^*Tito Cordella is a lead economist in the Latin American and the Caribbean Region of the World Bank. Hulya Ulku is a lecturer at the Institute for Development Policy and Management (IDPM) at the University of Manchester in the United Kingdom. The authors would like to thank Ratna Sahay for drawing their attention to the issue and for her initial collaboration on the project. They would also like to thank Oya Celasun, Alejandro Justiniano, Aart Kraay, Humberto Lopez, Domenico Lombardi, Ugo Panizza, Rodney Ramcharan, Arvind Subramanian, and one anonymous referee, as well as seminar participants at the IMF, the World Bank, and the 2005 Latin American and Caribbean Economic Association meeting for helpful comments and suggestions.

Abstract

Under what conditions should grants be preferred to loans? To answer this question, we present a simple model à la Krugman (1988) and show that, for any given level of development assistance, higher concessionality is good for growth if countries are poor, have bad policies, and have high debt obligations. We then test our model by estimating a modified growth model for a panel of developing countries, and find evidence supporting most of our predictions.