Foreign Aid Reduces Domestic Capital Accumulation and Increases Foreign Borrowing: A Theoretical Analysis

In an infinite-horizon model with endogenous time preferences, foreign aid, foreign borrowing, and domestic capital accumulation, a permanent increase in foreign aid leads to a reduction in long-run capital accumulation, a rise in domestic consumption, and an increase in foreign borrowing. Short-run analysis shows that an initial increase in foreign aid leads to a rise in investment, and a reduction in consumption and external borrowing. On the other hand, a temporal increase in foreign aid results in an increase in consumption and foreign borrowing, and a reduction in investment.