Economists have been trying to study the linkages between aid inflow and government activities in developing countries. With the passage of time, the analysis has become more sophisticated. The development of two-gap models [for example, Chenery and Bruno(1962); and Chenery and Adelman(1966), among others] was an important contribution to the literature. More recently, two-gap models have been extended into threegap models. Iqbal (1995) added a fiscal constraint to the traditional saving and foreign exchange gap. In such cases, the fiscal constraint is intended to reflect potential limitations to finance public investment that may be required to support a given level of output. Another development is the analysis of effectiveness of foreign aid on the fiscal behaviour of governments in underdeveloped countries. Empirical studies by Khilji and Zampelli(1991), Khan and Hoshino(1992), among others are important contributions to this topic. All these studies gave conflicting conclusions about the effectiveness of assistance in terms of fiscal behaviour. Generally, these studies prove that aid reduces the taxation effort and is substituted between public investment and public consumption.