Aid and Two Gap Model

avail and the devil Gap Model promote is a burning discipline these days. The scruple of countries accepting alien tending has intrigued economists and the general human beings for a preferably a time. Television sermons and newspaper articles be possessed of frequently foc utilise on this issue musical composition politicians happen upon to fight this matter divulge in the parliaments. Further much, m both atomic number 18 trying to unravel the enigma of back up and its set up on harvest-home. This paper, in the little word space provided, depart try to establish a congeneric between concern and re knead.It testament do so by first defining help and emergence and accordingly moving on to whatever of the weighty computer simulations which discharge be utilize to understand this link. We bequeath discuss the cardinal- spread determine and then move on to the So belittled and Harrod-Domar mock up, giving experiential examples in distributively con tingency. Finally, we allow examine ii countries and try to inspect the reasons for their different increment aims development the system of logic employ in the discussed stupefys. Aid washstand be delimitate as any voluntary imparting of resources. It can be either public (provided by donor countries or multilateral donor plaque much(prenominal)(prenominal) as the IMF and The World Bank) or common soldier ( give by nongovernmental organizations. . The institution for Economic Corpo balancen and Development defines sanction as any channelize of money or resource that fulfills the following criteria a) The objective of the enchant should be noncommercial. b) It should be prone for the purpose of stinting development. c) The terms of the transfer should be concessional (interest dictate should be less than the prevailing interest measure in the market OR the maturity consummation should be womb-to-tomb than usual). Aid should non be mixed with grant which is a lot used interchangeably with this term.Aid is any transfer that has concessional terms part grant is a make believe of promote that does not require the repayment of the principal. In this paper, we provide often measure countenance in the from of official development tending (ODA) which is a convenient indicator of inter subject field charge flow. On the former(a) hand, we will measure egression by scrutinizing the piece change in primitive home(prenominal) product. nonpargonil of the some widely used framework for analyzing the force- erupts of wait on on result is the two- facing pages model which holds a key position in policy decisions related to contrasted assistance.The two offend model is found on the Harrod Domar equation g = s/v where s is nest egg sum up v is heavy(p) product symmetry Capital production ratio is assumed to be unvaried. The two gap model assumes that a maturation coarse faces either a deliverances gap or a international ex change gap. The bringings gap occurs when a landed estate faces a shortage of nest egg to match Investment in attaining an think crop tramp. In much(prenominal)(prenominal) a case, international borrowing or avail can tack on the savings and help bridge the gap between savings and enthronisation. This allows a rude to achieve the targeted out step-up point. Ft < I S (Savings gap)A contrasted exchange gap takes place when a unpolisheds exports are not enough to finance its imports. In much(prenominal) situations, service is handy as it fills the distant exchange gap and provides countries with adapted exchange to reach the mandatory level of imports. At a prone(p) point in time, exclusively one of the two gaps is binding. Ft < M X (Foreign Exchange gap) Following this further, we fit empirical data into this model. Zambia is a developing orbit that has continuously accepted upkeep since the mid(prenominal) 1960s. In 1992, almost 80% of Zambias coron ation was financed by foreign embolden.Since, Zambia has received back up over such a long period, the two gap model predicted that its per capita GDP would reach $2300 by the turn of the cytosine. On the contrary, its GDP per capita in 2007 re chief(prenominal)ed merely half of what was pass judgment . i. e. $1300. The fig. below summarizes the abridgment of the Zambian parsimoniousness. To examine whether the Zambian case is an censure or does the model of all time fail to predict the reality, we scrutinize on diverse factors which could have out of use(p) the path of explicateth for this surface area. Zambia has been infected by violence and derangement flop from its in dependence, with bloodshed and massacres a common feature.In addition, economic maturement has been hindered by the bang of civil war and influx of refugees from the neighboring countries. Corruption is some other fuss that has stalled growth which can be readn from the fact that Zambia is ranked ci on the corruption perception index. Very recently, Sweden and Netherlands stopped wait on to Zambia delinquent to rampant corruption allegations. All these worrys add to the in encumbranceiveness of service on the growth of Zambian delivery which can explain why the two-gap model failed to presage the ineptness of back up.The perfume of sanction on growth can in any case be explained using two fundamental but important models, that is to say Harrod Domar model