FOREIGN-AID AND PUBLIC-GOODS

Most less-developed countries (LDCs) use foreign economic aid to finance public consumption goads, or public intermediate inputs. This paper constructs a two-country general equilibrium trade model, where an income transfer that takes place between the two countries is used by the recipient to finance a public consumption good. Within this framework, the paper identifies the conditions under which the income transfer improves or deteriorates the donor country's terms of trade, and shows that the transfer can be welfare enriching for the donor, and welfare immiserizing for the recipient country. The paper also demonstrates that the transfer can raise (reduce) world welfare, in which case a welfare increase (decrease) in both the donor and the recipient country is possible.