How is Foreign Aid Spent? Evidence from a Compelling Natural Experiment

by Eric Werker, Faisal Z. Ahmed & Charles Cohen

Overview — Foreign aid is viewed as a transfer of resources that can be used to generate meaningful growth in the recipient country's economy. How this aid is ultimately spent, therefore, determines how effective it is in achieving its purposes. Yet economists to date possess little understanding of how foreign aid trickles through a country's economy. This paper examines a foreign aid windfall that poorer Muslim countries have systematically received from rich, oil-producing Arab states. When the price of oil skyrocketed during the 1973-1986 oil crisis (and again after 2001), OPEC nations took a substantial portion of the money they received and gave it away as foreign aid, mostly to Muslim nations. When the price of oil crashed and income plunged in the oil-producing countries, the aid dried up. Werker, Ahmed, and Cohen examined the short-term effect of foreign aid on aggregate demand, the components of gross domestic product, and the balance of payments. Key concepts include:

  • Oil-driven bonuses in foreign aid from wealthy Arab oil producers to poor Muslim countries were mostly consumed on imported non-capital goods.
  • The aid crowded out domestic savings and did little to attract foreign investment. Long-term economic growth was unaffected.
  • The popular critique that aid is "wasted" did not jibe with the data. Every component of the domestic economy, including investment, was raised in the short term.
  • Foreign aid may be an effective tool of fiscal policy that can be used to smooth the business cycle in developing countries. But a challenge remains: How can the temporary stimulus be converted into lasting economic growth?

Author Abstract

We use yearly variations in the price of oil to construct a powerful new instrument to test the impact of an important but often-overlooked foreign aid channel: money given by wealthy OPEC nations to their poorer Muslim allies. The instrument identifies plausibly exogenous variation in foreign aid. We investigate how aid is spent by tracking its short-run effect on aggregate demand, prices, the national accounts, savings, and the balance of payments. We find that aid is mostly consumed, primarily in the form of higher imports of non-capital goods. Some aid is invested and aid has a small but insignificant effect on growth. Aid has no effect on the financial account, but does raise holdings of foreign reserves.

Paper Information