Tied Versus Untied Foreign Aid: Consequences for a Growing Economy

This paper contrasts the effects of tied and untied foreign aid programs on the welfare and macroeconomic performance of a small open economy. We show that the acceptance of tied aid inevitably obligates the recipient economy to undertake certain internal structural adjustments, and the flexibility it possesses to undertake these adjustments eventually determines the effectiveness of the aid program. The economic consequences of tied and untied aid programs, their relative merits from a welfare standpoint, and the transitional dynamics depend crucially upon several characteristics of the recipient economy that summarize this flexibility. These include: (i) the costs of installing public capital relative to private capital (intertemporal adjustment costs), (ii) the substitutability between factors of production (intratemporal adjustment costs), (iii) the flexibility of labor supply (work effort), (iv) the recipient's degree of access to the world financial markets (capital market imperfections), and (v) the recipient's opportunities for co-financing infrastructure projects by domestic resources