What is the foreign aid formula for sustainable growth and what's in it for the donor?

This paper develops a two country dynamic general equilibrium model of foreign aid by focusing on the optimal determination of  aid composition by the donor. We introduce donor country's purely utilitarian perspective into the strategic interaction between the donor and the recipient country. In addition to aid transfers, donor and recipient countries are linked through trade and foreign direct investment.  This setup allows us to endogenize aid-tying process by incorporating it into the donor's optimization problem. We analyze how different components of foreign aid, such as education, investment, commodity and general budget support are optimally supplied in determining growth outcomes in both countries. This article describes the interaction between the donor and the recipient governments as a simple repeated stage game, where the donor acts similar to a Stackelberg leader in choosing the optimal policy response given the recipients strategy space. Specifically, the donor government determines the amount and the composition of aid optimally by taking the decisions of the recipient government as well as domestic households and firms as given. The recipient government runs the domestic fiscal policy and decides on how much to invest in infrastructure. We show there are unambiguous indirect benefits of education aid for the recipient and the donor country. By increasing returns to foreign direct investment and the demand for donor exports, aid leads to a higher growth and welfare for the donor country. On the other hand, the positive growth effect from increased aid is not necessarily sustained for the recipient economy. Its growth rate might return to its structurally determined level despite further increases in aid flows.