We are measuring relationship between an foreign aid (Official Development Assistance - ODA) and economic growth (GDP growth) to see if ODA has any impact (long run or short run) in a developing country's GDP growth. We also include inflation and government spending in the model.
You can make a cointegration relationship between the variables as long term relationship. and ECM to reflect the short run.
the main problem is in the nature of the variables: they should be integrated of order 1 I(1).
it means non stationary but become stationary with making the first difference.
Capital accumulation is then the key to development. The only way in which savings, domestic and foreign (including aid), can impact on growth in this model is through the accumulation of physical capital, i.e., investment. Assuming the capital-output ratio, v is constant, the change in potential output, is given as
∆Y=1/v (∆K)........................................................................................ (1)
where Y = potential output, K= capital and V= constant capital-output ratio.
According to the model, change in capital stock equals to gross investment. Hence, considering constant rate of capital depreciation (δ) the growth rate of potential output will be:
∆Y/Y= (1/v). (I/Y)—δ.......................................................................... (2)
The model shows that output and capital formation is linearly related. That is, when there is more capital stock (which is financed by saving including one of its foreign component-aid), the higher would be the growth of an economy.
The Harrod-Domar model is used to calculate the amount of finance required
to bridge the gap between the available savings and the required amount that must be channeled to investment to bring about the targeted growth rate.
http://mpra.ub.uni-muenchen.de/33953/1/FOREIGN_AID_AND_ECONOMIC_GROWTH_IN_ETHIOPIA_33953.pdf
You can make a cointegration relationship between the variables as long term relationship. and ECM to reflect the short run.
the main problem is in the nature of the variables: they should be integrated of order 1 I(1).
it means non stationary but become stationary with making the first difference.
When studying the causal relationships betwenn foreign aid and economic growth, you should use the time series econometrics mainly the cointegration approach and the Granger causality tests. In the literature you find many studies dealing with that. You can consult for example Energy Economic or Energy Policy reviews.
Hi Pahlaj,
Most literature in the field uses UVAR techniques, followed by a series of Granger Causality Tests. I refer you to a highly cited paper by Kunst & Marin (1989), which uses these methods and explain the procedure step-by-step.
In addition, attached hereinafter is Granger (1969). Please note that in order to perform causality tests, you need to treat you series for any time/trend related correlations and reject any cointegration relationships in the data. By ignoring these steps, your study may lead to biased results due to spurious regression biases...
p.s.- I'd perform all three causality tests (One way, Feedback, and Instantaneous) since macro-economic series tend to be 'fueled' by a certain process in the short run, but often display a two-way causal relationship in the long run.
One more thing- make sure GDP, and Govt. spending data is seasonally adjusted! International databases (UNTCAD, OECDstatextract, etc.) offer non- adjusted data, so the best thing to do is try and derive data from national census bureaus...
You have to decide based on the reality of your country first and then you will be able to make the correct choices.
For example, how much % of ODA really goes where it is officially supposed to go?
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