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Unformatted text preview: On the Simultaneity Problem in the Aid and Growth Debate * Markus Brückner Universitat Pompeu Fabra October 2010 Abstract This paper shows that foreign aid has a signi cant positive average e ect on real per capita GPD growth if, and only if, the quantitatively large negative reverse causal e ect of per capita GDP growth on foreign aid is adjusted for in the growth regression. Instrumental variables esti- mates yield that a 1 percentage point increase in GDP per capita growth decreased foreign aid by over 4 percent. Adjusting for this quantitatively large, negative reverse causal e ect of economic growth on foreign aid yields that a 1 percent increase in foreign aid increased real per capita GDP growth by around 0.1 percentage points. Keywords : Aid Allocation, Aid E ectiveness, Economic Growth, Simul- taneity. JEL : 01, 02, 04. * Universitat Pompeu Fabra, Department of Economics, Ramon Trias Fargas 25-27, 08005 Barcelona, Spain. E-mail: [email protected]; telephone: 0034 681039957; fax: 0034 34935422533. I thank Fabio Canova, Francesco Caselli, Antonio Ciccone and Marta Reynal- Querol for helpful comments and suggestions. The paper has also bene ted from discussion at the Applied Econometrics Seminar at the University of Mannheim and the European Economic Association Meeting at the University of Glasgow. All remaining errors are my own. 1 1 Introduction Does foreign aid have a positive, causal e ect on economic growth? I show that the answer to this important policy question is yes if, and only if, one takes into account that economic growth itself has a quantitatively large, negative within- country e ect on foreign aid. The aid e ectiveness literature is well aware of this endogeneity problem. However, one of the main problems that this literature continues to struggle with, is nding a plausible time-varying instrumental vari- able for foreign aid (Temple, 2010). Moreover, despite standard macroeconomic theory predicting a positive e ect of foreign aid on economic growth if part of the foreign aid is used for investment, the consensus in the aid e ectiveness literature is that foreign aid does not have a signi cant positive average e ect on economic growth. 1 I show that indeed one may arrive at this conclusion if the negative reverse causal e ect of per capita GDP growth on foreign aid is not accounted for in the growth regression. Once the negative reverse causal e ect of economic growth on foreign aid is accounted for, estimates of the ef- fect of foreign aid on economic growth are positive, statistically signi cant, and economically meaningful. My estimation strategy to identify the causal e ect of foreign aid on economic growth is based on a two-step procedure. The two-step procedure is closely related to the approach taken in the empirical macro literature to identify the causal e ects of scal policy (see, in particular, Blanchard and Perotti, 2002)....
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This note was uploaded on 11/24/2011 for the course ECON 345 taught by Professor Jakiela during the Fall '11 term at Maryland.
- Fall '11