Working paper 07-1 Christina Bjerg, Christian Bjørnskov and Anne Holm

of heavy debt burdens but also circumvents the problem of Dutch Disease as the inflows 

are not exchanged to a local currency and thus do not ‘enter’ the domestic economy. 

This leads to the theoretical possibility that foreign aid is stronger associated with 

economic growth when the recipient country suffers from an external debt burden. 

We test this proposition in panel data from up to 38 Least Developed Countries. A 

series of fixed effects estimates show that inflows of foreign aid indeed tend to alleviate 

the strongly detrimental effect of heavy debt burdens, a finding that is robust to 

excluding relevant subgroups of observations. We also report supplementary evidence 

that foreign aid is also associated with higher investment rates when debt burdens are 

sufficiently heavy, a finding that is equally robust. 

Our results should in no way be taken as conclusive of this question. Instead, we 

simply point towards a hitherto uncharted possibility in the growing literature on 

conditional aid effects for which we provide a simple, theoretically consistent 

explanation. However, our findings hold potentially important implications for, for 

example, future aid policies as well as the current popular drive towards the cancellation 

of Third World debts. 

 

 

References 

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Bauer, P.T. 1971. Dissent on Development. London: Weidenfeld and Nicolson. 

 

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Bauer, P.T. 1984. Reality and Rhetoric. Studies in the Economics of Development. 

Cambridge, MA: Harvard University Press. 

Boone, P. 1996. Politics and the Effectiveness of Foreign Aid. European Economic 

Review 40: 289-329. 

Burnside, C. and Dollar, D. 2000. Aid, Policies, and Growth. American Economic 

Review 90: 847-868. 

Burnside, C. and Dollar, D. 2004. Aid, Policies, and Growth: Revisiting the Evidence. 

World Bank Policy Research Working Paper 3251. 

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York University, Development Research Institute. (accessed June 27, 2006 at 

http://www.nyu.edu/fas/institute/dri/

). 

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of Development Studies 37(6): 66-92. 

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Consolidation. Oxford Economic Papers, vol. 36(3), 359-380. 

Doucouliagos, Hristos and Martin Paldam. 2006. Aid Effectiveness on Accumulation. 

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Doucougliagos, Hristos and Martin Paldam. In press. Aid Effectiveness on Growth: A 

Met Study. Forthcoming in European Journal of Political Economy. 

Easterly, William. 1999. The Search for the Key: Aid, Investment, and Policies in 

Africa. Journal of African Economies, vol. 8 (4), 546-577. 

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Indebted? Reviewing 2 Decades of Debt Relief. World Development, vol. 30 (10), 

1677-1696. 

 

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Hansen, Henrik and Finn Tarp. 2000. Aid Effectiveness Disputed. Journal of 

International Development 12: 375-398. 

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Cross-Country Evidence Really Show? IMF Working Paper 05/127. 

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19

Table 1. Descriptive statistics 

 Mean 

Minimum 

Maximum 

Std. 

deviation 

Observations 

Growth rate 

.062 

-11.925 

22.934 

3.905 

199 

Log GDP per capita 

(GDP per capita) 

6.968 

(1167.9) 

5.774 

(321.8) 

8.285 

(3965.2) 

.429 

(558.8) 

199 

Investment rate 

8.753 

1.027 

50.208 

7.356 

199 

Government 

consumption 

27.605 3.453 150.711 

16.091  199 

External debt 

77.175 

.335 

616.509 

78.947 

199 

Foreign aid 

14.972 

.940 

113.821 

14.654 

199 

Openness  

65.380 

3.462 

281.177 

43.097 

199 

Real investment price 

2.500 

1.062 

6.432 

1.065 

189 

Note: 8 % of the observations are from Asia, the remaining 82% are from Sub-Saharan Africa. 

 

 

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