Effects of development aid (grants and loans) on the economic dynamics of the recipient country

Abstract

This paper investigates the nexus between foreign aid (in both forms: grant and loan), poverty trap, and economic development in a recipient country by using a Solow model with two new ingredients: a development loan and a fixed cost in the production process. The presence of this fixed cost generates a poverty trap. We show that foreign aid may help the country to escape from the poverty trap and converge to a stable steady state in the long run, but only if (i) the country’s characteristics, such as saving rate, initial capital, governance quality, and productivity are good enough, (ii) the fixed cost is relatively low, and (iii) the loan rule is generous enough. We also show that our model with foreign aid has room for endogenous cycles, unlike the standard Solow model.