Foreign Aid and Free Trade and Their Effect on Income: A Panel Analysis

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ABSTRACT

This paper uses a panel approach and annual observations of over 150 countries for the period 1975 - 2000 to examine the impact of foreign aid and trade on income. The paper addresses the simultaneity of international trade, foreign aid and economic performance by using a full information system or three-stage least squares approach. The findings of this paper strongly suggest that foreign aid and trade are strong determinants of GDP per worker, albeit in opposite directions. The regression results are robust to the inclusion of a multitude of exogenous variables that are considered to be determinants of GDP per worker. Foreign aid is a commonly owned resource, powerful individuals and state heads establish property right in the system and, as a result, rent extractors expend resources resisting deregulation that attempt to remove that privilege. On the other hand, the empirical evidence reaffirms that international trade appears complementary to economic performance.

JEL Classifications: F10, O10, O40

Key Words: Foreign Aid, Free Trade, Economic Growth

INTRODUCTION

The fact that so many countries register low per capita income after receiving enormous amounts of foreign aid questions its effectiveness on economic performance. Moreover, despite the world's massive movement toward trade liberalization both in goods and services, foreign aid recipients remain stagnated by lack of trade, restrictive trade policies, and low per capita income. The impact of foreign aid and trade on living standards is ultimately an empirical question, and one that will be addressed in this paper.

While the belief that foreign aid promotes economic growth is reasonable, it has been difficult to verify empirically. Despite extensive research devoted to the impact of foreign aid on economic development, improper measurement of official aid, endogeneity problems, and poorly specified models diminish the importance of these studies and have produced only mixed results. This paper addresses a previously unconsidered issue: empirical investigation that takes into account the simultaneity among international trade, foreign aid, and economic performance. Single-equation models overlooked much of the interdependence that exists in the world today. The best approach for understanding these interdependencies is to model them explicitly with feedback loops. This means using simultaneous equations instead of looking at one equation at a time, the approach in much of the prior studies. To account for the interdependencies among variables this paper uses a full information system, or Three-Stage Least Squares approach and identifies three equations, an income model, a trade model, and a foreign aid model.

The paper tries to quantify the determinants of GDP per worker, which is used as a proxy for living standards. It uses a panel approach and annual observations for over 150 countries for the period 1975 to 2000. The rest of the paper is organized as follows. Section Two is a literature review of the effects of aid and trade on income. Section Three sketches the model and section four presents the empirical results. Section five provides the summary and concluding remarks.

FOREIGN AID VERUS FREE TRADE: AN OVERVIEW OF THE LITERATURE

Trade as an Engine of Growth

Two contrasting events happened after the Great Depression. Foreign aid and international trade (financial and goods services) have emerged as the two primary aspects of global interdependence. International trade has expanded the volume of goods and services since World War II. The importance of international trade on economic performance has a long history in economic thought. The evidence overwhelmingly indicates that trade promotes economic performance. There is a voluminous literature on the positive effect of trade on growth. The most recent include Dollar (1992), Ben-David (1993), Sachs and Warner (1995), Edwards (1998), and Frankel and Romer (1999). …