Review of Political Economy, Volume 15, Number 1, 2003
Supply and Demand in the Theory of Long-run Growth: introduction to a symposium 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 has been, interpreted as a supply-side process. The focus of this symposium is the macroeconomics of demand-led growth. As a precursor to the contributions that follow, two central insights of demand-led growth theory are highlighted. First, chronic effective demand problems create a role for aggregate demand in determining the utilization rates of 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 the economy’s potential rate of growth.
It was once conventional to date the beginning of modern growth theory to the work of Harrod (1939).1 Harrod’s analysis is based on the separation of investment from saving. Speciﬁcally, investment varies independently of saving—a hallmark of Keynesian macroeconomics, with which Harrod’s contributions have long been associated. This results in an equilibrium or warranted rate of growth that repels, rather than attracts, the actual rate of growth because of the perverse macroeconomic effects of individual ﬁrms’ investment responses to microeconomic signals (speciﬁcally, their rates of capacity utilization). Moreover, the warranted rate need not coincide with the economy’s maximum or potential growth rate, which Harrod termed the ‘natural rate.’ Harrod thus created a dynamic counterpart to Keynes’s short-run theory of income determination in which aggregate demand plays a central role. The contribution of Solow (1956) was to ‘solve’ the problems posed by Harrod by demonstrating that the economy will automatically gravitate towards an equilibrium rate of growth consistent with the natural rate. This task was achieved in no small part by his assumptions that saving and investment are
1 See, for example, Harcourt (1972), Jones (1976) Hsieh et al. (1978). The term ‘modern growth theory’ is used here to delineate contributions to growth theory that postdate the marginalist revolution from earlier, Classical theories of growth. It is not intended to denote the obsolescence or redundancy of 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 Ltd DOI: 10.1080/0953825022000033107
identical and that saving creates investment. As such, both the distinction between these activities and the independence of investment behaviour that are characteristic of Harrod and Keynes are lost, together with all of the macroeconomic results that follow from this Harrodian/Keynesian thinking. Thus was born the ﬁrst generation of neoclassical growth theory, and thus began what Palley (1996a) describes as the ‘neoclassical capture’ of growth theory. This is nowhere more evident than in subsequent textbook discussions of Solow’s results, which pay more attention to his use of a continuous production function than to his assumptions about the relationship between investment and saving (see, for example, Jones, 1976). The variability of the capital–output ratio (which Harrod regarded as ﬁxed) implicit in a continuous production function certainly facilitates the adjustment of the warranted rate of growth towards the natural rate. But the assumption that investment is identical to saving is instrumental in causing this adjustment. By ruling out the possibility of effective demand failures at any point in time, it ensures that macroeconomic equilibrium must coincide with the economy’s supply-determined potential output. This same assumption also eliminates at a stroke the source of instability in Harrod’s model—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.2 This secondgeneration neoclassical growth theory differs from the ﬁrst by virtue of its assumptions about the technical properties of accumulable inputs into the production process.3 Speciﬁcally, the marginal returns to accumulable factors of production are assumed to be bounded from below, but above zero. This makes it possible to sustain long-run growth by investing in these factors.4 In Solow, accumulation alone cannot sustain growth, as the marginal returns to physical capital are assumed to fall to zero in the long run. Growth is therefore explained by 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 is explained within the model (usually in terms of its equilibrium solution) and in terms of variables such as the rate of savings, which are subject to agent choice. However, NEG theory shares with its Solovian predecessor an unrelenting focus on the supply side as the wellspring of growth. NEG theory is certainly capable of connecting demand to the rate of growth,5 but this connection is peripheral. The behaviour of aggregate demand is generally viewed as an unimportant and unnecessary 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 integral feature of the analysis. 4 Accumulable factors of production include not just physical capital but also human capital and ‘know how’. The knowledge content of these accumulable factors is thought to justify the assumption that 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) 5 See, for example, Blackburn (1999). Indeed, it would seem that there is very little that NEG theory is incapable of connecting to the rate of growth. This makes it difﬁcult for NEG theorists to reach a consensus as to what, exactly, the determinants of growth are (see Fine, 2000).
Supply and Demand in the Theory of Long-run Growth
Inspired by these developments, it has now become conventional to write the 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.6 The work of Harrod, together with the later Cambridge growth theory of Robinson (1956), Kaldor (1955–6, 1957) and Pasinetti (1962), and more recent Kaldorian (see, for example, Kaldor 1970, 1985; Thirlwall, 1979; McCombie and Thirlwall, 1994) and Kaleckian (see, for example, Rowthorn, 1982; Dutt, 1984; Blecker, 2002) contributions are ignored altogether.7 The upshot of all this is that growth is now commonly represented as an unambiguously supply-side process. Hence Stern (1991, p. 123) deﬁnes growth theory as being ‘about the accumulation of physical capital, the progress of skills, ideas and innovation, the growth of population, how factors are combined and managed and so on … [and] therefore, principally, about the supply side.’ There is no hint that demand may play a role in either the development 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 growth rates. First, there exists a potential for effective demand failures, even in the long run. Second, demand conditions inﬂuence the development of productive resources (and hence the potential output of the economy) over time. Demand matters, therefore, not just because of its chronic inﬂuence on the utilization rates of productive resources (and hence the proximity of the actual to the potential output path of the economy), but also because of its impact on the quantity 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 equilibrium towards which the level of output inevitably and inexorably converges.
