Three essays on foreign aid and macroeconomic performance
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The first chapter of this dissertation examines fungibility as a possible explanation for the "missing link" between foreign aid and its effectiveness. The composition of aid plays a crucial role in determining the composition of government spending, thereby affecting any potential growth benefits. Embedding fungibility as an equilibrium outcome in an endogenous growth framework, I show that the substitution away from domestic government investment is higher than from government consumption. This leads to a crowding-out of domestic public investment spending and offsets any positive impact that aid might have on growth. Further, I test the predictions of the model by using a panel of 67 countries for 1972-2000. I find strong evidence of fungibility at the aggregate level: almost 70 percent of total aid is fungible in the sample. I also find that investment aid is more fungible than other categories of aid, crowding out about 90 percent of government investment. There is also no statistically significant relationship between foreign aid and private investment, whereas aid has a positive impact on household consumption. In chapter 2, by using a new panel of 95 countries for 1995-2007, I test the main empirical findings of the first chapter on total foreign aid fungibility in the presence of governance quality measures. The results reveal that fungibility is still an existing problem for the governments with higher governance quality but the degree of fungibility is lower in those countries. This suggests that poor governance quality might be one of the missing pieces in foreign aid’s ineffectiveness puzzle. In the last chapter, I investigate whether the amount of foreign aid received by the governments in the developing and emerging economies affects the probability of equity market liberalization. Findings suggest that the amount of foreign aid received is positively related to the probability of equity market liberalization. In addition to the amount of foreign aid, the level of economic and financial development, the availability of growth opportunities, the quality of investor protection, and the level of the government's involvement in the economy are among the main determinants of the government's decision to liberalize their equity markets.