The Impact of Foreign Aid on Government Expenditure in Ethiopia: An Application of Vector Error Correction Model
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Date
2014-06
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Addis Ababa University
Abstract
Foreign aid represents an important source of finance in most countries in sub-Saharan Africa (SSA), where it increases government’s expenditure, supplements low savings, narrow export earnings and thin tax bases. In this paper, a welfare utility maximization function is used and the necessary diagnostic tests undertaken to determine how government spending respond to aid flows. It employs a co-integrated error correction model to account for potential endogeneity and non-Stationarity problems. The empirical results indicate that the flow of foreign aid does influence government spending patterns. It supports the hypothesis that in Ethiopia, during 1966 – 2013, foreign Aid has a positive effect on total government expenditure.
Foreign aid is fungible in Ethiopia, it flows to unintended purpose. Disaggregating the data into capital and non- development expenditures, like general service expenditure and defense expenditure, the relationship has been examined. Capital expenditure is positively and significantly affected by foreign Aid and also Foreign Aid finances Non- developmental Expenditures. The study also provides evidence that policy change increases total and capital expenditures significantly. Taking into account Foreign aid influences government expenditures positively the government has to design effective strategy that enhances flow of foreign aid to the capital expenditure and protecting from non-developmental sectors.
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Fiscal Policy Analysis, Management