total, twenty countries are included
in the analysis, chosen using random sampling method. More
specifically, these countries are: Afghanistan, Brazil, Thailand,
China, Egypt, Ethiopia, Croatia, Pakistan, Iraq, Kenya, Nigeria,
Nepal, Malaysia, Philippines, Tunisia, Turkey, Uganda,
Vietnam, South Africa and Zimbabwe.

6. Theoretical Argument
The model used for this study is adapted from the Solow’s
Economic Growth Model. The use of Solow’s Model in
analyzing the role of foreign aid plays in economic growth is
rationalized as follows.
More specifically, the Solow’s Economic Growth Model states
that:
In which is the GDP level, is the level of capital, is labor
available in the economy.
By taking first derivatives of K(t) and H(t), we get:
More specifically, is the proportion of output that is turned into
investment rather than consumption, is the proportion of output
that is regarded as the cost to improve human capital which is
measured as the average school years completed, d is regarded
as the depreciation of the capital.
Furthermore, following definitions are set:
In addition, let be the “GDP per capita”, be “foreign aid per
capita” and be “human capital per capita”. As a result, we get:
By solving the above three equations, an optimal level of GDP
per capita is:
Regression and Data Analysis
Following construction of the theoretical model as well as
solving relevant equations, a logarithm regression equation can
be obtained:
Where the technology growth rate and depreciation rate is
approximated to be 0.05. g is the growth rate of

7. “SCHOOLING”.
Therefore, the hypothesis test tests following null hypothesis:
If the null hypotheses are rejected, the alternative hypotheses
will be accepted. More specifically, the alternative hypotheses
are:
By running the linear regression analysis on the log values of
the variables, following results were found.
Coefficient
p-Value
AID
-0.01506
0.002
Schooling
2.1013
0.000
Constant
1.5523
0.000
The results show that the p-value of the log values of both
foreign aid and schooling are nearly 0. This implies that both
foreign aid and schooling have significant impact over
economic growth in developing countries. However, it is worth
noting that the coefficient associated to the log-value of
“foreign aid” is negative. Therefore, it implies that foreign aid
has a negative impact over economic growth in developing
countries. Meanwhile, the adjusted R-square was found to be
0.6151. This implies that the goodness-of-fit of this model is
relatively high. Conclusion Summary
In this research paper, the researcher modifies the Solow’s
Economic Growth Model in order to examine the impact of
foreign aid over economic growth in developing countries. The
empirical analysis finds that foreign aids have significantly

8. negative impact over economic growth in developing countries.
This result is consistent to the views of the scholars who are
anti foreign aid. This can be explained by a number of factors.
For example, many of the developing countries have relatively
corrupted political regime. As a result, the foreign aid received
is not used effectively.
Recommendations
Based on the results and findings, a number of recommendations
can be made correspondingly. First, foreign aid donor countries
need to assess the recipient countries before giving out foreign
aid. This can be achieve by conducting in-depth economic and
market analysis of the target countries. Second, international
organizations should supervise and monitor how aid recipient
countries use the money received. This will therefore motivate
and incentivize developing countries to use foreign aid
effectively.
Limitations and Further Research
However, there are some limitations of this research paper. First
of all, only 20 countries are analyzed in this study. This is a
very small proportion of all developing countries in the world.
As a result, the results may not be objective enough to be
generalized. In order to over come this issue, further research
should include in more countries in the analyzed sample.
Second, the analysis is only conducted across different
countries, whereas timeline analysis is not conducted. In order
to over come this issue, further research should take into
account of how foreign aid has impacted on economic growth
over the years.
Reference
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