The role of foreign aid in reducing poverty: Time series evidence from Ethiopia

Driven by recent shifts in international financial flows towards poverty reduction and the concentration of previous studies on aid economic growth relationships, this study took a new metric to investigate aid’s effectiveness,  that is poverty reduction. Based on this objective, the study employed multivariate cointegration analysis to a time series data from Ethiopia over the period 1975-2010. The empirical results indicated that foreign aid has a significant effect on poverty reduction, by reducing infant mortality rate and increasing household consumption expenditure. On the other hand, its impact found to be negative when poverty is measured by gross primary enrollment ratio. Nonetheless, when augmented by macroeconomic policy index the impact turned to be positive. Furthermore the result indicated the presence of diminishing returns to the inflow of foreign aid. The results also revealed that economic growth has a significant contribution for poverty reduction, while poor quality of governance exacerbates poverty. Thus, to achieve the poverty reduction objectives, measures have to be taken in the area of aid allocation, quality of governance and macroeconomic policies that can ensure sustainable economic growth.   Key words: Foreign aid, poverty reduction, cointegration analysis, Ethiopia.