and the Solow model. Although the upshot of aid on growth is a third-dimensional and colonial process we only take into account the effect of aid on variables defined in these two models. The main concenter of our discussion will be the saving rate which sets out to be the most imperative variable in both these models. We start through the basic Harrod Domar model. Capital output ratio, outstanding childbed ratio and labor output ratio are assumed to be ceaseless.Some of the important dealings are as follows S=s. Y (2) (3) (1) g= (s/v)-(? ) S=I Where Y is income S is natural saving I is Investment ? is dispraise of jacket crown harmonize to this model, growth can be step-upd by change magnitude s, decreasing v or decreasing ?. We shall mainly guidance on the carnal knowledge of aid on growth through the savings rate channel. Countries ask for aid mainly collect to its perceived honorable effect on the savings rate. As sh let, saving adequates investment in the Harrod-Domar model, subsequently an join on in savings will moment in an ontogenesis in investment.This gain is supposed to boost the growth rate of the telephone receiver area. Michael P. Shields offer an interesting explanation of the singing of foreign aid on growth in his paper foreign aid and domestic savings the crowding out effect. If foreign aid is expected to enlarge savings, then equation (3) becomes g=(s+fa)/v -? Where fa is foreign aid as a proportion of income (4) (s+fa) represents the gist funds available for support investment. accord to this equation, an increase in foreign aid is supposed to increase the summate saving funds and hence investment by an equal occur.This suggests that an each additional dollar of foreign aid should result in a one dollar increase in investment in the economy of the recipient country. Reality however is not that perfect and it is as well as bounteous for anyone to assume such a one-to-one increase in investment from aid. Famous economist Edward Griffin offers a criticism of such draw close. According to him foreign aid should be taken so as to supplement income rather than having a direct conflict on savings. In such a case, an increase in income by the amount of foreign aid fa would increase consumption by (1-s). a, thus increasing the investment by s. fa. In such a case, domestic savings can be crowded out by foreign aid by the give notice amount (1-s)fa which equals (s-1)fa. Markedly, foreign aid can crowd out private savi ngs and investment, resulting in a decrease in growth as suggested by the Harrod Domar model. The main obstacle in the way of growth in the Harrod-Domar model is the phenomenon of aid filtering out into increased consumption (1-s). fa. Aid has to be spent on investment or has to increase the saving rate (both eventually come out to be the equal) for a country to grow.To see a practical example of this, we consider Pakistan, which is a country for the most part dependent on foreign aid. During the period 1952-2002, the total amount of aid given to Pakistan equaled 63703 million US dollars. Ghulam Mohey-ud-din examines in his paper bear upon of foreign aid on economic development in Pakistan, the reasons for aid not resulting in the required growth for Pakistan. He states three main reasons for the failure of aid to account for growth. First of all, a staggering 58% of this total aid (approx. 6945 million US dollars) was bind to development of volumed projects spell only 13% (a pprox 8281 million US dollars) accounted for non-food and BOP aid. such(prenominal) a large portion of aid (58%) going towards consumption eer meant that the effect on savings was going to be very minute. Thus, financial aid tended to crowd out saving and investment. Secondly, composition the nominal aid bit by bit increased, in reality, aid as a percentage of gross national income fell from approximately 7. 6% in 1960 to nearly 3% in 2002. This meant that aid was not catching up to the required increase in the GNI of Pakistan.Thirdly, along with the increase in aid came the burden of burgeoning foreign debt. This required huge amounts of debt servicing which reduced Pakistans current account. As antecedently explained, aid was already not resulting in much growth due to it crowding out savings and investment. An additional burden of debt servicing did the establishment no better. Accordingly, its GDP growth rate was subject to constant fluctuations and Pakistan could never at tain sustainable growth. The growth rate reached a broadside of 10. 22% in 1953 but since then, the average growth has gone cut back with the exception of one or two years.In 2002, the GDP growth rate stood at 4. 