14 growth. However, when aid is delivered to countries that feature a good policy environment, it may increase growth but its effect is subject to diminishing returns (e.g. World Bank, 1998; Burnside and Dollar, 2000).<sup>25</sup> The issue of aid effectiveness has also been studied in the context of post-conflict transitions, where relative to normal peaceful environments, aid was found to be super-effective (e.g. Collier and Hoeffler, 2002). This is because civil wars are characterized by an immediate and substantial decline of output, and when they last long enough they can also destroy the physical, human, and social capital of affected countries.<sup>26</sup> Therefore economies tend to experience drastic underperformance during war years, which opens up a large potential for post-conflict catch-up growth, mainly driven by aid-financed reconstruction and recovery efforts.

Unlike Collier and Hoeffler, who emphasize the role of the overall institutional and policy environment in enhancing the absorptive capacity of aid at various post-conflict periods, we control for the direct growth effects of institutions and other conventional growth fundamentals but emphasize the growth and aid-effectiveness consequences of RER misalignment.

A strand of the empirical growth literature that accounts for the impact of RER misalignment finds robust negative association between RER overvaluation and growth. While moderate undervaluation might support growth, extreme undervaluation also leads to less growth (Razin and Collins 1997, Aguirre and Calderon, 2005). Another finding of this literature is that the growth impact of RER overvaluation and RER volatility is contingent on the level of financial development; they generally reduce growth in countries with low levels of financial development while having no significant effect in financially advanced economies (Aghion et al., 2006).

Next we specify and estimate an empirical growth model that nests the four latter strands of the growth literature: conflict periods, aid, RER competitiveness, and financial development, as well as their possible interactions. Controlling for conventional growth determinants that are robustly identified in the empirical cross-country growth literature, we address the following issues that have not been addressed in aid and post-conflict transition literature yet. First, which are the separate effects of peace and post-conflict periods, aid, RER misalignment, and financial development, on growth? Second, does aid reduce or augment the impact of RER misalignment on growth? Third, does aid increase the contribution of post-conflict peace to growth? Finally, is the growth loss from RER misalignment ameliorated by financial development?

To address these questions, we specify and estimate the following growth model:

> 25 More recent work by Radelet, Clements and Bhavnani (2003) argues for the need to disaggregate aid by its purpose in order to accurately assess its impact on economic growth. They find that the growth impact of disaggregated aid flows is larger than previously found (although it presents diminishing returns) regardless of recipient countries’ policy environment. This research direction path, although appealing, goes beyond the scope of our current work.

> 26 For example, Collier (1999) estimates a growth model that accounts for duration and legacy of civil wars. He finds that, relative to the counterfactual of peace, the marginal effect of a civil war causes per capita output to decline by about 2% per annum during wars.