Aid and Growth. New Evidence Using an Excludable Instrument

We use an excludable instrument to test the effect of bilateral foreign aid on economic growth in a sample of 97 recipient countries over the 1974-2013 period. Our instrument interacts donor government fractionalization with a recipient country’s probability of receiving aid. The results show that fractionalization increases donors’ aid budgets, representing the over-time variation of our instrument, while the probability of receiving aid introduces variation across recipient countries. Controlling for country- and period-specific fixed effects that capture the levels of the interacted variables, the interaction provides a powerful and excludable instrument. Making use of the instrument, our results show no significant effect of aid on growth. We also investigate the effect of aid on consumption, savings, investments, and net exports, and investigate heterogeneity according to the quality of economic policy, democracy, and the Cold War period. In no regression do we find that aid affects growth. However, we find that aid increases investment and consumption, while it decreases net exports.