ChainWhat it assumes · how to break it
Start
A developing country receives aid in the form of grants and concessional loans to build roads, power stations and irrigation.
1
As a result, funds for investment rise beyond what the country's low domestic savings could provide.
savings gap
savings gap
Assumes: Low savings are what limit investment.
But: If the constraint is weak property rights or corruption, more funds will not produce more productive investment.
2
At the same time, the aid arrives in foreign currency, which lets the country import machinery and fuel that it could not afford from its export earnings.
foreign exchange gap
foreign exchange gap
Assumes: The country is short of foreign currency to import capital goods.
But: A country with strong export earnings is not held back by foreign exchange, so this gain is small.
3
This means the capital stock grows, and according to the Harrod–Domar model the growth rate rises with the level of investment.
Harrod–Domar model · capital stock
Harrod–Domar model · capital stock
Best link to attack
Assumes: The extra capital is used productively.
Assumes: The extra capital is used productively.
But: Projects chosen for political reasons or poorly maintained can add little to output, so the capital-output ratio is high.
4
Therefore, LRAS shifts right as better infrastructure lowers firms' costs, so the economy's productive potential and real GDP rise.
long-run aggregate supply · infrastructure
long-run aggregate supply · infrastructure
Assumes: Firms can make use of the new infrastructure.
But: Without skilled workers, finance and stable demand, private firms may not expand even with better roads and power.
End
Economic growth rises as aid fills the savings and foreign exchange gaps and raises the capital stock.
Evaluation chain
- E1However, the Harrod–Domar link from investment to growth depends on the extra capital being used productively.
- E2If aid funds prestige projects, is diverted by corruption or pays for infrastructure that is not maintained, each unit of capital produces little output.
- E3As a result, the capital-output ratio is high and the rise in the growth rate is much smaller than the model predicts.
- E4So aid raises growth mainly where governance is sound and projects are well chosen, and may raise it very little where institutions are weak.
Another way to attack it: Concessional loans must be repaid, so debt service can later drain foreign exchange and government revenue that would otherwise fund investment.
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Questions this answers
- Assess the extent to which foreign aid increases economic growth in developing countries.
- Using the Harrod–Domar model, explain how aid might raise growth.
- Discuss the view that aid does more harm than good to developing economies.
Diagram
AD/AS: LRAS shifts right as the capital stock rises (AD also shifts right during construction). The Harrod–Domar model can be shown as a flow from savings to investment to a larger capital stock and higher output.
Reverse and related
Aid withdrawn → less investment in infrastructure, so the capital stock grows more slowly and potential growth falls.