Aid Effectiveness and Limited Enforceable Conditionality

This paper analyzes optimal foreign aid policy in a neoclassical growth framework with a conflict of interest between the donor and the recipient government. Aid condition-ality is modeled as a limited enforceable dynamic contract. We define the contract to be self-enforcing if, at any point in time, the conditions imposed on aid funds are supportable by the threat of a permanent aid cutoff from then onward. Quantitative results show that optimal self-enforcing conditional aid strongly stimulates the devel-oping economy and substantially increases welfare. However, aid effectiveness comes at a high cost: to ensure enforceability, less benevolent political regimes receive per-manently larger aid funds in return for a less intense conditionality. JEL: E13, F35, O11, O19. ∗I am especially grateful to Harald Uhlig for many suggestions and comments. Moreover, I am indebted Michael Burda for very helpful discussions. I thank Christian Stoltenberg, Ralf Brüggemann, Carsten Trenkler, Mirko Wiederholt and seminar participants at Humboldt-University Berlin, Univer