This observation is borne out by even the most cursory examination of contemporary textbooks on growth theory. See, for example, Barro & Sala-i-Martin (1995), Aghion & Howitt (1998) and Jones (1998). 7 NEG theory can be thought of as part of a colonizing project, in which economic theory, and social science more generally, are being re-written (with the aid of the sort of revisionist history described above) in the image of neoclassical economics and its singular methodological emphasis on the atomistic, optimizing, individual agent (Fine, 1999, 2000). Some mainstream economists have recently 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 ironic by the fact that, in NEG theory, the engine of endogenous growth is Harrod’s constant marginal capital—output ratio (see, for example, Hussein & Thirlwall, 2000). This, coupled with the fact that Kaldor is the true modern progenitor of endogenous growth theory (Palley, 1996b; Hussein & Thirlwall, 2000), cements the idea that the key difference between neoclassical and Keynesian growth theories is their treatment of demand, and not assumptions about technical properties of the relationship between inputs and outputs.
Instead, at any point in time, the utilization of existing productive resources is determined by demand conditions that are relatively autonomous from the conditions of supply. The actual output path of the economy (i.e. its growth trajectory) is therefore demand-determined.8 The sequence of short-run outcomes associated with the demand-determined utilization of productive resources traces out the economy’s long-run growth path, without displaying any tendency to gravitate automatically towards the potential output path of the economy. The latter, then, does not possess the properties of a strong attractor, as it does in neoclassical growth theory. The idea that demand conditions determine the utilization of productive resources in the long run has not met with universal approval, even amongst non-neoclassical theorists. For example, a common feature of classical macrodynamics is the notion that the economy must operate at its ‘normal’ rate of capacity utilization in long run. This normal rate is deﬁned independently of demand conditions by ﬁrms’ preferences with respect to the rate at which their physical plant and equipment is utilized.9 Put simply, the argument is that if the normal rate of capacity utilization is not achieved, ﬁrms will continue to work for change until their preferred normal rate of utilization is realized. But is the normal rate of capacity utilization really deﬁned independently of demand conditions? The ‘normal’ rate may simply be the average actual rate of capacity utilization (Dutt, 1999), or it may display hysteresis in response to changes in the actual rate of capacity utilization (Lavoie, 1996). These arguments rebuff Classical claims with respect to the behaviour of the capacity utilization rate and, in the process, re-assert the endogeneity of the utilization rate to demand conditions, even in the long run.
2.2. Demand and the Development of Productive Resources in the Long Run
The potential growth rate of the economy depends on the growth of physical capacity, labour resources, and factor productivity. But according to demand-led growth theory, each of these—and hence the potential rate of growth itself—is affected by the demand-determined actual rate of growth. This hypothesis is not new. It was Adam Smith who ﬁrst remarked that the division of labour depends on the extent of the market. What contemporary demand-led growth theorists have done is codify and expand upon Smith’s basic insight. In the ﬁrst place, if expanding demand involves increasing investment spending, it will have a direct effect on capacity and (to the extent that technical
By deﬁning the economy’s potential output at any point in time, the conditions of supply must, of course, deﬁne a ‘ceiling’ that the actual output path cannot exceed. Growth can be supply-constrained, then. The tenor of the comments above is designed to suggest that, whilst possible in principle, the idea of a supply constraint on growth is seldom binding in practice. Moreover, the potential output path of the economy is inﬂuenced by its (demand-determined) actual output path, for reasons that will be made clear subsequently. 9 Note that this argument applies strictly to the utilization of physical capital. There is no corresponding argument that the utilization rate of labour will also gravitate towards a pre-determined ‘normal’ rate.
