Encouraging Trade Liberalization : Theoretical and Empirical Analysis of Foreign Aid as Prize

We examine how foreign aid can be used to induce a recipient country to engage in trade-policy reforms. First, we develop a two-country and two-period theoretical model where the donor's promise of aid in period 2 depends on the recipient's chosen tariff in period 1. Without aid, optimal tariff is positive because of the presence of lobbying in the recipient country. We consider three variants of the model depending on whether the donor government is passive or active, and, when the donor government is active, whether the two governments move simultaneously or sequentially. When the donor government is active, it optimally chooses the degree of ex-post conditionality on aid. We find, inter alia, that if a passive donor government increases the level of ex-post unconditional aid, or decrease the degree of ex-post conditionality, optimal tariff goes up. Using a panel data, we then examine if there is any evidence for the ex-post conditionality of aid, and how this conditionality has affected the effectiveness of aid. We find some positive evidence on both counts