Foreign Aid and Economic Growth in Ethiopia: The Two Gap Model Approach

Abstract

Foreign aid mainly Official Development Assistance (ODA) with the objective of development is increasing in magnitude and getting more focus both from the recipient and donor perspectives. But empirically its effectiveness is debatable and inconclusive. Developing countries mainly Ethiopia has been experiencing the resource gap (saving and trade gaps) which leads to significant inflow of foreign aid. Therefore, the objective of the study was to examine the effect of foreign aid on economic growth through the transmission mechanism of investment and import equations using Autoregressive Distributed Lag (ARDL) estimation techniques for the period 1981 to 2015.The bound test for cointegration revealed that the existence of long run co-integration among variables in all three Investment and import (transmission) and growth equations. From the long run equations, we found that foreign aid has a negative and significant impact on per capita income growth in long run. Aid also has positive and significant effect in investment and growth equations. Aid having positive and significant effect in transmission equations but the negative and significant effect on per capita income growth indicates that the import financed by aid is more of noninvestment goods and outweighs the investment. Finally, the study recommends as per the two-gap model since the binding constraint is foreign exchange gap the country need to focus on domestic capacity development mainly to substitute import.