Sustainability of Capital, Investment Costs and Foreign Aid

This paper explores the relationship between foreign aid and public investment in the context of intertemporal growth. The static models in the existing development literature have predominantly neglected the intertemporal behavior of savings and investment in response to aid flows, and their consequent impact on growth and transitional dynamics. On the other hand, the macroeconomics literature has generally neglected the issue of external financing of public investment from official sources such as foreign aid and capital transfers. Moreover, an over-riding assumption in both strands of literature is that of a Cobb-Douglas production function that has the characteristic that the intratemporal elasticity of substitution between inputs is unity. Recent empirical evidence, however, points toward the CES production function as a better approximation for production structures in growing economies. This paper examines the dynamic consequences of financing public investment by foreign aid or capital transfers in an intertemporal optimizing growth framework by employing a CES production structure. We conduct a numerical analysis of the transitional dynamics of such an economy and characterize the trade-off between the degree of substitutability between public and private capital, cost of investment, and intertemporal welfare in response to both tied and untied ai