Correctly analysing the balance-of-payments constraint on growth

Arslan Razmi

Cambridge Journal of Economics, 2016, vol. 40, issue 6, 1581-1608

Abstract: The balance-of-payments-constrained growth (BPCG) model provides an interesting hypothesis regarding economic growth. The main implication is that world demand places the dominant constraint to which individual country growth adjusts. I discuss this implication and argue that tests of the BPCG model have essentially been tests of the hypothesis that trade is balanced over the long run; a plausible hypothesis but one that need not hold mainly through responses to world demand (as transmitted via income elasticities). I then discuss the role of relative prices and investment, point out logical inadequacies in the traditional BPCG framework and suggest an alternative theoretical framework to investigate its robustness. Our theoretical and empirical explorations suggest that traditional tests of the BPCG model may be misleading. Including investment as a proxy for the capacity to export and addressing endogeneity issues, for example, noticeably weakens the influence of world demand. The evidence presented contributes to reconciling evidence supporting the BPCG hypothesis with recent work that consistently finds an important role for the level of the real exchange rate and investment, independently of world demand.

Date: 2016
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