Moral Hazard and the Composition of Transfers: Theory with an Application to Foreign Aid

Amegashie, J. Atsu and Ouattara, Bazoumanna and Strobl, Eric (2007): Moral Hazard and the Composition of Transfers: Theory with an Application to Foreign Aid.

Abstract

The paper presents a theoretical and empirical analysis of a donor’s choice of the composition of unrestricted and in-kind/restricted transfers to a recipient and how this composition is adjusted in response to changes in the moral hazard behavior of the recipient. In-kind or restricted transfers may be used, among others, to control a recipient’s moral hazard behavior but may be associated with deadweight losses. Within the context of foreign aid, we use a canonical political agency model to construct a simple signaling game between a possibly corrupt politician in a recipient country and a donor to illustrate the donor’s optimal choice of tied (restricted) and untied foreign aid. We clarify the condition under which a reduction in the recipient’s moral hazard behavior (i.e., improvement in the level of governance) leads to a fall in the proportion of tied aid. We test the predictions of our theoretical analysis using data on the composition of foreign aid by multilateral and bilateral donors.

• Item Type: MPRA Paper
• Language: English
• Keywords: tied foreign aid; governance; moral hazard; political agency; restricted transfer
• Subjects: F - International Economics > F3 - International Finance > F35 - Foreign Aid; D - Microeconomics > D7 - Analysis of Collective Decision-Making > D73 - Bureaucracy ; Administrative Processes in Public Organizations ; Corruption; I - Health, Education, and Welfare > I3 - Welfare, Well-Being, and Poverty > I38 - Government Policy ; Provision and Effects of Welfare Programs

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