Wallaga University

Post Graduate Studies

By Mulugeta Tefera; Reviews
Review to Aid Economics
Setem!er "#$%
&e'emt
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(ontents
1. Introduction...............................................................................................................................................2
1.1. Interest on the topic /Statement of the problem..............................................................................2
2. Review literature.......................................................................................................................................
2.1. !he Right to aid and "evelopment !heories with relevance to #conomics of $id......................
2.1.1. !he %uest to Claim $id..............................................................................................................
2.1.2. Rostow&s 'rowth !heory()the ta*e(off+.....................................................................................,
2.1.. !he -alanced 'rowth !heory()-ig .ush+................................................................................./
2.2. "evelopment optimism and 0oreign $id models in 1123s............................................................./
2.2.1. !he Chenery(Strcut two(gap model()the capital oriented growth model+.................................2
2.2.2. !he 0oreign #4change 'ap $pproach to 0oreign $id Re5uirements........................................6
2.. !he #merging #vidence of the Importance of 'overnmental .olicies for 'rowth........................1
2..1. 7onetary .olicies and Savings.................................................................................................13
2..2. !rade and #4change .olicies and 'rowth................................................................................13
2... !he Supply of #ntrepreneurs....................................................................................................13
. Conclusion..............................................................................................................................................13
Reference........................................................................................................................................................12
1 8 . a g e
Review to Aid Economics
$) *ntroduction
0oreign aid by governments and by multilateral institutions financed by governments has
throughout the post(9orld 9ar II period been closely associated with the economics of
development. #4cept for emergency assistance following disasters that have left people
starving or homeless: foreign aid has had its ultimate purpose the predilection of
development rather than providing a temporary subsidy to consumption. !he foreign aid
policies of governments& arid multilateral institutions have been influenced by thin*ing of
development economists; this thin*ing has changed over the decades since 9orld 9ar II
in large part because we have learned more about the development process. !he goals of
foreign aid agencies as well as those of development economists have also changed:
mainly in the form of shifting priorities for development strategies and wit conse5uent
changes in the administration of foreign aid <Raymond 0. 7i*esell: 1162....1/=.
$ccording to its charter formulated at the -retton 9oods ccnference in 11,,: the 9orld
-an* had the dual function of promoting the reconstruction of the war(torn countries:
both
developed and developing: and of promoting economic development the less
developed countries.

!he concept of development assistance embodied in the $rticles of
agreement the 9orld -an* was that of promoting the flow of private international capital
in the form of both loan and direct investments to developing countries.
!he ob>ective of this paper is to discuss economics of $id in general; its importance and
management of aid. !he 5uestions are 9hat was aid historical bac*ground?: what
theories and approaches had been using in managing aid?: is aid important or some
improvements in developing countries policy planning?. @ence the paper will provide
some briefings on the above 5uestion by reviewing literature around the topic.
$)$) *nterest on t+e toic ,Statement of t+e ro!lem
7oyo states loudly and clearly: so there can be no misunderstanding: that it is time to stop
pitying $frica <7. Dambisa, 2009). She argues that pity has not helped the continent: and
has actually hurt its e4ternal and self(image. #verywhere today: we see the image of an
2 8 . a g e
$frica that is poor and needy: unable to help itself. It is time for that to end. Ai*ewise: she
points out the e4cesses and hypocrisy of the aid system: which benefits the most: those
who wor* in the aid industry. Aastly: she provides a call for $fricans to start representing
themselves on the world stage: rather than leaving it to 9estern roc* stars.
7oyo implies that economic development in $frica can come about through borrowing
on international capital mar*ets: plus Chinese investment: plus microfinance: plus
remittances: minus Bsystemic foreign aid&. Scholars argue that these ingredients might be
useful: but they will not turn into a ca*e by simply mi4ing them together in a bowl. !his
is not to say that foreign aid is the missing oven.
Stopping foreign aid may not realistically be able to be implemented and it may be
counterproductive. In the '#' blog series The (Dead) Aid Debate: some argued that the
debate should not be between more or less aids: but about the ob>ectives of aid and how it
is given. It is probably more radical to suggest a complete overhaul of the aid system than
to argue for an end to aid: partly because it would be easier to stop giving aid than to
change the current international aid architecture and the organiCation and practices of
bilateral and multilateral aid agencies.
