The Role of Foreign Aid and the Foreign Exchange Constraint in Growth: Some Extensions

An analytical framework that draws both upon the two-gap models and work on non-market clearing short-run constrained equilibria, and its application to long-run growth, is applied to find out when the contribution of foreign resources to growth is maximum. A theoretically consistent treatment of foreign inflows, starting from consumer and firm decisions, shows that foreign inflows need not have a negative coefficient in a behavioural savings function. A model with a saving function, an investment function and an import constraint generates a demand constrained short-run equilibrium in addition to savings and trade and capacity constrained equilibria. Considerations of dynamics and long-run persistence of constraints and equilibria, show foreign inflows make the maximum contribution, when the resource and trade constraints are binding, since rise in output and domestic savings results in the maximum increase in investment. Simulations show such a virtuous growth path was reversed in the sixties and seventies in India. A sudden fall in inflows reduced the slope and intercept of the investment function and the economy shifted to a stagflationary trajectory