Growth rates constrained by internal and external imbalances: a demand orientated approach.

Abstract

Thirlwall’s Law considers that growth can be constrained by the balance-of-payments when the current account is in permanent deficit. The Law focuses on external imbalances as impediments to growth and does not consider the case where internal imbalances (budget deficits or public debt) can also constrain growth. The recent European public debt crisis shows that when internal imbalances are out of control they can constrain growth and domestic demand in a severe way. The aim of this paper is to fill this gap by developing a growth model in line with Thirlwall’s Law that takes into account both internal and external imbalances. The model is tested for Portugal that recently fell into a public debt crisis with serious negative consequences on growth. The empirical analysis shows that the growth rate in Portugal is in fact balance-of-payments constrained and the main drawback is the high import elasticity of the components of demand and in particular that of exports.internal and external imbalances, import elasticities of the components of demand, equilibrium growth rates, 3SLS system regressions.