Effects of Foreign Aid on Income through International Trade

Abstract

This article presents a review of recent studies that estimate the trade effects of foreign aid. It also provides new results obtained using panel data techniques to estimate the direct effects of aid on international trade accounting for countries’ participation in free trade agreements, and the indirect effects that aid exerts on income through trade. A structural gravity model of trade augmented with aid and free trade agreement variables is estimated for a cross-section of 33 donor countries and 125 recipient countries over the period 1995 to 2016. In a second step, the indirect effect of aid on income is estimated using a control function approach and instrumental variable techniques. The main results indicate that development aid has a robust direct effect on donor exports (the effect on recipient exports, however, is not robust). It also has an indirect positive effect on income levels in the recipient countries. The effects are heterogeneous and vary by region.