Aid allocation, growth and welfare with productive public goods

This paper develops an open-economy intertemporal growth model with endogenous relative prices and an imperfect world capital market. The government provides infrastructure and health services, which are both productive. The model is calibrated for a 'typical' low-income country and used to examine the growth and welfare effects of both permanent and temporary, tied and untied, increases in aid. Simulation results show that aid tied to productive government spending delivers high growth rates and substantial welfare gains, without leading to a sustained real appreciation, only if the efficiency of public expenditure (a proxy for the quality of governance) is sufficiently high. The presence of production externalities has important implications for the path of the real exchange rate. © 2012 John Wiley & Sons, Ltd.