Tied aid, unemployment and welfare

The effect of foreign aid on the welfare levels of both the recipient and the donor country has been a much analysed topic for research in both the theory of international trade and development economics. In the development economics literature, concerns have been raised since the 1960s on the possible adverse effect of foreign aid on domestic savings and growth.1 The trade theory literature in this respect is much older and dates back to the 1920s when Professors Keynes and Ohlin debated on the effect of foreign aid on international terms of trade.2 Ever since, the terms of trade effect has been the cornerstone in the analysis of the welfare effect of foreign aid in the trade theory literature.3 After some early confusion, it is now well established that in a Walrasian stable world economy with two countries, a necessary condition for foreign aid to have perverse effects is that there is some distortion in either of the two countries.4 It is also known that, under normality and substitutability of goods, untied aid cannot be strictly Pareto-improving in a tariff distorted world.