ABSTRACT
When public consumption is utility enhancing, changes in its level directly alters the marginal utility of private consumption. A significant fraction of foreign aid finances public consumption in aid-recipient countries. In this paper, we embed these two features into a simple general equilibrium model (where a fraction of aid finances productive public investment) to study the impact of aid on aggregate demand. We demonstrate that when public and private consumption are Edgeworth substitutes, an increase in aid-financed public consumption diminishes the positive effect of aid on output generated by public investment. This is possible because the increase in government consumption generates a fall in marginal utility of private consumption and an increase in disutility of labor. These two effects simultaneously decrease the level of private consumption and labor supply, respectively. If this negative effect is large enough, it can fully offset and even outweigh the positive effect of aid-financed public investment on output. In contrast, Edgeworth complementarity between private and public consumption reinforces the positive effect of aid-financed public investment since aid allocated to public consumption raises the marginal utility of private consumption and provides additional motives for households in the aid-recipient country to work more. We use counterfactual analysis to highlight the empirical implications of our theoretical results and discuss the policy-relevant implications of our results for aid allocation to African countries.