Supply and Demand in the Theory of Long-run Growth
progress is embodied in capital) productivity. Moreover, any expansion of demand and output today will inﬂuence ﬁrms’ investment plans and their ability to execute these plans—and hence the availability and productivity of capacity tomorrow. The impact on planned investment works through accelerator effects and through the positive inﬂuence of rapid demand and output growth on the state of long-run expectations, which makes ﬁrms more willing to adopt illiquid positions that increase their exposure to the downside risks associated with fundamental uncertainty.10 The expansion of demand and output may also affect the type of investment that ﬁrms plan. According to Lamfalussy (1961), ﬁrms are more inclined to engage in ‘defensive investment’ (designed to protect market share) than ‘enterprise investment’ (designed to introduce transformative change in capacity and/or the technique of production) during periods of slow growth. Evidence suggesting that R&D expenditures are positively inﬂuenced by the rate of growth (see Schmookler, 1966; Brouwer & Kleinknecht, 1999) offers support for this idea. Moreover, there are issues of ﬁnance. Independent of their effects on planned investment, demand and output growth can inﬂuence whether or not investment plans get transformed into actual investment. Slow growth, which diminishes proﬁtability, may hamper the ability of ﬁrms to draw on retained earnings to ﬁnance investment and adversely affect their perceived credit-worthiness in the eyes of ﬁnancial institutions. The latter are also likely to have a higher liquidity preference, and therefore be less inclined to make ﬁnancial commitments to illiquid investments in industrial capital, during periods of slow growth. Demand-led output growth can also affect the development of productive resources through its inﬂuence on learning by doing. As the expansion of demand and output increases productive activity, it will also increase the amount of learning by doing, and hence the level of factor productivity that is associated with this productive activity. Finally, demand-led growth can directly affect the quantity and productivity of labour resources. The expansion of demand inﬂuences both the size and allocation of the labour force, through its inﬂuence on patterns of migration between regions and between sectors of the economy. Cornwall (1977) argues that vacancy rates rather than relative wages are the key determinant of labour supply; as greater aggregate demand and output increase the demand for labour, the supply of labour also increases. This increased labour supply may arise from changes in labour force participation rates in the short run. In the long term, it is sustained by the impact of employment growth on regional migration patterns. At the same time, an environment of unbalanced growth causes labour resources to be reallocated among different sectors of the economy (agriculture, industry and services) in which the levels and rates of growth of labour productivity differ. This process of sectoral labour reallocation impacts the overall (economy-wide) rate of productivity growth, and in a manner
10 The inﬂuence of demand and output growth on the quantity of investment may be complicated and even exacerbated by discontinuities due to the ‘lumpiness’ or indivisibility of capital. Indivisibilities mean that particular vintages of capital and the techniques of production they embody only become viable at certain discrete levels of output. Otherwise, capital is chronically underutilized.
that is sensitive to both the overall growth rate and the sources of this growth (Cornwall, 1991; Cornwall & Cornwall, 1994).
2.3. Reconciling the Rates of Growth of Supply and Demand
It should be obvious by now that, whereas neoclassical growth theory posits the operation of Say’s law in the long run (demand adjusts passively towards supply-determined potential output), demand-led growth theory postulates the operation of ‘Say’s law in reverse’ (Cornwall, 1972). Through changes in utilization rates and the impact of demand on the availability and productivity of factor inputs, supply adjusts to accommodate the growth of demand, which is the proximate source of the growth of output. However, this emphasis on the demand side and the resulting conception of growth as a demand-led process does not imply that the supply side can be neglected altogether. Apart from the importance of detailing the processes by which supply responds to demand, there is the question of how, if at all, the rates of growth of demand and supply come to be reconciled. Is the elasticity of supply with respect to demand always equal to one, which a casual interpretation of the ‘Say’s law in reverse’ dictum seems to imply and which must be the case if an economy subject to steady growth is to avoid either growing excess capacity or growing excess demand? When proponents of demand-led growth theory explicitly address this question, their answer is usually negative.11 It is therefore important to investigate not just the response of supply to the growth of demand, but also the relative magnitude of this response, and the question as to what (if any) processes exist that can reconcile the rates of growth of demand and supply so that steady growth is possible without either continually increasing excess capacity or continually increasing excess demand.12
3. Overview of the Symposium
The papers that follow are rooted in different traditions and focus on different issues in the theory of demand-led growth. The paper by Marc Lavoie contributes to the neo-Kaleckian tradition in growth theory, which was pioneered by Harris (1974), Asimakopulous (1975), Rowthorn (1982) and Dutt (1984) and derives from the Cambridge growth theory of Robinson (1956).13 Central to this tradition are two results—the paradox of thrift (an increase in the propensity to save reduces the rates of proﬁt and growth) and the paradox of costs (an increase in real wages increases the rates of proﬁt and growth). These results typically depend on a controversial discrepancy between the actual and target rates of proﬁt. Lavoie’s contribution is to develop a mechanism, based on the conﬂict
See Cornwall (1972) and the paper by Palley in this symposium. This is important even if capitalist growth is understood as being episodic, so that steady growth is conﬁned to discrete historical periods (such as the post-war Golden Age). Even these growth episodes are of sufﬁcient duration to render absurd theoretical outcomes that result in continually increasing excess capacity or demand. 13 See Blecker (2002) for a survey of the history and development of neo-Kaleckian growth theory.