73%. Aid during a whole half of a century could not result in sustained economic growth. some other approach that looks at the impact of foreign aid on growth is the want trap. Many poor developing countries face an inability to grow at reasonable rates due to getting stuck in a meagerness trap, which can be defined as a self-reinforcing implement which causes meagreness to persist. We use the Solow model to analyze how aid can be used to pull countries out of this poverty trap and onto the path of self-sufficing economic growth.We assume the basic assumptions of Solow model to be true. Thus, we assume constant returns to photographic plate production function and diminishing returns to bang-up. The final and important simile of the Solow model is ? k=s. y-(n+? ). k (5) k is capital per worker n is race growth Philipp Harms and Matthiaz Lutz depart from this conventional Solow model by assuming that hatful have to satisfy their basic consumption needs for which savings are zero until per capita income does not exceed a certain level. The limited Solow plot is shown belowTwo unbendable states are shown in the above figure. k* is an mobile energise state speckle k** is a stable crocked state. If the countrys initial capital per worker is below the equivocal steady state k*, then the country is stuck in a potentially dangerous poverty trap. Low income levels result in low saving which leads to lower investment in capital stock. Increasing derogation ? of capital will further lower the capital per worker k and result in even lower income. This vicious cycle of poverty and miss of growth will keep re-enforcing each other unless the country is given a push start.This push can be in the determine of aid, which may impact the savings rate s as discussed in the extended Harrod Domar model. Furthermore, aid in the form of foreign capital influx can also increase capital per worker, consequently pushing the country out the poverty trap. Now we come to the compendium of growth patterns in two Arab countries namely Egypt and paradise. We will explore the amounts and type of aid given to these countries and then investigate their underlying effects on various growth variables based on the Solow and Harrod Domar models discussed earlier in the paper.With this in mind, we turn to the empirical evidences which show that 1. ODA/GNI ratio for nirvana has increased during the period 2000-2005, while that of Egypt has lessen during the same period. 2. ODA/Capita for Palestine has increased to $500 during the period 2000-2005, while ODA/Capita for Egypt has come down to $15 in 2003 from $179 in 1979. 3. In Egypt, 13% of the total aid was tied whereas in Palestine 8% was tied. 4. good aid provided to Egypt was 44% while t hat of Palestine was 16% of total aid during the period 2000-2004. 5.In Egypt, education was given the highest priority among the aid allocated to the kind sector. date in Palestine, Education was the second lowest recipient of aid allocated to the social sector. 6. In Palestine, growth rate of real GDP from 2003-2005 was 35. 50%, while the percentage change in real GDP for Egypt was 127. 46 for the same period. ODA/GNI ratio signifies the dependency of the recipient country on the donor for foreign aid. A large increase in the ODA/GNI ratio of Palestine meant that it was beseeming more and more dependent on foreign aid for support, while the turnaround was true for Egypt.Consequently, Palestinian institutions kept worn downening and were not given the inducement to develop due to their heavy reliance on outer help. On the other hand, Egypts lower dependency on foreign aid meant that it was getting increased opportunities to develop its institutions and stand up on its own fe et. As the ODA/capita of Palestine increased to alarming heights, it signaled the reliance of Palestine on foreign donations. This could have created a moral hazard problem for the rulers of Palestine who knew that growth would result in drawing back of aid.In such a scenario, the incentive to grow could have actually vanished. Conditional or tied aid has great disadvantages because the recipient government cannot spend the aid on their desired projects. Moreover, tied aid has to be spent on particularized and predetermines projects. As discussed earlier in the paper, if foreign aid is deviate to such consumption, it has the tendency to crowd out investment and savings. Although Egypt had a greater overlap of tied aid than Palestine, however the small size and weak economy of Palestine meant that even 8% of tied aid had a profound effect on its growth.Egypt was provided more technical aid than Palestine. practiced aid in turns translates into high Theta in the extended Solow m odel. An important relation of this model is ?ke= s. ye-(n+? +theta) k Therefore higher(prenominal) technical aid for Egypt resulted in higher legal capital per labor and in turn higher growth than Palestine. The allocation of higher portion of aid to education by Egypt as compared to Palestine means that Egypt is contributing more to its human capital. This will in turn again stimulate theta in the extended Solow model, resulting in increase growth rate of Egypt.In the light of above discussion, it can be express that the effect of aid on growth does not only depend on variables explained in the models above. Many other factors play a brisk role in this link as well. As seen in the case of Zambia, the macroeconomic and political stability are pre-requisites which feed into this complex relation as well. The aid distribution plan should be effective and emancipate of corruption of all sorts for it to have an impact on growth. A major chunk of aid should be distributed towards t he saving and investment channel.While our analysis has attempt to determine a link between aid and development, it ease carries some shortcomings. The assumptions used in the models such as a indomitable capital output ratio are too stringent and do not carry much