A Survey of the Theoretical Economic Literature on Foreign Aid

This paper surveys the theoretical economic literature on foreign aid -- in
particular, the aid donor–recipient relationship. Economic theory, especially
new institutional economics, can be very helpful in understanding
foreign aid relationships -- especially the incentive problems involved --
and in designing institutions to improve aid effectiveness. In particular, it
helps in understanding the chain of principal–agent relations inherent in
the aid delivery system and the resulting potential for agency problems.
The survey shows that economic theory can improve the design of cooperation
modalities by aligning the incentives of donors and recipients for
poverty reduction, but that, in order to address the problems, policy analysis
must take into account the constraints faced by stakeholders in
the aid relationship. The aid 'contract' should thus seek to improve the
agents' incentives to use aid effectively, given the circumstances of the
developing country