Supply and Demand in the Theory of Long-run Growth
theory of inﬂation, that reconciles the actual and target rates of return in a Kaleckian growth model, without forfeiting either the paradox of thrift or the paradox of costs. A standard Kaleckian growth model is ﬁrst developed. Both the paradox of thrift and the paradox of costs are present, but the actual and target rates of return need not be equal in the long run. When mechanisms that cause the target rate of return to adjust towards the actual rate are introduced, this problem is solved, but at a cost. The paradox of thrift and/or the paradox of costs are wont to disappear. Lavoie then introduces the conﬂict theory of inﬂation, in which inﬂation is a function of inconsistencies in the nominal income aspirations of workers and ﬁrms. He shows that when this model of inﬂation is combined with the standard Kaleckian growth model, the latter exhibits the paradox of thrift. Moreover, when a mechanism that causes the target rate of return to adjust towards the actual rate is introduced, not only are these rates of return equalized in the long run, but the rate of capacity utilization remains endogenous. This ensures that the model also exhibits the paradox of costs. In a paper that picks up from the contributions of Cornwall (1972), and revisits one of the key issues in the theory of demand-led growth discussed earlier, Thomas Palley argues the importance of modelling not just the rate of growth of demand, but also the rate of growth of supply and (crucially) the interaction between the two. This helps render explicit the ‘Say’s law in reverse’ property of demand-led growth models, and also draws attention to the need for the rates of growth of supply and demand to be reconciled if an equilibrium growth path is to be sustainable in the long run. Palley begins by reviewing a number of different models of the supply side, each of which renders a different set of possibilities for reconciling supply and demand growth in the long run. He then demonstrates the importance of these considerations in the context of a neo-Kaldorian balance-of-payments-constrained growth (BPCG) model (Thirlwall, 1979). The BPCG model is shown to be over-determined, giving rise to two rates of growth (a rate of growth of demand and a rate of growth of supply) whose equivalence is a special case. Palley then proposes various resolutions to this problem, based on demand- or supply-side responses to changes in the rate of capacity utilization. For example, it is postulated that the income elasticity of demand for imports may be a negative function of excess capacity. This is because, as excess capacity falls, bottlenecks in domestic industry become more prevalent, and these supply constraints increase the proportion of incremental income that is spent on imports. As a result, the rate of growth of demand that is consistent with a given rate of growth of world income (as determined by Thirlwall’s law) adjusts towards the rate of growth of demand consistent with supply growth, as determined by the rate of growth of the labour force and Verdoorn’s law. The focus of the paper by Sergio Cesaratto, Franklin Serrano and Antonella Stirati is technical change and full employment in a growing economy. The authors argue that, contrary to received wisdom, unless technical change is accompanied by exogenous events or policy interventions that stimulate autonomous demand, long run effective demand failures are likely and technical
change will not be consistent with the maintenance of a full employment growth path. According to neoclassical theory, technical change impacts unemployment in the long run only to the extent that it affects the value of the natural rate of unemployment or NAIRU—by exacerbating skill mis-match problems, or raising the equilibrium real wage set by insiders, for example. If these ‘imperfections’ can be expunged from the labour market, technical change will only have a transitory effect on unemployment. Cesaratto, Serrano and Stirati contend that a long-run theory of effective demand is necessary in order to identify the precise effects of technical change on unemployment. To this end, they develop a ‘super multiplier’ analysis in which the rate of growth of autonomous demand determines the rates of growth of effective demand and productive capacity. This model is then used to study the impact of technical change on the process of accumulation and hence the rate of unemployment. Cesaratto, Serrano and Stirati show that technical change is unlikely to increase the demand-led actual rate of growth and, to the extent that it does, its effects are mediated by factors such as the distribution of income and the system of credit creation. Moreover, there is no guarantee that any increase in the actual rate of growth will be commensurate with the supply-side impact of technical change on the potential rate of growth, as must be the case (ceteris paribus) if the rate of unemployment is to remain constant. The authors conclude by suggesting that more emphasis should be placed on the demand side in analyses of European unemployment, and less attention paid to institutional features of European economies that allegedly impede adjustment to technical change.
4. Final Remarks
The essential purpose of demand-led growth theory is to demonstrate the importance of effective demand in the determination of long-run growth outcomes. As such, it serves as an important antidote to the supply-side vision of the long run propagated by neoclassical growth analysis. But demand-led growth theory also raises issues connected with the distribution of income, the balance of payments, technical change and the reconciliation of demand and supply in the long run that are either peripheral to, or entirely absent from, neoclassical growth theory. It is to the further investigation and development of these issues—as well as to the championing of effective demand as an essential constituent of growth theory—that the papers in this symposium are devoted.
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