The paradox of transfers: Distribution and the <scp>Dutch</scp> disease

Abstract We develop a new model of international trade with nonhomothetic preferences whereby within‐country income distribution affects the pattern of trade and economic growth. Alternative forms of foreign transfers, such as foreign aid and remittances, interact with the income distribution in dissimilar manners, which in turn generates differences in spending patterns, production patterns, and the pattern of international trade. In a three sector model with international trade and production we show that while remittances foster economic growth, foreign aid can cause economic stagnation. A production shift to the sector with less long‐run growth potential is known as the Dutch disease and in our model the disease is triggered by within‐country income differences and the form of the foreign transfer. We empirically verify these hypotheses with data from a panel covering the years 1991–2009 while controlling for the issues of omitted variable bias and the possible endogeneity of foreign aid and remittances.