The Impact of Foreign aid on Public Spending in Ethiopia: A Vector Autoregressive Approach

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Foreign aid is an important source of finance to a majority of developing countries since it supports the budgetary process and therefore enhances the development of these countries. In this paper, a welfare utility maximization function is used to determine how government spending and domestic revenue respond to aid flows. It employs a co-integrated vector autoregressive model to account for potential endogeneity and non stationary problems. The empirical evidence supports the hypotheses that in Ethiopia, during 1966-2008, foreign aid has a positive effect on total government expenditure. But disaggregating the data into government development expenditure and recurrent expenditure, total aid has positive effect on recurrent expenditure where as program aid has negative effect on development expenditure. In totality foreign aid is fungible in Ethiopia. Disaggregating the data in to recurrent and development headings also shows aid is more fungible under the recurrent expenditure heading than the development expenditure heading. The study also provides evidence that policy change increases development expenditure, and aid flow reduces domestic resource mobilization. Provided that foreign aid influences government expenditure and its fungibility the government has to design effective economic policy and improve institutional quality.



Autoregressive Approach, Impact