The Balance of Payments Constraint as an Explanation of International Growth Rate Differences ‘he neo-classical approach io the question of why growth tates differ between countries, typified by the meticleu eaten of Denison £3] [4] and Maddison (7) 8), Fine of the economy using the concept of the production anes Having specified the functional form, the growth of output is appor. tioned between the growth of labour, While the ma precise, it does rents why the growth of factor supplies and productiegy die between countries, To answer this question some would say the ‘more is resses demand The question then becomes. why docs demand gov ifferent rates between countries? One explanation may be the inability of capa iBGnts. Patticuaely governments, to expand demand, Ths explanation by itself, however, is not very stistanons The more probable explanati i46 Banca Nezionale del Lavoro In fact, the rate of growth of exports divided by the income elasticity of demand for imports gives such a good approximation to the actual growth ‘expe. rience of major developed countries since 1950 that a new economic law might almost be formulated here ate a number of possible mechanisms through which this may happen: the encouragement to investarene which would augment the capital stock and bring with it technolo. sical progress; che supply of labour may inctease by the entry inte the workforce of people previously outside or from abroad, the mo vement of factors of production from low productivity 10 high pro- Guctivity sectors, and the ability to import more may ineveare capa- city by making domestic resources more productive. Te is this argu. iment that lies behind the advocacy of exportied growth, because is is only through the expansion of exports that the growth rave ean be raised without the balance of payments deteriorating at the same time. Believers in exported growth are really postulating a balance of payments constraint theory of why growth rates differ Ih should be stressed, however, that the same rate of export growth in different countries will nor necessarily permit the same rate of growth of Sutput because the import requirements associated with growth will differ berween countties, and thus some countries will have to cons: {fain demand sooner than others for balance of payments equilibiem The relation between a country's growth rate and its rate of of i income elastici i‘The Balance of Payments Constmint et ” ‘The Determination of the Balance of Payments Equilibrium Growth Rate Balance of payments equilibrium on current account measured in units of the home currency may be expressed as Pak = Poles, wo where X is the quantity of exports; Pa is the price of exports in home ccarzency; M is the quantity of imports; Pris the price of imports n foreign currency; Eis the exchange rate (ie. the home price of foreign currency), and tis time In a growing economy, the condition for balance of payments equi- librium through time is that the rate of growth of the value of exports equals the rate of growth of the value of imports ive. pa to = pe bm te (2) where lower-case letters represent (continuous) rates variables. ange of the Using standard demand theory, the quantity of imports demanded may be specified as a multiplicative function of the price of imports (ineasured in units of the home carrency in order te incorporate the ct of exchange rate changes), the price of import substitutes, and ' domestic income. ‘Thus { My = (PeEs)*Pte Ye 6) where Wis the own price elasticity of demand for imports (¥ < 0}; is the cross clasticity of demand for imports (> 0); Y is domestic income, and 7 is the income elasticity of demand for imports (= > 0). The rate of growth of imports may be written: m= Ype) + Mle) + Mpa) + ve cy ~ where lower-case letters again represent continuous rates of change of the variables, “The quantity of expotts demanded may also be expressed as a multiplicative function in which the arguments in the demand function fare: the price of exports measured in foreign currency (to capture the8 Banca Nazionale del Lavoro cffect of exchange rate changes), the price of goods competitive with exports, and the level of world income, Thus: x= (PV mz. 5 ars & where X: is the quantity of exports; Pa is the domestic price of exports; Pais the price of goods competitive with exports; Z ts the level of world income; 1/6 is the foreign. price of home cutreney; 45 the own price elasticity