Should foreign aid finance private or public investment?

Recently there has been discussion in bilateral and multilateral aid agencies on whether foreign development assistance should be directed to private instead of public sector investment projects in order to promote welfare in the recipient countries and to accelerate their move towards self-reliance. It has been argued that public sector projects are less productive than private ones and that to raise the standards of living in the country, aid should be given to finance private sector activities. Using a two-country overlapping generations framework, the paper shows that categorical recommendations to give aid to finance only private investment or only public investment are likely to be misguided. The appropriate allocation of aid varies from country to country depending on the structure of the economy, in particular on the initial stock of private and public capital and on how investment projects affect the productivity of private capital and labor. Thus, depending on the circumstances, aid to finance either private or public investment may enrich the recipient country. Specifically, the paper shows that aid to finance public investment benefits the recipient country if its initial stock of public infrastructure capital is small and aid is given to social infrastructure projects like education and health care that raise the productivity of labor. (Author abstract)