A NOTE ON FOREIGN AID, HUMAN CAPITAL, AND WELFARE

Abstract

Should foreign aid be tied or untied? We study this question in the context of a dynamic growth model in which agents can accumulate human capital through education. We compare the growth and welfare implications of three polar scenarios in which foreign aid is either (i) completely untied, (ii) tied to public investment in infrastructure, or (iii) tied to public spending on education. Our results indicate that tying aid to education is more beneficial from a long-run welfare perspective than the two alternative scenarios. We also compute the optimal allocation of foreign aid and find that the largest fraction of aid flows ought to be tied to public spending on education. Finally, we study the transitional dynamics of the recipient economy following an aid inflow and find that aid programs that are tied (entirely or partially) to public spending on education generally entail some welfare losses in the short run.