The Causal Link between Foreign Aid and Economic Growth in Ethiopia

Abstract

This paper investigates the causal linkage between foreign aid and economic growth in Ethiopia based on time series annual data for the period 1981 to 2020. The Autoregressive Distributed Lag approach to Co-integration and Error Correction Model was applied to investigate the long-run and short-run relationship between economic growth and its determinants. Therefore, the results of the bound test confirmed that the long-run relationship between explanatory variables and economic growth. The empirical results implied evidence of a long-run and short run negative impact of foreign aid on economic growth in Ethiopia. Concerning other control variables except for squared foreign aid and political instability, all variables significantly influence economic growth in the long run. While in the short-run, gross capital formation, total export, external debt, inflation rate, and drought have a significant impact on economic growth but human capital, and political instability is insignificant. Furthermore, Vector error correction model Granger causality tests show that the direction of causality is running from economic growth to foreign aid in the long run, and no short-run causality exists between foreign aid and economic growth. The study also found that economic growth during EPRDF relatively strong in growth compared to the military regime, and foreign aid as a percentage of GDP declining during the study period under consideration. Therefore, based on the finding, the government should minimize the dependence on foreign aid, and work to bridge gaps in the financial source by setting policies to increase domestic saving which is believed as a backbone of economic growth.