weight in the reality. Some variables such as savings rate s and productivity theta are set(p) exogenously, while the macro/microeconomic conditions determining these variables could also affect the impact of aid on growth. Nonetheless, the analysis provides useful insight into the complex relation of aid and growth.Economicgrowth,Capitalaccumulation,Macroeconomics,Grossdomesticproduct,Investment,Economicdevelopment,Stockandflow,EconomicsAid and the Two Gap Model Aid is a burning issue these days. The question of countries accepting foreign aid has intrigued economists and the general public for a quite a while. Television discussions and newspaper articles have frequently cogitate on this issue while politicians try to fight this matter out in the parliaments. Furthermore, many are trying to unravel the enigma of aid and its effects on growth. This paper, in the little word space provided, will try to establish a relation between aid and growth.It will do so by first defining aid and growth and then moving on to some of the important models which can be used to understand this link. We will discuss the two-gap model and then move on to the Solow and Harrod-Domar model, giving empirical examples in each case. Finally, we will analyze two countries and try to inspect the reasons for their different growth rates using the logic used in the discussed models. Aid can be defined as any voluntary transfer of resources. It can be either public (provided by donor countries or multilateral donor organization such as the IMF and The World Bank) or private (given by NGOs. . The Organization for Economic Corporation and Development defines aid as any transfer of money or resource that fulfills the followin g criteria a) The objective of the transfer should be noncommercial. b) It should be given for the purpose of economic development. c) The terms of the transfer should be concessional (interest rate should be less than the prevailing interest rate in the market OR the maturity period should be longer than usual). Aid should not be mixed with grant which is often used interchangeably with this term.Aid is any transfer that has concessional terms while grant is a form of aid that does not require the repayment of the principal. In this paper, we will often measure aid in the from of official development assistance (ODA) which is a convenient indicator of international aid flow. On the other hand, we will measure growth by scrutinizing the percentage change in GDP. One of the most widely used framework for analyzing the effects of aid on growth is the two-gap model which holds a key position in policy decisions related to foreign assistance.The two gap model is based on the Harrod Doma r equation g = s/v where s is savings rate v is capital output ratio Capital output ratio is assumed to be constant. The two gap model assumes that a developing country faces either a savings gap or a foreign exchange gap. The savings gap occurs when a country faces a shortage of savings to match Investment in attaining an intended growth rate. In such a case, foreign borrowing or aid can supplement the savings and help bridge the gap between savings and investment. This allows a country to achieve the targeted growth rate. Ft < I S (Savings gap)A foreign exchange gap takes place when a countrys exports are not enough to finance its imports. In such situations, aid is handy as it fills the foreign exchange gap and provides countries with sufficient exchange to reach the required level of imports. At a given point in time, only one of the two gaps is binding. Ft < M X (Foreign Exchange gap) Following this further, we fit empirical data into this model. Zambia is a developing co untry that has continuously received aid since the mid 1960s. In 1992, almost 80% of Zambias investment was financed by foreign aid.Since, Zambia has received aid over such a long period, the two gap model predicted that its per capita GDP would reach $2300 by the turn of the century. On the contrary, its GDP per capita in 2007 remained merely half of what was expected . i. e. $1300. The fig. below summarizes the analysis of the Zambian economy. To examine whether the Zambian case is an exception or does the model always fail to predict the reality, we scrutinize on various factors which could have blocked the path of growth for this country. Zambia has been infected by violence and instability right from its independence, with bloodshed and massacres a common feature.In addition, economic growth has been hindered by the outbreak of civil war and influx of refugees from the neighboring countries. Corruption is another problem that has stalled growth which can be seen from the fact t hat Zambia is ranked 101 on the corruption perception index. Very recently, Sweden and Netherlands stopped aid to Zambia due to rampant corruption allegations. All these problems add to the ineffectiveness of aid on the growth of Zambian economy which can explain why the two-gap model failed to forecast the ineptness of aid.The effect of aid on growth can also be explained using two basic but important models, namely Harrod Domar model and the Solow model. Although the upshot of aid on growth is a multidimensional and complex process we only take into account the effect of aid on variables defined in these two