of demand for exports {n <0); & is the eross elasticity of demand for exports (3> 0); fis the income elsticity of demand for exports (e > 0), and tis time ‘The rate of growth of exports may be written: X= n{Px)— led + lpn + ela) 6 Substituting equations (4) and (6) into (2), we can solve for the rate of growth of domestic income consistent with balance of payments equ Hbeium which we shall call the balance of payments ecuilibieg stowth rate, ya, pall +} — pal 1 34+¥) — {1 t+y+¥) + a(x) rea) = omembering the signs of the parameters (n<0; D> 0; 2>0; F< 0; ¢>0, and > 0), equation (7) expresses several familie: economic propositions (i) Inflation in the home country will lower the balance of peyiments equilibrium growth rate ifthe sum of che own price elastiiey of demand for exports and the cross elasticity of demand for impor '8 greater than unity in absolute value (ie if jy + | > 1) (i Inflation abroad will improve the home country’s balance of payments equilibrium growth rate provided the sum of the one price elasticity of demand for imports and the cross elasticity of demand for exports is greater than unity in absolute value (ie, of iit) Devaluation or currency depteciation, ie. a rise in the home price of foreign currency (e.> 0), will improve the balate of payments equilibrium growth rate provided the sum of the awa price elasticities of demand for imports and exports exceeds unity in absolute value, which is the socalled Marshall-Letner condition (ic. if fn + ¥I> 1). Notice, however, the important point that a oaceforall depreciation of the currency cannot wise the belance of‘The Balance of Payments Consuaine ete 6 cerments equilibrium growth rate permanently, After the initial -preciation, ¢: = 0, and the growth rate would revert to its former ‘l, To taise the balance of payments equilibrium growth rate pet- sancntly would requiee continual depreciation ie, e > 0 in successive ds. (iv) A faster growth of world income will raise the balance of payments equilibrium growth rate. (») The higher the income elasticity of demand for imports (=), the lower the balance of payments equilibrium growth rate. Empirical Evidence The interesting question is how well does the actual growth experience of countries approximate to the balance of payments equi- librium growth raze? There may, of course, be an asymmetry in the system. While a country cannot grow faster than its balance of pay- ments equilibrium growth rate for very long, unless it can finance an ever-growing deficit, there is little t0 stop a country growing slower and accumulating latge surpluses. This may particularly occur where the balance of payments equilibrium growth rate is so high that a country simply does not have the physical capacity to grow at that race, This typifies many oil producing countries and would also seem to typify the experience of Jepan, as we shall see below, To calculate che balance of payments equilibrium growth sate from equation {7) for a number of countries requires a substantial amount of data and estimates of parameters which are not readily available. If the usual assumption is made, however, that the owa price elasticities of demand for imports and exports are equal to the cross elasticities (¥ = P and y, = 3), equation (7} becomes: _ + 4") (pa = pee) + ef) yee (8) which, if the’ Marshall-Lctnet condition is just satisfied or if relative prices measured in a common currency do not change over the long run, reduces to: % yo (using equation (6) } 9)con 7 Banca Nazionale del Lavoro Many models (see [1] (9]}, and the empitical evidence, suggest that ‘over the long period there can be little movement in relative inter- national prices measured in a common currency, either because of arbitrage (the law of one price) or because exchange depreciation forces up domestic prices equiproportionately so that in the long run (pa — pee) & 0. Applying equation (9) to international data gives a remarkable approximation to the growth experience of maay countries over the last twenty years, and ipso facto provides an explanation of why growth raies differ. It might almost be stated as a fundamental law that, except where the balance of payments equilibrium growth rate exceeds the maximum feasible capacity growth rate, the tate of growth of a country will approximate to the ratio of its rate of growth of exports and its income elasticity of demand for imposts. The approximation itself vindicates the