Aid refers only to those parts of capital inflow which normal market incentives do not provide.

It consists of long term loans repayable in foreign currency, grants and “soft loans” repayable in local currency, sale of surplus products for “local currency” payments (PL 480 in the USA) and technical assistance which is a most important part of aid to underdeveloped countries.

Economists have defined foreign aid, therefore, as any flow of capital to LDCs that meets two criteria: its objective should be non-commercial from the point of view of donor; and it should be characterized by concessional terms that is, the interest rate and repayment period for borrowed capital should be softer (less stringent) than commercial terms.

Even this definition can be inappropriate for it could include military aid which is both non­commercial and concessional, normally, however, military aid is excluded from international economic measurements of foreign aid flows. The concept of foreign aid that is now widely used and accepted is one that encompasses all official grants and concessional loans, in currency or in kind, that are broadly aimed at transferring resources from developed to less developed nations on development or income distribution grounds.


Unfortunately there often is a thin line separating purely developmental grants and loans from sources ultimately motivated by security or commercial interests just as there are conceptual problems associated with the definition of foreign aid, so too there are measurements and conceptual problems in the calculation of actual development assistance flows. In particular, three major problems arise in measuring aid.

(i) First, we cannot simply add together the dollar values of grants and loans; each has a different significance to both donor and recipient countries. Loans must be repaid and therefore cost the donor and benefit the recipient less than the nominal value of the loan itself. Conceptually, we should deflate or discount the dollar value of interest bearing loans before adding them to the value of outright grants.

(ii) Second, aid can be tied either by source (loans or grants have to be spent on the purchase of donor-country goods and services) or by project (funds can only be used for specific project, such as road or steel mill). In either case the real value of aid is reduced because the specified source is likely to an expensive supplier or the project is not of the highest priority. Again, aid may be tied to the importation of capital intensive equipment which may impose an additional real resource cost, in the form of higher unemployment, on the recipient nation.

(iii) Finally, we always need to distinguish between the nominal and real value of foreign assistance, especially during periods of rapid inflation. Aid flows are usually calculated at nominal levels and tend to show a steady rise overtime, however, when deflated for rising prices, the actual real volume of aid from most donor countries has declined substantially during the past decade.

Public Financial Aid: Calculation of Capital Requirements:


Calculation of capital requirements proceed on the basis of projections of four important magnitudes: savings, investments, exports and imports. A target rate of growth is specified and then the amount of additional capital that will be required in order to reach that target rate of growth is estimated. This gives a figure for capital requirements which can be compared with the likely availability of domestic savings. At the same time it is possible to make projections of the likely behaviour of exports and imports.

The former will depend on the supply of goods and services available or likely to be available for export from the domestic economy, the state of world markets and the economic health of the developed countries which are the markets for such exports. A similar estimate can be made for import requirements.

All these projections can be made independently of one another, and it follows that there is very little likelihood that such independent projections will arrive at an answer which satisfies the basic accounting relationship already referred to above.

Projected investments may well exceed projected savings; and projected imports, on the other hand, may exceed the projected exports by a different amount. However, national income accountancy demonstrates that the excess of investment over savings must necessarily be equal to the excess of imports over exports and this must hold true at all points of time. It follows that there is something inconsistent about the projections that have been made.


The two-gap method, therefore, is essentially a way of ensuring that inconsistencies, which may be implicit in other ways of making projections, are brought out into open. Estimates of capital requirements made by this method, therefore, yield not one, but two figures for consideration.

The use of this approach requires either that the projections include the necessary changes in the structure and the behaviour of the economy which will make the two estimates consistent with each other, or that a decision has to be made the larger of the two gaps will be the more significant and will be taken as the required capital inflow from abroad.

A “Three-Phase” Approach:

A variant on the approach has also been followed by Mollis B. Chenery and Alan M. Strout who in a study prepared for the U.S. Agency for International Development, (AID), employed a three phase approach, where an attempt was made to specify in quantitative terms the constraint on development arising from the limit of absorptive capacity. In their study, various constraints : a savings constraint, the foreign exchange constraint and limitation of absorptive capacity come into operation for a particular developing economy at various stages of its economic development.

They focus special attention on two aspects: first the savings behaviour of the economy concerned, or its ability to refrain from consumption and allocate additional resources to investment and second, the question of absorptive capacity, viewed in this instance, as a performance factor.

In other words, if absorptive capacity is increasing over the years it can be regarded as a measure of the improved economic performance of the country concerned, and of its ability to make better use of capital from abroad. In their work they spelled out the operation of these three constraints in terms of three different stages of development.

This three phase approach can be useful for expository purposes, but it can only be an approximation to the real life problems of many developing countries where the three constraints often coexist and interact with one another.

A pioneering effort to estimate foreign aid requirements by means of a combination of capital absorptive capacity and two gap approaches is that by Max Millikan and W.W. Rostow. They view aid as a means of assisting countries to achieve condition of self-sustained economic growth. However countries that are in early stages of development are likely to have a relatively low capital absorptive capacity, nevertheless owing to their limited domestic resources virtually all the additional capital needed to launch the growth should come from external sources.

Specific attention have been focused on the ability of developing countries to employ or absorb productively additional amounts of capital. Capital absorptive capacity has sometimes been regarded as a more or less absolute limit to the amount of capital, foreign or domestic that can be productively employed in the sense of yielding some net rate over and above depreciation and obsolescence.


