...increases effect aid on growth has ratcheted up that debate. This particular policy view has also had an enormous impact on donor policies (Easterly 2003). Given limited resources and the implication that aid should be directed to countries with good policies, many developing poor countries with questionable policy records would be especially vulnerable. Not surprisingly, large number of empirical papers followed to re-examine the aid-growth relationship, in general, and the aforementioned policy view, in particular (for example, Collier and Dehn 2001; Dalgaard and Hansen 2001; Hansen and Tarp 2001; Collier and Dollar 2002; Burnside and Dollar 2004; Clemens, Radelet, and Bhavnani 2004; Dalgaard, Hansen, and Tarp 2004; Easterly, Levin, and Roodman 2004; and Rajan and Subramanium 2005, to name a few). Although there is some corroboration, several papers dispute this policy view. Some papers argue that aid works by itself but with diminishing returns, and the controversy continues.

A number of issues have been raised in the existing empirical literature, of which nonlinearity is a major one. Previous papers have tried to address nonlinearity in the aid variable mainly by adding quadratic terms in the linear regressions. However, it is almost impossible to pinpoint the exact form of nonlinearity in the aid-policy-growth relationship that would be appropriate for all data sets and for all data ranges. By using widely referenced aid and policy variables (which have been applied by authors in both camps in the debate), we revisit the issue from a different intuitive and econometric angle that has not been explored before. We do not superimpose any a priori functional form on the relationship, so that our analysis remains free from any possible functional form misspecification bias. We then raise an important question: Do various aid-policy combinations (ranges) yield different returns to growth, and, more importantly, can we discern any meaningful patterns in the underlying aid-policy-growth relationship? By pursuing a nonparametric estimation framework, we are able to derive specification-free, data-driven, point-wise estimates that capture the varying effects on growth at different levels of aid and policy. This is particularly helpful because we can focus on specific values (ranges) of aid and policy in assessing when they are growth enhancing, neutral, or possibly growth detracting. If they happen to accommodate all three possibilities, perhaps in different data segments, linear estimation would possibly tend to average out the varying effects and could possibly "tilt" the results in either direction, depending on the sample of countries and periods included.

To keep the main contributions of our paper crisp and focused, we use the traditional measures of aid and policy--effective development assistance (purchasing power parity [ppp] adjusted) and a macroeconomic policy index a la Burnside and Dollar (2000). This allows us to abstract from several other issues, including the use of a measure of aid that is adjusted for emergency relief and other political and long-impact noneconomic motivations "(for example, democracy, health, and education; see Clemens, Radelet, and Bhavnani 2004; and Rajan and Subramanium 2005) and broader measures of policy that incorporate institutions and rule of law (as in Burnside and Dollar 2004). Following some of the important papers in this debate (including Burnside and Dollar 2000 and Easterly, Levin, and Roodman 2004), we keep the institutional variable as a control variable in the regression. Also, in keeping with tradition, we abstract from the issue of policy endogeneity in a growth regression, as recently pointed out by Rodrik (2005). (1) It also allows us to examine the aid-policy-growth nexus in various ranges of aid and policy in a data-driven way while staying with the conventional measures of the variables.

As is common in the literature (for example, Burnside and Dollar 2000; Clemens, Radelet, and Bhavnani 2004; Dalgaard, Hansen, and Tarp 2004; and Rajan and Subramanium 2005, to name a few), we use standard parametric estimations as benchmarks, although our conclusions are solely based on the semiparametric framework. We apply several statistical tests to validate the semiparametric estimation strategy. The main findings are the following: policy is mostly an important determinant of growth; there is partial corroboration of the Burnside-Dollar policy view; and we find some evidence of diminishing returns to aid, though at very high levels of aid.

The paper is organized as follows. Section 2 reviews the relevant literature. Section 3 discusses the econometric model and tests. The data and empirical results are discussed in section 4, and section 5 concludes with a discussion.

2. Related Literature

Throughout the 1970s and 1980s, the two-gap model of Chenery and Strout (1966) provided the main framework to conceptualize the links between aid and growth, and this model was subsequently extended by Bacha (1990) to incorporate the fiscal behavior of government. Aid was perceived to fill gaps that were the most pressing. The currently popular view is that developing countries suffer more from an "institutions gap" and a "policy gap" than a financing gap. In this regard, the usual empirical framework for testing the aid-growth relationship...

NOTE: All illustrations and photos have been removed from this article.



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