Promoting Trade Liberalization: Theoretical Analysis of Foreign Aid as Prize

• DOI: http://doi.org/10.1111/rode.12157
• Date: 01 August 2015
• Author: Malokele Nanivazo,Sajal Lahiri
• Published date: 01 August 2015

Promoting Trade Liberalization: Theoretical

Analysis of Foreign Aid as Prize

Malokele Nanivazo and Sajal Lahiri*

Abstract

We investigate whether foreign aid can be used to induce trade policy reforms. We develop a two-period

political economic model where promise of aid in period 2 depends on chosen tariff in period 1. We con-

sider three scenarios depending on whether the donor is passive/active and whether the two governments

move simultaneously or sequentially. We find a sufficient condition for unconditional aid to increase the

level of optimal tariff, and the possibility of unconditional aid increasing optimal tariff decreases when

the donor is active rather than passive.

1. Introduction

Whether we like it or not, most donors impose conditions on foreign aid (Radelet,

2006). There is a debate on whether conditionality can be effectively implemented.

Many studies have found that for all intents and purposes aid is fungible (Feyzioglu et

al., 1998; Swaroop et al., 2000). Because of this, we consider a disbursement strategy

where conditional aid may be easier to implement. Our approach avoids putting

explicit conditions on aid and allows a recipient government to pursue its own policy

agenda. Within this framework, “good” policies are rewarded ex-post. We focus on a

specific policy in the form of tariff on imports.

We develop a two-period, two-country model of international trade. In period 1,

the recipient country decides on the optimal level of tariff on imports. In the absence

of any terms of trade effect, the optimal tariff is positive because of special interest

politics in the recipient country. In particular, we assume that owners of capital lobby

the government for the imposition of tariff and the recipient government takes such

lobbying into account in its political support function. The donor is assumed to be

altruistic toward the recipient and decides on the level of aid disbursement in period

2, which is negatively related to the level of tariff imposed by the recipient country in

period 1. Within this framework, we consider three scenarios depending on whether

the donor is active or passive, and whether the two governments move simultaneously

or sequentially.

Our model draws on the theoretical framework set in Sayanak and Lahiri (2009)

where aid is granted as a prize for poverty reduction.1Using a single-period model,

Lahiri et al. (2002) investigate how foreign aid and trade policies impact the welfare

of the recipient and the donor when aid and tariff are both endogenously and simulta-

neously determined or when the donor decides on the level of both aid and tariffs. In

another single-period framework, Lahiri and Raimondos-Møller (1997) consider the

* Lahiri, Department of Economics, Mailcode 4515, Southern Illinois University, Carbondale, IL 62901-

4515, USA. Tel: + 1-618-453-9472; Fax: +1-618-453-2717; E-mail: lahiri@siu.edu. Nanivazo: Department of

Economics, University of Kansas, Lawrence, KS 66044, Phone: 682 205 0972; E-mail: nanivazo@ku.edu.

The authors are grateful to an anonymous referee for very helpful comments.

Review of Development Economics, 19(3), 748–757, 2015

DOI:10.1111/rode.12157

© 2015 John Wiley & Sons Ltd