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 isincreasing in magnitude and getting more focus both from the recipient and donor perspectives. Butempirically its effectiveness is debatable and inconclusive. Developing countries mainly Ethiopia hasbeen experiencing the resource gap (saving and trade gaps) which leads to significant inflow of foreignaid. Therefore, the objective of the study was to examine the effect of foreign aid on economic growththrough the transmission mechanism of investment and import equations using AutoregressiveDistributed Lag (ARDL) estimation techniques for the period 1981 to 2015.The bound test for co-integration revealed that the existence of long run co-integration among variables in all threeInvestment and import (transmission) and growth equations. From the long run equations, we found thatforeign aid has a negative and significant impact on per capita income growth in long run. Aid also haspositive and significant effect in investment and growth equations. Aid having positive and significanteffect in transmission equations but the negative and significant effect on per capita income growthindicates 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 foreignexchange gap the country need to focus on domestic capacity development mainly to substitute import.