Question: To what extent can aid help an economy develop?
Firstly, aid can help an economy fill their domestic savings gap. Aid can fill a country’s domestic savings gap and thus provide funds for domestic investment. An increase in investment then acts through the multiplier to boost AD, income, employment and real GDP.
However, aid is likely to have interest. Aid could be in loan form, meaning the recipient must repay the loan with interest. This interest could become unsustainable if the recipient country fails to repay it on time.
Additionally, aid can help an economy to fall their foreign exchange gap. Aid can fill a country’s foreign exchange gap and thus provide foreign exchange reserves required to import vital foreign technology that cannot be produced within domestic shores.
But, aid could lead to dependency. Aid dependency could occur. A country could become reliant on receiving aid to boost its economy. So the domestic economy does not focus on developing its own economy, it focuses on attracting more aid. The economy may then remain underdeveloped.
Moreover, aid may be free. Aid could be free so there is nothing to repay. Alternatively, aid may be on concessionary terms so it is cheaper than a commercial loan.
On the other hand, aid may be tied. Aid may be tied and could destroy the recipient’s domestic economy. For example, PL 480 food aid given by the US to LDCs means domestic LDC farmers are outcompeted by the cheaper food and they may go bust. At the same time domestic consumers switch to buying more US food. So imports rise and foreign exchange reserves deplete.
Furthermore, aid could help improve human capital. Aid could be used on healthcare and education, so the economy’s human capital increases. This helps reduce poverty as people have a better education, health and skill-set so they can earn a higher income and work longer.
Although, aid may be spent on the military. Aid could be used on military expenditure or diverted into politicians’ bank accounts if there is corruption in the recipient’s government. The opportunity cost is the lost spending to increase the productive capacity of the economy.