How is Foreign Aid Spent? Evidence from a Natural Experiment by Eric Werker, Faisal Z. Ahmed, and Charles Cohen :: NEUDC 2007 Papers :: Northeast Universities Development Consortium Conference :: Center for International Development at Harvard University

We use yearly variations in the price of oil to construct a new instrument to test the impact of an important but often-overlooked foreign aid channel: money given by wealthy OPEC nations to their poorer Muslim allies. The instrument identifies plausibly exogenous variation in foreign aid. We investigate how aid is spent by tracking its short-run effect on aggregate demand, prices, the national accounts, savings, and the balance of payments. We find that much aid is consumed, primarily in the form of higher imports of non-capital goods. Some aid is invested and aid has a positive, though statistically imprecise, effect on growth. Aid has no effect on the financial account, but leads to a negative entry on errors and omissions, suggesting unaccounted capital flight. ∗ Eric Werker, Harvard Business School, Boston MA, 02163, [email protected]; Faisal Ahmed, University of Chicago, [email protected]; Charles Cohen, Sankaty Advisors, [email protected]. We would like to thank Alberto Alesina, Laura Alfaro, Andreea Balan, Abhijit Banerjee, Francesco Caselli, Edward Glaeser , Michael Kremer, and participants at the Harvard Development Workshop for valuable comments and suggestions on earlier drafts.