Foreign aid, external debt and governance

This paper investigates the impact of foreign aid, external debt and governance on the economic growth by extending the Ramsey–Cass–Koopman's growth model in an open economy framework. Steady-state and short run analysis shows that external debt and foreign aid do not affect the growth rate of consumption but have level impact on consumption. Foreign aid and governance encourage the economic growth but external debt creates a burden on the economy. Both investment and saving are independent of external debt and thus the current account surplus. Foreign aid does not affect investment directly but it has a direct positive impact on the savings in the economy. Therefore, it is argued that improvements in the quality of governance will stimulate the output and consumption rapidly and it acts like a catalyst. •Non-linear inverse U-shape relationship exists between aid and economic growth.•Aid and economic growth relationship depends upon the quality of institutions.•External debt has a negative correlation with output in steady state.•Any improvement in governance will stimulate output and it acts like a catalyst.