Academic journal article The Journal of Developing Areas

Nonlinearity in the Efficacy of Foreign Aid and Evidence of Poverty Traps

Academic journal article The Journal of Developing Areas

Nonlinearity in the Efficacy of Foreign Aid and Evidence of Poverty Traps

Article excerpt

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While the efficacy of foreign aid has been extensively studied, the question still remains empirically unanswered. Over the last half century more than $2.3 trillion in foreign aid has been given to developing countries (Easterly 2006), but the results appear lackluster as 1.1 billion people are still living in extreme poverty (Sachs 2006). The lack of a consensus in the literature on efficacy of foreign aid remains troubling in light of the amount of money being spent. This lack of consensus can be explained by previous researchers reliance upon linear Solow Growth Models in their analysis.

A neo-classical Solow (1956) growth model has been shown to be empirical consistent with theory by Mankiw, Romer, and Weil (1992), henceforth MRW, using a Cobb-Douglas production function with a log-linear estimation. By controlling for human capital accumulation within the country, their "Augmented Solow Growth Model" is able to explain 80 percent of the variation in income per capita within countries. Later research, by Karras (2008), has demonstrated that data released following MRW has shown this relationship to be even stronger. Yet a stream of research by Azariadis and Drazen (1990), Durluaf and Johnson (1995), Liu and Stengos (1999), Galor and Weil (2000), Hansen (2000), and Odell (2009 and 2012) has found possible inconsistencies with a standard linear model, indicating the necessity of nonlinear estimation techniques. By relaxing the linearity assumption those papers have found models that are more efficient at modeling economic growth, while also satisfying a necessary condition for the existence of a poverty trap.

A consequence of nonlinearities in a textbook Solow Model is the assumption of conditional convergence is violated by the presence of multiple steady states. The existence of multiple steady state levels means the efficacy of foreign aid will be dependent upon the size of the foreign aid the country receives. In this paper we find that foreign aid has a positive effect on a countries steady state level of income per capita only if it is sufficiently large. This result is a necessary condition of a poverty trap model, and could also be a reason that previous literature has been inconsistent.

In the literature, three possible causes of nonlinearities exist that could create a poverty trap. The first example is a technologically induced poverty trap that follows from the work of Rosenstein-Rodan (1943, 1961), Singer (1949), Nurkse (1953), Lewis (1954), Myrdal (1957), Rostow (1960), Murphy, Shleifer, and Vishny (1989), and Barro and Sala-i-Martin (1995). These models consider a production function that has regions that exhibit increasing returns to scale. The second example occurs with a violation of a constant savings rate assumption. This nonlinearity in the effect of savings on growth will result in a savings-induced poverty trap. Kuznets (1966), Ogaki, Ostry, and Reinhart (1996), and Laoyza, Schmidt-Hebbel, and Serven (2000) have found evidence that supports this form of a poverty trap. The final example is a demographically induced poverty trap. In a demographically induced poverty trap a countries population growth is a function of the income level. Malthus (1798), Leibenstien (1954, 1957), Nelson (1956) and Becker and Lewis (1973) have found evidence of population growth being a function of the income level.

One solution to a country that is trapped in a low steady state equilibrium created by a poverty trap, as suggested by both Rostow (1960) and Sachs (2004), is receiving foreign aid that is sufficiently large to push them out of the trap. A large amount of foreign aid could supplement a developing countries' investment enough to ignite their stagnant growth pushing the country to a higher steady state level. But, if the amount of foreign aid they receive is not large enough then it will not have any effect on their steady state outcome. …

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