R.F. Mikesell points out that unless injections of capital are accompanied by new technology and modern skills and methods plus the right mix of complementary investments in both physical and human capital, there is no reason to expect high returns on capital in developing countries. Capital absorptive capacity has been defined in terms of the volume of investment on which the marginal rate of return is equal to the “socially acceptable discount rate”.

Factors responsible for limited capital absorptive capacity are:

(i) A lack of knowledge of the natural resources in the country; of the appropriate technology and of basic data on the economy,

(ii) A lack of skills,

(iii) A lack of managerial competence and experience in both private and public sectors,


(iv) Institutional limitations which encompass all the attributes of good government from law and order to fiscal and monetary policies,

(v) Cultural and social constraints which relate to education, worker incentives and entrepreneurship.

Aid through Trade:

It has been generally recognized that aid and opportunities for trade are not only complementary but that they may be substitutes for one another. Opportunities for increased exports can raise real incomes by making possible a fuller utilization of domestic resources and a realization of the gains from specialization and trade. The importance of foreign aid is demonstrated by the proportion of imports in developing countries which are financed by it.

In recent years aid has increasingly been given for purposes of long term development and with greater concern for economic performance on the recipient .side. Aid agencies both bilateral and multilateral have acquired a greater familiarity with problems of poor countries and recipients have learnt much about how to use the help given.


The growth of transport and communications which has revolutionized the developing world and which forms the basis for Industrial and agricultural development has been financed largely by development assistance. Aid has financed the work of large number of personnel and very extensive training programmes.

It has thus contributed to the transfer of technology and ideas. Above all, it is realized that development must come from within and that no foreign help suffice where there is no national will to make the fundamental changes which are needed.

To overcome the obstacles and take advantage of the opportunities for further growth, aid, trade and investment policies should be integrated into a single strategy which rests firmly upon the performance of the developing countries themselves and the sustained commitment of the richer countries. The developed countries should take part in the industrialization of developing nations not only for humanitarian and political reasons but for economic reasons serving the benefits of both sides.

Effects of Aid:

While there is much debate about the pros and cons of multilateral corporate investment and public foreign aid in developing countries few people doubt the value of one of the fastest growing and most significant forces in the field of development assistance, private non­governmental organizations (NGOs). NQOs are voluntary organizations that work with and on behalf of mostly local people’s organizations in LDCs. Most NGOs are able to work much more effectively at local levels than massive bilateral and multilateral programmes could.

The issue of the economic effects of aid is fraught with disagreement. On the one side are the economic traditionalists who argue that aid has indeed promoted growth and structural transformation in many LDCs. On the other side are critics who argue that aid does not promote faster growth but in fact may retard it by substituting for rather than supplementing domestic savings and investment and by exacerbating LDCs balance of payments deficit as a result of rising debt repayment obligations and the linking of aid to donor country exports. Official aid is further criticized for focusing on and stimulating the growth of the modern sector thereby increasing the gap in living standards between the rich and the poor in developing countries.

Some critics would even assert that foreign aid has been a positive force for antidevelopment in the sense that it both retards growth through reduced savings and worsens income inequalities. Rather than relieving economic bottlenecks and filling gaps, aid not only widens existing savings and foreign exchange resource gaps by even create new ones (that is, urban rural or modern sector traditional sector gaps). Critics also charge that foreign aid has been a failure because it has been largely appropriated by corrupt bureaucrats, has stifled initiative and has generally engendered a welfare mentality on the part of recipient nations.



Foreign aid includes private or public, bilateral or multilateral assistance to nations suffering the ravages of war, natural calamity or long standing poverty. Foreign aid may also be given for reasons relating to economic, diplomatic or national security interests. The concept is derived from humanitarian concerns and in larger sense from the processes of colonialism, world war, and economic depression.

The depression of the 1930s, World War II, and the cold war, for example, demonstrated the necessity of resource transfers from rich to poor nations in order to correct the inherent capitalist tendency toward unequal income distribution. Aid is a voluntary transfer of resources from one country to another, given at least partly with the objective of benefiting the recipient country.

Humanitarianism and altruism are significant motivations for the giving of aid. Aid may be given by individuals, private organizations or governments. Standards delimiting exactly the kinds of transfers that count as aid vary. Aid may be given in the form of financial grants or loans, or in the form of materials, labour or expertise. Aid is often pledged at one point in time but disbursements (financial transfers) might not arrive until later.

There are three basic approaches to foreign aid requirements for developing countries, either singly or in combination:

(i) The savings investment gap approach,

(ii) The foreign exchange earnings expenditure gap approach and


(iii) The capital absorption approach.

The net capital imports or foreign aid is equal to both the gap between imports and exports and to that between domestic investment expenditures and domestic savings. This approach has become known as the “two gap” approach. The capital absorptive capacity approach regards capital requirements are being determined by the ability of an economy to employ both domestic and foreign capital productively in sense that aid yields some minimum rate of return.

In future aid is more likely to be linked to market reforms and the building of institutional capacities and more effective form of governance as preconditions for structural adjustment. It is also being linked to poverty alleviation as well as growth and the rising concerns about environmental consequences. Eliminating poverty, minimizing inequality, promoting environmentally sustainable development and raising levels of living for the masses of LDCs peoples may turn out to be in the most fundamental self interest of developed nations.

This is not because of any humanitarian ideals but simply because in the long run there can be no dual futures for humankind, one for the very rich and another for the very poor without the proliferation of global or regional conflict.