The effect of foreign aid on domestic private investment has been a controversial issue. Many economists claim that aid has positive effect via relaxing saving gaps and trade gaps of developing countries. Whereas, others take the position that aid is counterproductive effect by generating ‘’Dutch disease effect’’, encouraging corruption, rent seeking activities and weakening institution. Moreover, others also contest that aid has a positive relation with domestic private investment in developing countries if it's conditioned with good policies and institutions. This paper empirically investigated the effect of aid on domestic private investment in 9 Eastern African countries by using Dynamic OLS methodology, which assumed to detect omitted variable bias and endoginiety problems over the period 1971 to 2012. In addition, this study tried to investigate the co-movement characteristics and conditionality behavior of aid by interacting it with FDI and polity IV variable, respectively. The results clearly indicate that aid has a significant negative effect both at the panel and individual country level (except Kenya) but when it interacted with FDI it has significantly positive result. Moreover, its interaction with polity variable shows negative and significant effects. However, the interaction of both at the individual country level shows mixed result.

Keywords: Foreign aid, FDI, Domestic Private Investment and Dynamic OLS