When is Foreign Aid Policy Credible? Aid Dependence and Conditionality

Disbursements of foreign aid are guided (in part) by the needs of the poor. Anticipating this, recipients have little incentive to improve the welfare of the poor. In principle, conditionality could partly solve the problem, but this requires a strong commitment ability by the donor. Without such a commitment technology, aid will be allocated (partly) to those in most need, and the recipient governments will exert low effort in alleviating poverty. Contrary to conventional wisdom in the aid literature, we show that tied project aid and delegation of part of the aid budget to an (international) agency with less aversion to poverty improve welfare of the poor in the recipient countries. Keyword: Aid Policy, Credibility, Policy Design