ABSTRACT
One of the main aims of growth theory has been to explain why growth rates differ across countries and over time. The pioneering studies trying to answer this question were based on a neoclassical framework and, as a result, concluded that most growth differences could be explained by the diversity of growth rates of the inputs that made up the production function. In recent years, a new approach, the so-called endogenous growth theory, has stressed the role played by the production function. Thus, endogenous growth theorists argue that not only does growth vary across countries because of their dynamic resource endowment, it also varies to an important extent according to the form of the production function. Both approaches, however, are supply-side oriented and give no role to demand. When a country has factors to be employed and a production function, it is assumed that it will grow and no attention needs to be paid to where the goods produced are consumed. Nevertheless, this is only true under the unrealistic assumption that there is only one sector in the economy. In a previous study, one of the authors showed that, in an economy with more than one sector and different degrees of returns to scale, demand plays a crucial role in growth since it affects the endogenous process.1 Thus, in order to explain why growth varies across countries and over time, it is necessary to pay attention not only to the discrepancies in the growth of inputs and to the shape of the production function but also to the form of the demand function. This being true for a closed economy, it also holds for an open economy. In order
to grow, a country that trades with the rest of the world not only needs inputs. It also needs to be able to sell the new goods produced. Because of the structure of consumption, a country cannot consume every new good produced and it needs to exchange some of them for other goods that better fit domestic demand patterns. Since in a pure neoclassical framework every country can sell the goods produced at the international price, this fact does not add anything new to the standard onesector theory. But if price elasticity is not infinite, the country must reduce either the selling price – thus worsening the terms of trade – or potential output.