") Review literature
")$) T+e Rig+t to aid and -eveloment T+eories wit+ relevance to Economics of
Aid
")$)$) T+e .uest to (laim Aid
!he
emergence of economic nationalism in Aatin $merica and in developing countries
that became independent during the 11/3s and 1123s was accompanied by a growing
demand
for large amounts of foreign assistance from industrialiCed countries for the
promotion of economic growth. $nd coloniCers were also as*ed to pay bac* in form
rehabilitation and reconstruction aid to the developing countries the resource they
e4ploited from their colonies. 0ollowing political independence: economic growth as
measured by the percentage increases in per capita national income: become the primary
political ob>ective of the developing countries. !he DE Secretariat played an important
role in articulating these demands: while much of the economic and social rationale was
supplied by social scientists in the developed countries. In a report by the group of e4perts
8 . a g e
to the Secretary 'eneral of the DE issued: in 11/1: estimates were made of the total
capital re5uired by all developing countries to support an annual rate of growth in per
capita national incomes of 2 percent over the 11/3(1123 periods. Ff the total annual
re5uirements of G11 billion: it was estimated that G/ billion could be met by domestic
saving: leaving about G1, billion per year to be covered by foreign capital <DE: 11/1=.
")$)") Rostow/s Growt+ T+eory01t+e ta'e0off2
!he economic rationale or theoretical underpinnings for the global e4ternal capital
re5uirements put forth in the early 11/3s were rather crude: but a number of capital
oriented development models were formulated by economists during the 11/3s and
1123s: which provided a certain scientific respectability to the estimation of these
re5uirements for the developing world as a whole. Fne of the important underpinnings
for the e4ternal capital re5uirements was supplied by 9alter RostowHs hypothesis of the
Ita*e(off into self(sustaining growth.I RostowHs concept of the Ita*e(offI caught the
imagination of the worldHs economists and became part of the standard le4icon of foreign
aid policyma*ers and development economists in the late 11/3s and 1123s: but its
popularity subsided with a better understanding of the development process in the 11J3s.
$s him ta*e(off re5uires a rise in productive investment: say: from / percent or less to
over 13 percent of national income; the development of one or more manufacturing
sectors with a high rate of growth; and the e4istence or rapid emergence of a political:
social and institutional framewor* conducive to the transmission of impulses to e4pansion
throughout the economy: including the capacity to mobiliCe capital from domestic
sources. <Rostow.9: 11/2=. Rostow suggested that domestic savings during the ta*eoff
period could be supplemented by capital imports so as to increase the level of investment
re5uired for the increase in the growth rate.
!he aspect of ta*e(off hypothesis that was seiCed upon by a number of development
economists to >ustify the provision of large amounts of aid to initiate the ta*e(off process
and assure the rapid achievement of self(sustaining growth. Dnfortunately: many
development economists seemed to have forgotten the preconditions for the ta*e(off
originally specified by Rostow and sought to apply the ta*e(off hypothesis to a large
number of developing countries that were far from having attained these preconditions
<Raymond 0. 7i*esell: 1162....1/=.
, 8 . a g e
")$)3) T+e Balanced Growt+ T+eory01Big Pus+2
!he case for promoting development all fronts emerged from the Ibalanced growth
theoryI which suggested that if all sectors: including industry: agriculture: infrastructure
and human s*ill development: could grow at relatively rapid rates at the time: same the
conditions for the ta*e(off could be achieved without the long historical period
e4perienced by the older developed countries. !his approach was formally developed as
the theory of the Ibig pushI by .aul Rosenstein(Rodan: 1121.
@owever: pig push was challenged by several economists that for many underdeveloped
countries there were severe limits on how much e4ternal capital could be utiliCed
productively: or Iabsorbed:I as a conse5uence of low s*ill levels: lac* of managerial
talent: and poor governmental administrative facilities. Some other economists were
convinced that large infusions of e4ternal capital and technical assistance could achieve
the preconditions for self(sustaining growth <4) @. $dler: 112/=.
")") -eveloment otimism and 5oreign Aid models in $67#s

"uring the 1123s the development optimism approach of the 9orld -an* and of the
#isenhower $dministration to development assistance was abandoned in favor of a
commitment on the part of the D.S. and other developed countries to provide large
amount of concessionary aid directed to supporting comprehensive development plans.
!he new approach was accompanied by a high degree of optimism that most of the
worldHs underdeveloped countries could be elevated to a condition of self(sustaining
growth within a generation or so: and the D.S. and other international agencies
disseminated estimates of global aid re5uired to achieve growth targets in the developing
world. !his development optimism and dedication of the governments of developed
countries to providing substantial amounts of development assistance found economic
>ustification in capital(oriented growth models broadly accepted by most of the worldHs
leading development economists.
