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This study is situated within two streams of research that examine how foreign aid and ethnic diversity impact development. Institutions and governance, specifically market-protecting institutions (MPIs), have increasingly become the focus of foreign aid donors as the key to development success. At the same time, however, ethnic diversity thwarts institutional development. Does foreign aid in diverse states present a cross-cutting relationship or can aid help diverse states out of the development-trap? I explore whether or not targeted foreign aid can help states break out of the diversity-development trap. To begin, I look at the necessity of sound formal MPIs to spur economic growth. Ethnic diversity, however, is associated with weak and fragmented MPIs. I then put forth a theory that foreign aid can have a positive influence on development in diverse states. I argue that foreign aid helps to overcome incentive deficiencies created by diversity and provides an opening for externally induced change. Foreign aid, thereby, mitigates the negative effect of ethnic diversity on the development of MPIs. To test the theory, I employ a time-series cross-sectional design for all developing countries during the years of 1995-2005. The results of various tests show support for the argument that aid for institutional reform has a differential impact on MPIs in ethnically diverse states. Specifically, I find that 1) aid mitigates the negative effects of ethnic diversity on the development of MPIs, 2) that aid is better able to mitigate the negative effects of diversity in democracies than in autocracies, 3) that aid has a greater positive effect on MPIs as the level of ethnic diversity increases, and lastly 4) that aid is more effective in ethnically diverse democracies than ethnically diverse autocracies. The results have profound implications for the 5 billion people who currently live in underdeveloped and ethnically diverse states.