How Does Conditional Aid (Not) Work?

Abstract

Does policy conditionality worsen domestic welfare, as governments are forced to attempt unpopular reforms resulting in damaging protests, or does conditionality help implement reforms that otherwise would have been impossible? This paper analyzes these questions. Using a game-theoretic framework, it argues that the impact of conditional aid on welfare is nonmonotonic. Sufficiently conditioned aid can enhance the signaling power of reform announcements, thereby deterring protest and enabling reform. In contrast, inadequately conditioned aid may induce a weak government to mistakenly attempt reform, resulting in protest and a worsening of domestic welfare relative to the status quo.

Keywords: conditionality, policy reform

JEL Classification: E61, F35