.resident Kennedy set forth ambitious goals for the D.S. for accelerating the growth of
the developing countries and pledged the D.S. government to a leading role in achieving
self(sustaining growth in most of the developed world. -ut it was during the Lohnson
/ 8 . a g e
$dministration that D.S. bilateral aid <in real terms= for promoting economic growth in
the A"Cs reached a Cenith.
")")$) T+e (+enery0Strcut two0ga model01t+e caital oriented growt+ model2
!he Chenery(Strcut two(gap model combined three strains of thin*ing of economists for
estimating foreign aid re5uirements. !hese were <1= the s*ill limitation <essentially the
capital absorptive capacity approach=; <2= the gap between domestic investment re5uired
to achieve a given rate of economic growth and domestic savings; and <= the gap
between foreign e4change re5uirements to sustain the re5uired level of domestic
investment and the countryHs foreign e4change earnings.
$ countryHs progress is constrained during different periods or phases byM the s*ill
limitation; the savings limitation; or the foreign e4change limitation. It was argued that
foreign aid could play a role in relieving each of these constraints and could promote the
level of investment necessary to achieve eventual self(sustaining growth. !he operation of
the model for any particular country assumed the e4istence of a positive marginal
propensity to save which would eventually yield the critical level of domestic savingsto
finance the re5uired investment: and a rate of growth of e4ports in e4cess of the import
growth rate: so that e4ports would eventually rise sufficiently to overcome any foreign
e4change constraint. In addition: countries would need to ta*e appropriate measures with
the help of foreign technical and other assistance to remove the internal obstacles to
raising investment to the re5uired level.
Chenery(Strout model was capital oriented. It fully recogniCed the need for governmental
policies that would promote productivity: savings: and the allocation of resources to
productive investment. 9here the s*ill level was too low to permit a level of investment
sufficient to achieve the target rate of growth: foreign aid: including technical assistance:
served to increase the capacity of a country to employ capital productively.
!he Chenery(Strout model became e4ceedingly popular and was broadly used as a basis
for both the administration of foreign aid programs in individual countries and estimation
of global aid re5uirements. In the basic model: the capital output ratio was fi4ed: although
the authors recogniCed that it would change over time with increases in productivity.
2 8 . a g e
@owever: by ma*ing capital the independent variable and output the dependent variable
in a @arrod("omar type model: capital became the primary engine of growth.
!hus: rNI/*O; where r is the target rate of growth of output: O; I is annual domestic
investment; and * is the capital(output ratio
!he Chenery(Strout two(gap foreign aid model has been widely criticiCed on several
grounds. Fne criticism has to do with the assumptions of the model regarding the
relationship between output and international trade implied in the foreign e4change
constraint and another relates to the dominant role given to capital inputs in the growth
process. !he possibility of an e4 ante foreign e4change gap which is different from an e4
ante savings investment gap rests on the assumption of relative inelasticity between
imported and domestic inputs for production and the assumption that e4ports are not
readily e4pandable. If imported and domestic inputs are relatively substitutable or if
e4ports are responsive to price ad>ustments: there can be no difference in the e4 ante gap
e4cept in the short run <7ichalopoulos: 11J/=.
!he Chenery(Strout foreign aid model has been widely criticiCed: mainly(on the basis of
its assumptions and the dominant role given to capital in the growth process. $nother
criticism relates to the assumption of the model that capital inflow from concessionary or
non concessionary sources necessarily constitutes a net addition to domestic capital
investment. $ net inflow of resources will not necessarily ta*e the form of an e5ual
amount of increase in domestic investment: no matter how carefully the foreign aid donor
may see* to tie the resources he provides to particular investment pro>ects or activities.
!he savings function employed in the Chenery(Strout model: which is essentially the
Keynesian savings hypotheses is based on the e4istence of a marginal propensity to save
that is higher than the average propensity to save: has been re>ected by a number of
economists in favor of other types of savings functions such as the 0riedman permanent
income hypothesis: or the 7odigliani lifecycle hypothesis. $lso statistical studies do not
bear out the assumption that the average savings rate increases with the growth in per
capita income <Raymond 0. 7i*esell and Lames #. Pinser: 11J/=.
$ number of economic treatises have not only attac*ed the basic assumptions of the
capital(oriented foreign aid models: but have suggested that in some countries at least
J 8 . a g e
foreign aid might impair rather than promote long(term growth <K. -. 'riffin and L. A.
