Is there a convincing instrumental variable to identify the causal effects of aid and growth? In his new paper, Sebastian Galiani and his coauthors exploit an instrumental variable based on the fact that since 1987, eligibility for aid from the International Development Association (IDA) has been based partly on whether or not a country is below a certain threshold of per capita income.
The paper finds evidence that other donors tend to reinforce rather than compensate for reductions in IDA aid following threshold crossings. Overall, aid as a share of gross national income (GNI) drops about 59 percent on average after countries cross the threshold. By focusing on the 35 countries that have crossed the income threshold from below between 1987 and 2010, they find a positive, statistically significant, and economically sizable effect of aid on growth. They find that a one percentage point increase in the aid to GNI ratio from the sample mean raises annual real per capita growth in gross domestic product by approximately 0.35 percentage points. The analysis shows that the main channel through which aid promotes growth is by increasing physical investment.