The Balance of Payments Constraint: Export Growth Over Income Elasticity of Imports

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What we are talking about:

The balance of payments (BP) constraint on growth is usually associated with Thirlwall’s (1979) model, which imposes balanced trade as a necessary long-run 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.

Barbosa-Filho in "The balance of payments constraint: from balanced trade to sustainable debt", in "Essays on Balalnce of Payment Constrained Growth. Theory and Evidence, Mccombie, Thirlwall, 2004

In both the international economics and economic developmentliteratures, it has been noted that there is a tendency for the income elasticity of import demand to rise over time. In the first part of the paper, data from a large sample of countries is used to show that this tendency seems to be a general phenomenon. However, the previous studies on this issue have not offered a general explanation of this tendency. The second part of the paper develops a general explanation of why the income elasticity of import demand rises with the level of GDP per capita. The starting point of the analysis is that the process of economic development normally is associated with a rising share of manufacturing in GDP. In turn, this tends to increase the share of manufactured relative to nonmanufactured imports. Given that the income elasticity of import demand is higher for manufactured than nonmanufactured imports, the changing composition of imports increases the overall elasticity of import demand. The empirical results indicate that this is a plausible explanation for why the income elasticity of import demand rises with the level of GDP per capita.

Lo, Sawyer, Sprinkle