assumptions used to arzive a: che simple rale in equation (9). The hypothesis is tested on two sets of data on the growth of output and exports: one for the period 1953 to 1976 [6], and the other from a different source [2] for the period 1951 to 1973.) On the income elasticity of demand far imports, Houthakker and Magee’s estimates [5] have been taken as applying to the whole of these periods even though they were only estimated over the period 1951 to 1966, They are the best consistently estimated inter- national estimates available, but are probably now on the low side, ‘The data, and the results of applying equation (9), ate presented in tables 1 and 2. Tn both tables there is a general tendenéy for the estimates of the balance of payments equilibrium growth rate to be higher than the actuel growth rate, which, if true, would produce a balance of payments surplus. For countries which bave built up suc- pluses, the estimates are consistent with the empirical evidence. Japan is a striking example of a country where the gap between its actual growth rate and its balance of payments equilibrium growth rate has resulted in the build up of a huge payments surplus. Presumably Japan could not grow faster than it did because of an ultimate capacity ceiling. But Japan still grew considerably faster than other countries because demand wes unconstrained and induced its own supply of factors of production. For countries which have moved into deficit cover the period, the estimate of their balance of payments equilibrium growth rate must be too high, As suggested cbove, this may be 2 T did not want to be accused of choosing the eousce to suit che argument?CALCULATIONS. United Kingdom | 271 United Kingdom SA, CALCULATIONS OF THE GROWTH RATE CONSISTENT WITH BALANCE, ‘OF PAYMENTS EQUILIBRIUM 19511973 USING DATA GIVEN BY CORNWALL 12} 51 107 na 4a 94 134 py 6 120 az oi 1 50 1 192 37 108 39 31 a 23 35 134 123 30 101 182 2 73 140 25 a ta see ¢ i eeeeat cates ans, | 2 347. Sores Comreice [2], #12 fone sean Abbe “he Balane of Pyisnts Constant x anus 1 Of THE GROWTH RATE CONSISTENT WITH BALANCE (OF PAYMENTS EQUILIBRIUM 19531976 T-. | oh |e) = | a lanes Bigtcty, Puan ote ce, | HE | Bees wale | ONSET | Sine | cane | bce | eubacteria eee aa re Si as cr 33 493 12 3 367 1% iar a | te saz Se | ) ie 3 5 530 6 as | | 23 sar 358 iso 38 as | is 350 to re 06 aor 133 Bas sar Fy i jt a ior | ts iB 594 oe iz a te = Sor of at: Kw (8), ant Homan an Mc {3 ‘Tams 2 4g iB 4s 300 37 520 232 335 sy 2H 53822 ance Nezionsle del Lavoro because the assumed income flasticity of demand for imports is an Uadderestimate for the period jacething into the late 19605 ant spite the overestimation of the balance of payments equili. brium Stowth rate in fome cases, and the fact that some countries rank wow slower and build up payment surpluses, nonetheless the Zunk conelations between the pies Brow rates from applying Siz Simple rule and the actual greece rates ate very high for bork rank opatt.. For the sample of contr in table 1 the Spearman Conclusion“the Balince of Payments Consttaot ete 3 and the countzy’s propensity to import. For countries with a slow ae growth of exports, combined with a relatives hhigh income rae Sie of demand for imports, the message i, plain: the goods Soduced by the country ate relatively unatracse St both home srodirond, We have concentiated in this study on growth rate atHerences between developed countries, The argument probably caeeryen.areatcr relevance for developing, countries Canterbury AD, THUREWALL [REFERENCES 1) He}, Boat, T, Burs and J.S.B. Laon, = Thy Rok af esha Rate Chenges Ry Ba, T Byres Aahasinents the UK Cae,” eorowie Jourral, Nace 1977 (21 J. Comvwant, Moder Roberton, 1977. caption Tes Growth and Transformation, Martin ol Sr by Goomth Rates Difers Postwar Experience tw Nine Wesent Foes tne Brookings Tnstiewion, 1967. 4) B, Dowoon and WK. Cone, ow Teper’, ogo i, So Fast: The E, Dense ar Paponsion, The Beackings Tastnrion 1976 {5} HY Movrmaceen and S. Maco, *Iocame and rice Basics ‘Workd Trade” Be ert Economics end Statistics, May 1989. {65 D, Kens, “An Setexttonat Compasivon of Mais ssn ‘Trends 199376" D. Kemcrdminier Bonk Quarterly Reviee, May 8 £7) A Maun, Economie Progen: end Pay Deneoping Cours Allen and Vawia 1970. te] A Mavoisos,“Eaplining Eeonemie Growth.” in tis Kavige, September 1972. {01 3, Watson, “Esfecive Devaluation and Tafaon,” Ostord Economic Papers, Mach 1978