The main objective of this study is to access the fiscal response to external aid inflows in Ethiopia, specificallyrnto study the impact of foreign aid inflows on public expenditure, revenue and domestic borrowing in Ethiopia.rnThe paper provides a critical review of literature on the aid-fiscal relation, and then applies a VAR/VECMrnand impulse response analysis, using data for the period 1961-2007.The study is a good indication thatrndisaggregated data utilization could point out which variables are responsive to changes in external shocks. Byrnstudying the particular fiscal dynamics in Ethiopia using three separate models, the study finds that foreign aidrnin the form of grant and loan has had a positive impact on government expenditure (loan being pro-investmentrnand grant being pro-consumption), both have a negative impact on domestic borrowing (domestic borrowingrnbeing more elastic to a change in grant) and indirect tax collection and no effect on the direct one. Moreover, byrnincorporating total ODA inflow in a separate model, the study tried to analyze the joint impact of budgetaryrngrant and loan, and that of off -budgetary ODA. The results support the conclusion that aid inflows increasernpublic expenditure and are biased to be pro- investment. While total ODA flows have a negative impact onrnrevenue of the government and borrowing from domestic sources, suggesting that aid and domestic borrowing arernclose substitutes and that higher aid flows displace domestic revenues. In the final analysis to mitigate thernundesirable impacts of aid, building a better national capacity to collect domestic revenue and regulatoryrnschemes by donors to avoid possible problems of aid fungiblity should be put in place