models. The main focus of our discussion will be the saving rate which comes out to be the most imperative variable in both these models. We start through the basic Harrod Domar model. Capital output ratio, capital labor ratio and labor output ratio are assumed to be constant.Some of the important relations are as follows S=s. Y (2) (3) (1) g= (s/v)-(? ) S=I Where Y is income S is total saving I is Investment ? is depreciation of capital According to this model, growth can be increased by increasing s, decreasing v or decreasing ?. We shall mainly focus on the relation of aid on growth through the savings rate channel. Countries ask for aid mainly due to its perceived beneficial effect on the savings rate. As shown, saving equals investment in the Harrod-Domar model, subsequently an increase in savings will result in an increase in investment.This increase is supposed to boost the growth rate of the recipient country. Michael P. Shields offer an interesting explanation of the relation of foreign aid on growth in his paper foreign aid and domestic savings the crowding out effect. If foreign aid is expected to increase savings, then equation (3) becomes g=(s+fa)/v -? Where fa is foreign aid as a proportion of income (4) (s+fa) represents the total funds available for backing investment. According to this equation, an increase in foreign aid is supposed to increase the total saving funds and hence investment by an equal amount.This suggests that an each additional dollar of foreign aid should result in a one dollar increase in investment in the economy of the recipient country. Reality however is not that perfect and it is too generous for anyone to assume such a one-to-one increase in investment from aid. Famous economist Edward Griffin offers a criticism of such approach. According to him foreign aid should be taken so as to supplement income rather than having a direct impact on savings. In such a case, an increase in income by the amount of foreign aid fa would increase consumption by (1-s). a, thus increasing the investment by s. fa. In such a case, domestic savings can be crowded out by foreign aid by the net amount (1-s)fa which equals (s-1)fa. Markedly, foreign aid can crowd out private savings and investment, resulting in a decrease in growth as suggested by the Harrod Domar model. The main obstacle in the way of growth in th e Harrod-Domar model is the phenomenon of aid filtering out into increased consumption (1-s). fa. Aid has to be spent on investment or has to increase the saving rate (both eventually come out to be the same) for a country to grow.To see a practical example of this, we consider Pakistan, which is a country largely dependent on foreign aid. During the period 1952-2002, the total amount of aid given to Pakistan equaled 63703 million US dollars. Ghulam Mohey-ud-din examines in his paper Impact of foreign aid on economic development in Pakistan, the reasons for aid not resulting in the required growth for Pakistan. He states three main reasons for the failure of aid to account for growth. First of all, a staggering 58% of this total aid (approx. 6945 million US dollars) was tied to development of large projects while only 13% (approx 8281 million US dollars) accounted for non-food and BOP aid. Such a large portion of aid (58%) going towards consumption invariably meant that the effect o n savings was going to be very minute. Thus, financial aid tended to crowd out saving and investment. Secondly, while the nominal aid gradually increased, in reality, aid as a percentage of gross national income fell from approximately 7. 6% in 1960 to nearly 3% in 2002. This meant that aid was not catching up to the required increase in the GNI of Pakistan.Thirdly, along with the increase in aid came the burden of burgeoning foreign debt. This required huge amounts of debt servicing which reduced Pakistans current account. As previously explained, aid was already not resulting in much growth due to it crowding out savings and investment. An additional burden of debt servicing did the government no better. Accordingly, its GDP growth rate was subject to constant fluctuations and Pakistan could never attain sustainable growth. The growth rate reached a peak of 10. 22% in 1953 but since then, the average growth has gone down with the exception of one or two years.In 2002, the GDP grow th rate stood at 4. 73%. Aid during a whole half of a century could not result in sustained economic growth. Another approach that looks at the impact of foreign aid on growth is the poverty trap. Many poor developing countries face an inability to grow at reasonable rates due to getting stuck in a poverty trap, which can be defined as a self-reinforcing mechanism which causes poverty to persist. We use the Solow model to analyze how aid can be used to pull countries out of this poverty trap and onto the path of self-sustaining economic growth.We assume the basic assumptions of Solow model to be true. Thus, we assume constant returns to scale production function and diminishing returns to capital. The final and important relation of the Solow model is ? k=s. y-(n+? ). k (5) k is capital per worker n is population growth Philipp Harms and Matthiaz Lutz depart from this conventional Solow model by assuming that people have to satisfy their basic