Everything is obvious – once you know the answer
– Title of book by Duncan Watts
Abstract
It is sometimes argued that foreign aid leads to a virtuous circle in which growth becomes self-reinforcing. We study two versions of this argument, using a modified neoclassical growth model in which the effects of parameter changes and capital accumulation are amplified. Simulations are used to quantify the welfare benefits from aid transfers. We find that, contrary to expectations, amplification makes only a modest difference to the welfare benefits from aid. This is true even when aid allows a faster exit from a vicious circle or poverty trap.
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Notes
The minister was the British Foreign Secretary, Ernest Bevin, quoted in Judt (2005, p. 91).
Sachs (2006) sketches a virtuous circle in which rising tax revenues strengthen political authority and public investment, which support further increases in revenues.
Note that our use of the term differs from that in Dutta, Leeson and Williamson (2013), who consider the possibility that aid leads to a polarization in political institutions.
Acemoglu (2009, p. 370) briefly discusses the use of the Mankiw, Romer and Weil (1992) production function in a Ramsey model with investment taxes; the aggregate consequences of tax distortions are then amplified. Endogenous investments in human capital are also present in the models of Erosa, Koreshkova and Restuccia (2010) and Manuelli and Seshadri (2014).
Voors, Bulte and Damania (2011) find that positive income shocks in corrupt countries can raise corruption, but a virtuous circle can arise when corruption is low.
Acemoglu (2009, p. 116) draws a distinction between models with multiple equilibria, and models with multiple steady-states. In the former case, the equilibrium can change when agents simultaneously change behavior or expectations, giving rise to indeterminacy; in the latter case, the equilibrium path and the final outcome are determined by initial conditions. See Mourmouras and Rangazas (2007) for analysis of aid in a model of the latter type.
In the terminology of Section 2, this is an amplification effect rather than a virtuous circle, because it will reduce to a model with a capital externality. Put differently, although there is an extra state variable in the model at first glance, it can be eliminated from the system of equations, and the resulting system will then be identical to the case of a capital externality.
Away from steady-state, alternative definitions of convergence rates will typically give different results. We use the first measure of the four considered by Mathunjwa and Temple (2007).
One reason for this result is that aid does not greatly alter the path of the capital stock: in this baseline simulation, the capital stock with aid is never more than 4 percent higher, at any given instant, than in the case without aid.
Alternatively, as discussed in Obstfeld and Taylor (2004, pp. 262–265), a higher discount rate could imply larger welfare gains.
Examples of high estimates of output-capital elasticities for developing countries include Benhabib and Spiegel (1994) and Kim and Lau (1994). Barro and Sala-i-Martin (2004, pp. 112–118) explain how the Ramsey model with a low output-capital elasticity generates quantitative predictions that are at odds with the data; see also King and Rebelo (1993). For a critique of the empirical relevance of capital externalities, see Benhabib and Jovanovic (1991).
For example, Mankiw, Romer, and Weil (1992) used an estimate of 2 percent a year for the long-run growth rate, and Jones (1995, p. 498) estimated US growth in GDP per capita over 1929–1987 as 1.75 percent. Note that higher values of \(\theta\), as well as raising the long-run growth rate, would bring the reduced-form production technology closer to linearity, which seems unrealistic.
There is no closed-form expression for this variation in the case of Stone–Geary preferences, so we obtain it numerically.
The Marshall Plan did involve large transfers, since the US donated 1 percent of its GDP on average over the years it operated (Crafts 2013).
Gimbel (1976) discusses the wide range of objectives that have been attributed to the Marshall Plan.
For an informal discussion of this role for aid, see Rogerson (2011).
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Acknowledgments
We are grateful to Pierre-Olivier Gourinchas and an anonymous referee for helpful comments which have improved the paper. We are responsible for its remaining shortcomings. Carter thanks the British Academy for financial support under award PF110079. Temple thanks the British Academy for financial support from a Mid-Career Fellowship.
