Aid and the Two Gap Model

Aid and the Two Gap Model

Aid is a burning issue these days. How does aid effect economic growth? Why developing countries accept aid? What motives drive developed countries to give aid? Television discussions, Newspaper articles all are trying to answer these questions and unravel the enigma of aid and its effects on growth. To understand and answer these questions, first of all, we need to define aid.

Aid can be defined as the voluntary transfer of resource. Aid and grant are two terms that are often used interchangeably but they are different. Aid is any transfer that has concessional terms and grant is a form of aid that does not require the repayment of the principal. Moreover, Aid is either public (provided by donor countries or multilateral donor organization such as the IMF and The World Bank) or private (given by NGO’s.). The Organization for Economic Corporation and Development defines aid as any transfer of money or resource that fulfills the following criteria:

a) The objective of the transfer should be noncommercial.

b) It should be given for the purpose of economic development.

c) The terms of the transfer should be concessional (interest rate should be less than the prevailing interest rate in the market OR the maturity period should be longer than usual).

Military assistance is not considered aid under this OECD definition as it is not for development purposes. Now as we have defined aid let’s take a look how aid effects economic growth. To analyze the affects of aid on growth, the most widely used framework is the two gap model and despite of the criticism on the model, it still holds a key in the policy decisions related to aid. The two gap model is based on the harrod domar equation g = s/k and makes the same assumption of fixed capital output ratio.

The two gap model assumes that a developing country face