The balance of payments constraint: from balanced trade to sustainable debt
The balance of payments (BP) constraint on growth is usually associated with Thirlwall’s (1979) model, which imposes balanced trade as a necessary longrun constraint on open economies. According to Thirlwall’s Law, international capital flows and interest payments balance out during long intervals of time so that, given a stable real exchange rate, the long-run growth rate of a small open economy is limited by the growth rate of its exports divided by the income elasticity of its imports. Independently of whether such an empirical law holds for some sufficiently long intervals of time, in practice open economies may take several years to show balanced trade and, in the meanwhile, capital flows and interest payments are an important part of the BP constraint. To deal with capital flows, Thirlwall and Hussain (1982) extended Thirlwall’s
(1979) original model to allow trade deficits and showed how the growth rate of a small open economy may also be constrained by capital inflows in addition to trade factors. However, a particular characteristic of their extension is that
although it allowed for nonzero capital inflows, it imposed no restriction whatsoever on their trajectory except for the balance-of-payments accounting principle, which forces debit and credit items to cancel out.