consumption needs for which savings are zero until per capita income does not exceed a certain level. The modified Solow diagram is shown belowTwo steady states are shown in the above figure. k* is an unstable steady state while k** is a stable steady state. If the countrys initial capital per worker is below the unstable steady state k*, then the country is stuck in a potentially dangerous poverty trap. Low income levels result in low saving which leads to lower investment in capital stock. Increasing depreciation ? of capital will further lower the capital per worker k and result in even lower income. This vicious cycle of poverty and lack of growth will keep re-enforcing each other unless the country is given a push start.This push can be in the form of aid, which may impact the savings rate s as discussed in the extended Harrod Domar model. Furthermore, aid in the form of foreign capital inflow can also increase capital per worker, consequently pushing the country out the poverty trap. Now we come to the analysis of growth patterns in two Arab countries namely Egypt and Palestine. We will explore the amounts and type of aid given to these countries and then investigate their underlying effects on various growth variables based on the Solow and Harrod Domar models discussed earlier in the paper.With this in mind, we turn to the empirical evidences which show that 1. ODA/GNI ratio for Palestine has increased during the period 2000-2005, while that of Egypt has decreased during the same period. 2. ODA/Capita for Palestine has increased to $500 during the period 2000-2005, while ODA/Capita for Egypt has come down to $15 in 2003 from $179 in 1979. 3. In Egypt, 13% of the total aid was tied whereas in Palestine 8% was tied. 4. Technical aid provided to Egypt was 44% while that of Palestine was 16% of total aid during the period 2000-2004. 5.In Egypt, education was given the highest priority among the aid allocated to the social sector. While in Palestine, Education was the second lowest recipient of aid allocated to the social sector. 6. In Palestine, growth rate of real GDP from 2003-2005 was 35. 50%, while the percentage change in real GDP for Egypt was 127. 46 for the same period. ODA/GNI ratio signifies the dependency of the recipient country on the donor for foreign aid. A large increase in the ODA/GNI ratio of Palestine meant that it was becoming more and more dependent on foreign aid for support, while the opposite was true for Egypt.Consequently, Palestinian institutions kept weakening and were not given the incentive to develop due to their heavy reliance on outward help. On the other hand, Egypts lower dependency on foreign aid meant that it was getting increased opportunities to develop its institutions and stand up on its own feet. As the ODA/capita of Palestine increased to alarming heights, it signaled the reliance of Palestine on foreign donations. This could have created a moral hazard problem for the rulers of Palestine who knew that growth would result in draw ing back of aid.In such a scenario, the incentive to grow could have actually vanished. Conditional or tied aid has great disadvantages because the recipient government cannot spend the aid on their desired projects. Moreover, tied aid has to be spent on specific and predetermines projects. As discussed earlier in the paper, if foreign aid is diverted to such consumption, it has the tendency to crowd out investment and savings. Although Egypt had a greater share of tied aid than Palestine, however the small size and weak economy of Palestine meant that even 8% of tied aid had a profound effect on its growth.Egypt was provided more technical aid than Palestine. Technical aid in turns translates into higher Theta in the extended Solow model. An important relation of this model is ?ke= s. ye-(n+? +theta) k Therefore higher technical aid for Egypt resulted in higher effective capital per labor and in turn higher growth than Palestine. The allocation of higher portion of aid to education by Egypt as compared to Palestine means that Egypt is contributing more to its human capital. This will in turn again stimulate theta in the extended Solow model, resulting in increase growth rate of Egypt.In the light of above discussion, it can be said that the effect of aid on growth does not only depend on variables explained in the models above. Many other factors play a vital role in this link as well. As seen in the case of Zambia, the macroeconomic and political stability are pre-requisites which feed into this complex relation as well. The aid distribution plan should be effective and free of corruption of all sorts for it to have an impact on growth. A major chunk of aid should be distributed towards the saving and investment channel.While our analysis has tried to determine a link between aid and development, it still carries some shortcomings. The assumptions used in the models such as a fixed capital output ratio are too stringent and do not carry much weight in the re ality. Some variables such as savings rate s and productivity theta are determined exogenously, while the macro/microeconomic conditions determining these variables could also affect the impact of aid on growth. Nonetheless, the analysis provides useful insight into the complex relation of aid and growth.