ABSTRACT
According to Thirlwall’s well-known model of balance of payments constrained growth, output growth is demand-determined, provided demand is below supply capacity, which is normally the case in capitalist economies. However, the balance of payments situation can restrict the growth of aggregate demand because a country cannot persistently undergo an ever-increasing current account deficit. From this general idea, “Thirlwall’s Law” is derived as follows. Let y stand for the rate of growth of domestic real income compatible with exter-
nal equilibrium. It can be shown that the following relation holds (see, Thirlwall, 1999 or Heike, 1997, for details):
y = (1+ η + ψ)( pd − pf − e)+ εz π
, (16.1)
where z is the proportional rate of growth of world real income; η(<0) and ε(>0) are the price and income elasticity of exports; and ψ(<0) and π(>0) are the price and income elasticity of imports. Also, pd is the rate of growth of the average price of exports, pf is the rate of growth of the average price of imports in foreign currency, and e is the rate of growth of the nominal exchange rate (say, pesos per dollar). Now suppose, following McCombie and Thirlwall (1994), that the real terms
of trade, or real exchange rate (RER), remains constant in the long run – that is, ( pd − pf − e) = 0. Then equation (16.1) becomes:
y = εz π , (16.2)
or (on the same assumption):
y = x π . (16.3)
This last equation has come to be known as “Thirlwall’s Law.”
