Revisiting the aid-growth nexus in light of the Sachs-Easterly debate

In light of the renewed interest on the aid-growth connection spurred by the recent Sachs-Easterly debates, this note revisits the aid-growth nexus, hypothesizing that aid impacts on growth nonlinearly and that its particular effect conditions on the quality of policies and governance. Using the dynamic panel estimation method, Two-step system generalized method of moments, on more recent data involving an unbalanced panel of 106 countries for the period 1989-2013, we verify some key findings in the aid-growth literature. In particular, aid’s effect on growth is subject to diminishing returns, indicating that there are absorptive capacity constraints that may hinder the effectiveness of aid. However, these absorptive capacity constraints may be relaxed in environments of good governance and policy, enabling aid to have a positive impact on growth.  JEL classification: C14, C23, F35, O11, O19