Problem: Foreign Aid and Economic Development. In The aid of Poverty, economist Jeff Sachs recommends a large expansion in foreign aid from the developed countries to the developing world. This question asks you to study the impact of foreign aid within the (somewhat narrow) confines of the Solow growth model.
Suppose the gift of foreign aid comes in the form of income. Assume the developing country starts with a per capita income of $300, and the foreign aid amounts to $300 per person — provided as a one-time gift. Assume that the developing country treats this foreign aid Just like it treats other income, saving and investing the fraction s‾ and consuming the fraction 1 - s‾ To keep things simple, assume s‾ = .10.
(1) What happens to income and consumption immediately when the foreign aid is received?
(2) Use a Solow diagram to show how the economy evolves over time in response to this one-time gift of foreign aid. Hint: You do not need to show the imme-diate impact that you described in part (1).
(3) What happens to income and consumption in the long run?
(4) Qualitatively, how would your answer change if the foreign aid were given in the form of capital — electric power plants, plows, trucks, and so on —instead of as income?
(5) Discuss briefly the ways in which foreign aid is and is not useful according to a Solow framework.
(6) Discuss briefly what is missing in this framework and suggest how this might affect your view of foreign aid.