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The paper analyses the “Dutch Disease” effect of foreign aid on the Ethiopian Economy. After a brief review of aid theory, it goes on reviewing the available evidences about the Dutch disease effects aid has in the other countries. Then illustrative model is presented. The study employed three stage-least square methods in estimating the real exchange rate and aid variable, on the one hand, and export performance and aid, on the other. The finding is that external aid inflows to Ethiopia result in appreciation of exchange rate and hence loss of export competitiveness, that is, “Dutch Disease” problem has been identified. The study concludes that for external aid inflows to be an effective investment, economic policy needs to focus infrastructure development and the government needs to subsidize firms in the tradable sector.


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