Political Economy of Conditional Aid in a Federal Economy

Abstract

This paper employs a political economy approach to model the joint determination of national and subnational sectoral protection in an open federal economy. Political interactions between special interest groups and policymakers as well as economic interrelationships between federal and state government policies are analyzed. The model is applied to study the effects of conditional financial assistance on policy-making in the aid-receiving federal economy. We find that policy-based financial assistance to the federal government tends to reduce the extent of distortions resulting from the federal government policy. However, if federal and state government policies are strategic substitutes, state government induced policy distortions would increase, thereby detracting from the effectiveness of conditionality in reducing overall policy distortions in the recipient economy.