Unraveling the Impact of Foreign Aid on Economic Dynamics: Evidence from Palestine

Abstract

This study delves into the complex dynamics of foreign aid in Palestine, seeking to unravel its impact on key macroeconomic variables. Drawing upon theoretical literature that presents divergent views on the effects of aid, ranging from positive to negative outcomes, our analysis focuses on two primary aspects: the influence of aid on domestic savings and its implications for economic growth. Additionally, we explore whether the phenomenon of Dutch disease, characterized by adverse effects on domestic industries due to foreign aid inflows, is evident in the Palestinian context. To investigate these relationships, we employ two distinct modeling approaches. First, we utilize a single-equation model to assess the direct impact of aid on economic growth, employing ordinary least squares (OLS) regression techniques. Subsequently, we adopt a two-equation simultaneous equations model to examine the joint effects of aid on both domestic savings and economic growth, employing the two-stage least squares (2SLS) technique to address potential endogeneity concerns. Our empirical findings reveal several noteworthy insights. Firstly, we observe that foreign aid tends to crowd out domestic savings, indicating a substitution effect whereby external inflows replace rather than supplement domestic sources of capital accumulation. Furthermore, our analysis indicates a negative impact of aid on economic growth, suggesting that the presence of aid may impede overall economic performance in Palestine. Importantly, our results also provide evidence of the Dutch disease phenomenon, wherein the influx of aid disrupts the balance of the domestic economy and hampers the growth of indigenous industries. In light of these findings, we offer several policy recommendations aimed at mitigating the adverse effects of foreign aid while maximizing its developmental impact. These include measures to bolster domestic savings, such as incentivizing savings behavior and fostering a conducive environment for investment. Additionally, we advocate for a strategic allocation of aid towards productive sectors and infrastructure projects that stimulate long-term economic growth. Furthermore, enhancing the policy environment to attract foreign direct investment (FDI) and promote private sector development emerges as a critical priority. By shedding light on the nuanced relationship between foreign aid, domestic savings, and economic growth in Palestine, this study provides valuable insights for policymakers, development practitioners, and stakeholders seeking to navigate the complexities of aid effectiveness and promote sustainable development in the region.