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Over the last half a century, foreign aid has emerged as a dominant strategy for alleviating poverty in the third world. Not coincidentally, during this time period, major international institutions such as the United Nations, World Bank and International Monetary Fund gained prominence in global economic affairs (Hjertholm and White, 2000). But despite increased aid inflows into the developing economies over these years, economic hardship persisted. Hence, there has been doubt regarding the usefulness of foreign aid inflows in fostering growth and development in these economies. Consequently, studies on foreign aid-growth nexus have surged. However, the empirical evidences from these studies have been mixed.
One of the shortcomings of the aid-growth literature is the common neglect of the fact that aid is given primarily to the government and therefore any macroeconomic impact will depend on the public sector fiscal response and/or behavior (McGillivray, 1994; Franco-Rodriguez et al., 1998; McGillivray and Morrissey, 2001; and Mavrotas, 2002). Consequently, only a limited number of studies explicitly recognized that aid inflows go to the public sector of recipient countries and, hence, the ultimate effect of aid on economic growth depends on how governments respond to aid flows. The flow of aid may encourage governments to become wasteful or provide an incentive to relax their tax efforts. In such instances, governments pursue macroeconomic policies which tend to favor larger budget deficits, thereby resulting in larger savings-investment gaps. Consequently, there is greater quest for more aid flows.
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