#nos: 11J3=. !his aid pessimism is based in part on statistical findings that foreign aid for
development does not simply add ane5uivalent amount to total investment: but is partly or
even largely consumed <depending upon the data employed and the statistical
methodology= and thereby reduces the savings rate. Fne of the reasons for a reduction in
the savings rate is that foreign aid enables governments to shift some of their e4penditures
from investment pro>ects financed by foreign aid to social programs: or to reduce ta4es.
$nother argument is that to the e4tent that savings are a function of investment
opportunities: as suggested by @outha**er: 112/ and that some opportunities are
preempted by foreign capital: capital flows will be offset in part by a decline in domestic
savings.
Fn the other hand: it has been argued that some investment opportunities are created by
foreign aid. #ven though some of the foreign aid resources are consumed <and it would be
surprising if they did not add directly or indirectly to consumption=: growth could still be
increased by foreign aid so long as domestic savings do not decline by the full amount of
foreign aid. -ut this raises the 5uestion of what happens to domestic savings after foreign
aid declines or is terminated.
!he increasing emphasis of modern growth theory on productivity has greatly
undermined the capital(oriented growth models which attributed a substantial portion of
increased growth to capital inputs: including capital flows from abroad.
")")") T+e 5oreign E8c+ange Ga Aroac+ to 5oreign Aid Re9uirements
$lthough foreign aid constitutes only a small proportion of the 'E. of developing
countries: aid finances over half of the current account deficits of low(income oil(
importing A"Cs and a significant proportion of the current account deficits of middle(
income oil(importing A"Cs In recent years it has become customary to pro>ect aid
re5uirements on pro>ected current the basis of account deficits: less what might be
e4pected to be covered from non concessionary capital sources. !he current account
deficits are pro>ected by estimating imports the level of and e4ports associated with a
target rate of growth.
6 8 . a g e
!he importance of the foreign e4change constraint on economic growth has been brought
into 5uestion in recent years by substantial increases in international reserves of a number
of oil(importing developing countries: some of which have not e4perienced satisfactory
growth rates in recent years. !hese countries include $rgentina: .eru: Druguay and
Lordan; even IndiaHs reserves have grown about five(fold since 11J/ to a total of some
G12 billion in 1163. Countries with satisfactory growth rates such as Colombia: #gypt:
Korea: 7alaysia: .hilippines and !hailand have all increased their reserves several(fold
during the 11J3s: despite the fact that most of them continue to receive substantial
amounts of concessionary aid.
In a recent study entitled #conomic "evelopment with Dnlimited Supplies of 0oreign
#4change: @enry L. -rutonii pointed out the limitations of ample foreign e4change
availabilities for promoting development when the foreign e4change comes from
remittances of nationals wor*ing abroad or from petroleum e4ports: rather than from
e4ports produced by the manufacturing and agricultural sectors of dynamic indigenous
economies. !hese so(called IunearnedI foreign e4change flows not only fail to develop
the productive sectors of the domestic economy: but fre5uently create a number of
economic and political problems. 0oreign e4change per se does not remove the
bottlenec*s to development created by large foreign e4change receipts that ma*e nearly
all tradable commodities cheaper to import than to produce at home.
")3) T+e Emerging Evidence of t+e *mortance of Governmental Policies for
Growt+
"isillusionment with the capital(oriented foreign aid models of the early 1123s came with
the failure of the development programs in many countries that were recipients of large
amounts of aid from both the D.S. and from other bilateral and international sources: and
the growing evidence that having the right domestic policies constitutes an indispensable
contributory factor to successful development. 7ost of the successful developers:
including Korea: -raCil: Ivory Coast: .hilippines: !hailand and 7alaysia: have received
substantial amounts of F"$: but so also have some of the less successful countries such
as $rgentina: India: .a*istan: !anCania: Pambia and Paire. Some of the moderately
successful countries such as Indonesia and 7e4ico owe their success in part to the fact
that they have become substantial petroleum e4porters.
1 8 . a g e
")3)$) Monetary Policies and Savings
7onetary and credit policies in most developing countries have been employed to hold
down interest rates in the face of inflation generated by e4cessive monetary e4pansion
and large fiscal deficits. Ronald I. 7cKinnon and #dward S. Shaw have analyCed the
effects of what they call Ifinancial repressionI in the form of e4cessive growth in the
money supply and interest rate controls. !hey find that financial repression contributes to
low savings as a conse5uence of negative real rates of interest and to the misallocation of
investment arising from various forms of credit controls <7cKinnon: 11J=.
