Aid allocation rules

•Studies allocation rules used by multilateral development agencies.•Welfare-based analysis based on dynamic allocation when recipients make optimal investment decisions.•Demonstrates that donors should not target growth in presence of Bauer׳s paradox.•Illustrates the principles of optimality and provides calibrated examples

This paper studies an aid allocation rule used by major development agencies, and investigates optimal allocations when recipients are neoclassical economies undergoing transition dynamics. When recipients face aid absorption constraints, allocations that favor poorer recipients are not always optimal, contrary to what is assumed in assessments of donor performance. The most quantitatively significant factors that determine the optimal sensitivity to recipient characteristics are the generosity of the aid budget and the extent of absorption constraints. In neoclassical recipients, aid can only accelerate growth where there is already growth, so the optimal rule places little weight on growth and optimality is largely a matter of balancing recipient need against absorption constraints.