The relationship between aid and economic growth of developing countries : does institutional quality and economic freedom matter?

Foreign aid is an important means of finance for governments of developing countries. The current study investigates whether too much inflow of aid to developing countries is beneficial or harmful to their economy and whether institutional quality and economic freedom matters in aid–growth relationship. To this base, a panel data covering the period 2002-2019 was collected from 44 developing countries of the world. System generalized method of moment was employed to examine the nature of relationship between foreign aid and economic growth, and dynamic panel threshold regression is utilized to uncover the mediating role of institutional quality and economic freedom. The result thus obtained reveals that the relationship between foreign aid and economic growth takes inverted U shape indicating the existence of optimal level of aid equal to 9.7% of GNI. The result from dynamic panel threshold regression shows that the effect of aid on economic growth is negative when arithmetic mean of institutional quality index is less than or equal to -0.614 and the overall index of economic freedom is less than or equal to 60.521. Above the indicated thresholds, the effect of aid on economic growth is positive which means institutional quality and economic freedom matters in aid-growth relationship. Drawing on the results obtained, the study suggest that developing countries should not receive huge amount of aid from donors, reform their institutions for the better, and improve economic freedom if they want to reap the benefit of aid.