DF201|Q6 (Howard White)| P2

#6. Discuss Howard White's view that the aid literature has failed to advance our understanding of the macroeconomics of aid because it neglects the mechanisms by which aid may affect savings.

Critiques of Dual Gap Theory:
First, it is a very sticky model, with no substitution in production (either between factors to reliever capital shortage or to reallocate factors between sectors).
Second, the underlying Harrod-Domar model is too simplistic a representation of the growth process: many other factor besides capital accumulation affect growth. (Like human capital.)
Finally, the two gap model does not incorporate any mechanisms by which aid may not be matched by one-for-one increases in investment, government development or foreign exchange.

The Savings Debate:
...an anticipated aid inflow will be treated as an increase in income and so, unless the marginal propensity to save is one, allocated between both savings and consumption.
1. Griffen's Presentation of the Negative Impact of Aid on Savings.

Four adverse effects on foreign aid are postulated:
1. lowering domestic savings
2. distorting the composition of investment
3. frustrating the emergence of an indigenous entrepreneurial class
4. inhibiting institutional reform

Four sets of issues are critically analyzed:
1. whether domestic savings should be defined as being determined by income alone
2. the secondary (feedback) effects of aid via future increases in income
3. fungibility of aid between consumption and investment
4. the centrality of savings in the determination of growth potential

...it may be argued that aid inflows reflect low savings rates in developing countries (rather than vice versa).
...the share of exports in GNP is found to provide a better explanation of changes in the savings rate compared to aid.

Harrod-Domar Growth Model:
g=s/c
g: is growth (dY/Y)
s: the net investment or savings ratio (dK/Y)
c: incremental capital-output ratio or ICOR (dK/dY) the quantity of capital needed for attaining a one unit increase in output, thus:
dY/Y=(dK/Y)*(dK/dY)

Phases of Growth in Chenery and Strout's Dual Gap Model:
Phase-Growth Constraint----Foreign Capital Determined by
IA----Ability to invest----Savings Gap
IB----Ability to invest----Trade Gap
II----Growth target--------Savings Gap
III---Growth Target--------Trade Gap

The point may be clarified by using the leontief fixed-coefficients production function, as done by McKinnon [1964]
Y=min{aK(d),bK(m))
K(d) is domestically produced capital goods
K(m) imported capital goods
a and b are the output capital ratios for both d and m respectively.

...aid...will cause indirect effects on savings that will be difficult to isolate, and their inclusion on the right hand side is inappropriate.
...aid will affect savings including:
1. there will be a relationship between aid and the savings rate.
2. aid will affect the interest rate
3. aid alters income distribution in ways that are imperfectly understood.
4. aid will affect the level of exports.
5. public savings will vary directly according to how government responds to changes to its income from aid.
...
It is possible that high aid inflows per capita and low average savings propensities are both caused by some third, exogenous, factor...
The problem of simultaneity.
Studies have found aid allocation to be more strongly influenced by donor interests than by recipient need.

Conclusion:
The radical position that aid displaces savings, most strongly associated with the name of Keith Griffin, was shown to have a weak theoretical foundation. It is therefore not surprising that the empirical data do not, contrary to the claims of some, support their arguments.

...three channels for aid impact on the growth of output:
direct impact
crowding out
crowding in
Dennison's study for 1950-62 found that increases in capital stock accounted for only 25% of growth.
Joshi and Findlay's Critique of the Dual Gap Model:
the impossibility of substituting domestic for imported inputs in to the production of the investment good sector. The assumption of rigidly fixed technical coefficients may be valid in each particular line of investment, but the overall proportions can be changed by varying the composition of investment so the model assumes that not only techniques but also demand patterns are rigidly determined.
Edwards on Real Exchange Rate (RER)
aid is a transfer from the rest of the world, and as such it will generate an equilibrium real appreciation. That is, foreign aid-perhaps paradoxically-will reduce the degree of international competitiveness in the recipient country, making the country's exports less competitive internationally.
Notes:
Bacha's three gap model [1990]