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Setter Field, M. 2003. Supply and Demand in the Theory of Long-Run Growth

Setter Field, M. 2003. Supply and Demand in the Theory of Long-Run Growth

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 Review of Political Economy, Volume 15, Number 1, 2003
Demand in the Theory of  Long-run Growth: introduction to asymposium on demand-led growth
 Department of Economics, Trinity College, Hartford, CT, 06106 USA
 Recent developments in growth theory have encouraged a revisionist interpretation of the field. According to this interpretation long-run growth should be, and always hasbeen, interpreted as a supply-side process. The focus of this symposium is the macro-economics of demand-led growth. As a precursor to the contributions that follow, twocentral insights of demand-led growth theory are highlighted. First, chronic effectivedemand problems create a role for aggregate demand in determining the utilization ratesof productive resources, even in the long run. Second, the demand-led actual rate of growth influences both the accumulation and productivity of factor inputs, and hence theeconomy’s potential rate of growth.
1. Introduction
It was once conventional to date the beginning of modern growth theory to thework of Harrod (1939).
Harrod’s analysis is based on the separation of investment from saving. Specifically, investment varies independently of sav-ing—a hallmark of Keynesian macroeconomics, with which Harrod’s contribu-tions have long been associated. This results in an equilibrium or warranted rateof growth that repels, rather than attracts, the actual rate of growth because of the perverse macroeconomic effects of individual firms’ investment responses tomicroeconomic signals (specifically, their rates of capacity utilization). More-over, the warranted rate need not coincide with the economy’s maximum orpotential growth rate, which Harrod termed the ‘natural rate.’ Harrod thuscreated a dynamic counterpart to Keynes’s short-run theory of income determi-nation in which aggregate demand plays a central role.The contribution of Solow (1956) was to ‘solve’ the problems posed byHarrod by demonstrating that the economy will automatically gravitate towardsan equilibrium rate of growth consistent with the natural rate. This task wasachieved in no small part by his assumptions that saving and investment are
See, for example, Harcourt (1972), Jones (1976) Hsieh
et al
. (1978). The term ‘modern growththeoryisusedheretodelineatecontributionstogrowththeorythatpostdatethemarginalistrevolutionfrom earlier, Classical theories of growth. It is not intended to denote the obsolescence or redundancyof the latter, which continues to inspire many contemporary contributions to growth theory.
ISSN 0953-8259 print/ISSN 1465-3982 online/03/010023-10
2003 Taylor & Francis LtdDOI: 10.1080/0953825022000033107
Mark Setterfield 
identical and that saving creates investment. As such, both the distinctionbetween these activities and the independence of investment behaviour that arecharacteristic of Harrod and Keynes are lost, together with all of the macroeco-nomic results that follow from this Harrodian/Keynesian thinking. Thus wasborn the first generation of neoclassical growth theory, and thus began whatPalley (1996a) describes as the ‘neoclassical capture’ of growth theory. This isnowhere more evident than in subsequent textbook discussions of Solow’sresults, which pay more attention to his use of a continuous production functionthan to his assumptions about the relationship between investment and saving(see, for example, Jones, 1976). The variability of the capital–output ratio (whichHarrod regarded as fixed) implicit in a continuous production function certainly
the adjustment of the warranted rate of growth towards the naturalrate. But the assumption that investment is identical to saving is instrumental in
this adjustment. By ruling out the possibility of effective demandfailures at any point in time, it ensures that macroeconomic equilibrium mustcoincide with the economy’s supply-determined potential output. This sameassumption also eliminates at a stroke the source of instability in Harrod’smodel—namely, independent (of saving) variations in investment spending.The neoclassical capture of growth theory continued with the emergence of neoclassical endogenous growth (NEG) theory in the mid 1980s.
This second-generation neoclassical growth theory differs from the first by virtue of itsassumptions about the technical properties of accumulable inputs into theproduction process.
Specifically, the marginal returns to accumulable factors of production are assumed to be bounded from below, but above zero. This makesit possible to sustain long-run growth by investing in these factors.
