Aid, Policies, and Growth in Developing Countries: A New Look at the Empirics

The relationship between foreign aid and economic growth has been the subject of much controversy. A recent theme suggesting that aid promotes growth, but only in a good policy environment has ratcheted up that debate. In this paper, we assess the importance of policy and aid in generating growth when the aid, policy, and growth relationship is nonlinear. This allows us to examine the varying effects of aid and policy in different data segments, which we do without imposing any particular structure on the underlying relationship. We find that policy is an important determinant of growth. We also find partial corroboration of the view that aid is growth enhancing in a good policy environment, and some evidence of diminishing returns to aid. These findings suggest that nonlinearities if not appropriately addressed fail to capture the detailed underlying dynamics and thereby mask some key features of the aid-policy-growth relationship.