")3)") Trade and E8c+ange Policies and Growt+
!rade and #4change .olicies and 'rowth initiated in 11JJ by the new government of Sri
Aan*a: which included <a= the unification and floating of the e4change rate; <b= the
liberaliCation of import restrictions; <c= the removal of price controls on most
commodities; and <d= interest rate reform: were accompanied by a substantial rise in
annual rates of growth alter 11JJ: 7ore than twice the average rate of growth over the
11J3(11JJ period. Eearly all sectors shared in the rapid growth: and open unemployment
was reduced from about 23 percent to about 1/ percent <!homas $. 7orrison and Aouis.
$: 11J=.
")3)3) T+e Suly of Entrereneurs
!he empirical findings of a positive relationship between open economies and growth are
supported by new evidence on the supply of entrepreneurship in developing countries.
!he development literature in the early post(9orld 9ar II period placed substantial
emphasis on the lac* of entrepreneurship as a constraint on development: and economists
and sociologists put forth a variety of e4planations for this lac* and suggested approaches
to overcoming it <#verett #. @agen: 1122=. @owever: the actual e4perience in A"Cs in
the post(war period shows that a lac* of entrepreneurship has not been a serious barrier to
economic development and that industry and agriculture have readily responded to
economic opportunities created by a liberaliCation of governmental policies.
3) (onclusion
0oreign aid by governments and by multilateral institutions financed by governments has
throughout the post(9orld 9ar II period been closely associated with the economics of
13 8 . a g e
development. @owever: there are still debates on the aid outcomes. Some li*e 7ayo
argues that pity has not helped the $frica: and has actually hurt its e4ternal and self(
image. !he other still argues that the debate should not be between more or less aids: but
about the ob>ectives of aid and how it is given.
!he aspect of ta*e(off hypothesis of Rostow >ustifies the provision of large amounts of
aid to initiate the ta*e(off process and assure the rapid achievement of self(sustaining
growth. Fn the hand Ibalanced growth theoryI which suggested that if all sectors:
including industry: agriculture: infrastructure and human s*ill development: could grow at
relatively rapid rates at the same time: the conditions for the ta*e(off could be achieved
without the long historical period e4perienced by the older developed countries.
In 1123s "evelopment optimism and 0oreign $id models started to present the need of
aid management s*ills. "isillusionment with the capital(oriented foreign aid models of
the early 1123s came with the failure of the development programs in many countries that
were recipients of large amounts of aid from both the D.S. and from other bilateral and
international sources: and the growing evidence that having the right domestic policies
constitutes an indispensable contributory factor to successful development.
11 8 . a g e
Reference
1. IInternational $id for "eveloping Countries:I Review of #conomics and Statistics: 0ebruary
1121: pp. 13J(16
2. IEotes on the !heory of the -ig .ush:I in #conomic "evelopment for Aatin $merica: Eew
Oor*M St. 7artinHs .ress: 1121
. I!he Inter($merican -an*:I 0ederal Reserve -ulletin: Lune 11,3: pp. /1J(/2/: for a
bac*ground and te4t of the Charter for an Inter($merican -an* proposed by the .an
$merican Dnion in $pril 1613.
,. I!he !a*e(Fff Into Self(Sustained 'rowth:I #conomic Lournal: 7arch 11/2: pp. 2/(,6.
/. <.roceedings of a conference held by the International #conomic $ssociation=: Eew Oor*M St.
7artinHs .ress: 112.
2. "eterminants: 9ashington: ".C.M !he -roo*ings Institution: 112/.
J. K. -. 'riffin and L. A. #nos: I0oreign$ssistance Fb>ectives and Conse5uences:I #conomic
"evelopmentand Cultural Change: $pril 11J3;
6. 7cKinnon: 7oney and Capital and #conomic "evelopment: 9ashington: ".C.M -roo*ings
Institution: 11J
1. 7easures for the #conomic "evelopment of Dnderdeveloped Countries: <Report by a 'roup
of #4perts $ppointed by the Secretary 'eneral: Eew Oor*M Dnited Eations: 11/1=
13. 7ichalopoulos: I.roduction and Substitution in !wo('ap7odels:I !he Lournal of
"evelopment Studies: Qol. ii: Eo. ,: Luly 11J/: pp. ,(/2
11. Raymond 0. 7i*esell and Lames #. Pinser: I!he Eature of the Savings 0unction in
"evelopingCountriesM $ Survey of the !heoretical and #mpiricalAiterature:I Lournal of
#conomic Aiterature: 7arch 11J: pp.
12. Rostow: ed.: !he #conomics of !a*e(Fff Into Sustained 'rowth
1. 9orld "evelopment Report 1161: 9ashington: ".C.M -an*: 1161:
12 8 . a g e