In Solow,accumulation alone cannot sustain growth, as the marginal returns to physicalcapital are assumed to fall to zero in the long run. Growth is therefore explainedby exogenous variables—the rate of growth of the labour force and the pace of technical change. In NEG theory, growth is rendered endogenous because it isexplained within the model (usually in terms of its equilibrium solution) and interms of variables such as the rate of savings, which are subject to agent choice.However, NEG theory shares with its Solovian predecessor an unrelenting focuson the supply side as the wellspring of growth. NEG theory is certainly capableof connecting demand to the rate of growth,
but this connection is peripheral.The behaviour of aggregate demand is generally viewed as an unimportant andunnecessary constituent of growth analysis in NEG theory.
The seminal contributions are those of Romer (1986) and Lucas (1988).
As is typical in neoclassical theory, the process of production is treated as a technical phenomenon.Social relations of production, as described by Classical theorists such as Marx, are not an integralfeature of the analysis.
Accumulable factors of production include not just physical capital but also human capital and‘knowhow’.Theknowledgecontentoftheseaccumulablefactorsisthoughttojustifytheassumptionthat their marginal returns are bounded from below but above zero, because of the non-rivalrous and(partially) non-excludable nature of knowledge as a commodity (see, for example, Grossman &Helpman, 1991)
See, for example, Blackburn (1999). Indeed, it would seem that there is very little that NEG theoryis
of connecting to the rate of growth. This makes it difficult for NEG theorists to reacha consensus as to what, exactly, the determinants of growth are (see Fine, 2000).
Supply and Demand in the Theory of Long-run Growth
25Inspired by these developments, it has now become conventional to writethe history of modern growth theory in terms of a seamless development of supply-oriented, neoclassical growth analysis, which begins with Solow (1956)and leads directly to NEG theory.
The work of Harrod, together with the laterCambridge growth theory of Robinson (1956), Kaldor (1955–6, 1957) andPasinetti (1962), and more recent Kaldorian (see, for example, Kaldor 1970,1985; Thirlwall, 1979; McCombie and Thirlwall, 1994) and Kaleckian (see, forexample, Rowthorn, 1982; Dutt, 1984; Blecker, 2002) contributions are ignoredaltogether.
The upshot of all this is that growth is now commonly representedas an unambiguously supply-side process. Hence Stern (1991, p. 123) definesgrowth theory as being ‘about the accumulation of physical capital, the progressof skills, ideas and innovation, the growth of population, how factors arecombined and managed and so on [and] therefore, principally, about thesupply side.’ There is no hint that demand may play a role in either thedevelopment or subsequent utilization of the productive forces he names.
2. Demand-led Growth
The contributions to this symposium challenge the supply-side vision of growth.Demand-led growth theory identifies a twofold impact of demand on growthrates. First, there exists a potential for effective demand failures, even in the longrun. Second, demand conditions influence the development of productive re-sources (and hence the potential output of the economy) over time. Demandmatters, therefore, not just because of its chronic influence on the utilizationrates of productive resources (and hence the proximity of the actual to thepotential output path of the economy), but also because of its impact on thequantity and productivity of inputs, and hence the potential output path itself.
2.1. Demand and the Utilization of Productive Resources in the Long Run
According to demand-led growth theory, there is no supply-determined equilib-rium towards which the level of output inevitably and inexorably converges.
This observation is borne out by even the most cursory examination of contemporary textbooksongrowththeory.See,forexample,Barro&Sala-i-Martin(1995),Aghion&Howitt(1998)andJones(1998).
NEG theory can be thought of as part of a colonizing project, in which economic theory, and socialscience more generally, are being re-written (with the aid of the sort of revisionist history describedabove) in the image of neoclassical economics and its singular methodological emphasis on theatomistic, optimizing, individual agent (Fine, 1999, 2000). Some mainstream economists haverecently begun to acknowledge, celebrate and encourage this imperialism (see, for example, Lazear,2000).Harrod’s exclusion from contemporary histories of growth theory is rendered somewhat ironicby the fact that, in NEG theory, the engine of endogenous growth is Harrod’s constant marginalcapital—output ratio (see, for example, Hussein & Thirlwall, 2000). This, coupled with the fact thatKaldor is the true modern progenitor of endogenous growth theory (Palley, 1996b; Hussein &Thirlwall,2000),cementstheideathatthekeydifferencebetweenneoclassicalandKeynesiangrowththeories is their treatment of demand, and not assumptions about technical properties of therelationship between inputs and outputs.

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