Reconciling Supply and Demand: New Evidence on the

Adjustment Mechanisms Between Actual and Potential

Growth Rates
Arthur B. Cordeiro
Department of Economics, Federal University of Minas Gerais (UFMG).
Email: arthurbouchardet@gmail.com

João P. Romero
Department of Economics, Universidade Federal de Minas Gerais (UFMG), and Centre for Regional
Development and Planing (CEDEPLAR).
Email: jpromero@cedeplar.ufmg.br
INTRODUCTION
o Supply-oriented growth theories:
• Focus on the development of productive factors
• Assumes demand is infinitely elastic in the long-run

o Demand-oriented growth theories:

• Focus on demand constraints
• Assumes supply is infinitely elastic in the long-run
INTRODUCTION

o Disequilibrium:
Growth of Supply > Growth of Demand Secular trends in
the rate of capacity
Growth of Supply < Growth of Demand utilization
o Equilibrium:
Growth of Supply = Growth of Demand
THE POTENTIAL RATE OF GROWTH

The Solow model describes the growth rate of the productive

factors, which is called potential rate of growth

• Fundamental Equation: 𝜅ሶ = 𝑠𝐹 𝜅 − 𝑛 + 𝛿 + 𝑎 𝜅

𝐾ሶ
• Growth in the Steady State: y= =𝑎+𝑛
𝐾
THE ACTUAL RATE OF GROWTH
The actual growth rate can be constrained by the growth of
demand, diverting from its potential value
𝜀𝑧
• Thirlwall’s Law: 𝑦𝐵𝑃 =
𝜋

• Correspondence between the actual rate of growth and the

growth rate consistent with balance of payments equilibrium
𝑦𝑎 = 𝑦𝐵𝑃
ENDOGENIZING THE POTENTIAL
RATE OF GROWTH
• Kaldor (1966) called attention to the evidence of a positive
effect of actual output growth on the growth of productivity.
• Verdoorn Law: 𝑎 = 𝑎0 + 𝜆𝑦𝑎

• The Verdoorn Law makes the potential rate of growth endogenous

in relation to the actual rate of growth.
𝑦𝑝 = 𝑛 + 𝑎0 + 𝜆𝑦𝑎
• Endogenizing the potential rate of growth relative to the
actual rate of growth does not solves the reconciliation
problem

• Steady State Condition: 𝑦𝑎 = 𝑦𝑝 = 𝑦 𝑛 + 𝑎0

𝑦=
1−𝜆
• Equation for Endogenous 𝑦𝑝 : 𝑦𝑝 = 𝑛 + 𝑎0 + 𝜆𝑦𝑎

𝜀𝑧 𝜋 𝑛 + 𝑎0
• Now, using y=
𝜋
𝑧=
𝜀 1−𝜆
RECONCILING MECHANISMS
The endogeneization of the income elasticity of demand relative
to the rate of capacity utilization
𝑌𝑎
o Rate of Capacity Utilization: 𝐶=
𝑌𝑝

o Positive relation between 𝜋 and

VZZZ 𝐶 :

• 𝜋=𝜋 𝐶
𝑑𝜋
• = 𝜋′ > 0
𝑑𝐶
o Imports are driven by bottlenecks
o As 𝐶 increases, a higher share of income increments would be
spent on imports
Source: Authors’ elaboration based on Setterfield (2006).
RECONCILING MECHANISMS
The endogeneization of the Verdoorn Coefficient relative to the
rate of capacity utilization
o Positive relation between 𝜆 and 𝐶 :
• 𝜆=𝜆 𝐶 VZZZ
𝑑𝜆
• = 𝜆′ > 0
𝑑𝐶

o Investment spending is reduced by low levels of 𝐶

o Excess capacity in the economy reduces incentives for firms to
engage in innovative activity
Source: Authors’ elaboration based on Setterfield (2006).
EMPIRICAL ANALYSIS
Estimating changes in the rate of capacity utilization

o The potential rate of growth was estimated using a methodology

proposed bt Leon-Ledesma and Thirlwall:
• 𝑦 = 𝛽0 − 𝛽1 Δ%𝑈

• 𝑦𝑝 = 𝛽0 .

o The avarage diference between this estimative and the one

obtained by Okun’s Law is only 0,38%
EMPIRICAL ANALYSIS
Estimating the endogeneity of the income elasticity of demand
for imports
𝑃𝑓 𝐸
• 𝐼𝑚𝑝𝑜𝑟𝑡 𝑑𝑒𝑚𝑎𝑛𝑑 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛: 𝑙𝑛 𝑀 = 𝛽01 + 𝛽11 𝑙𝑛 + 𝛽21 ln 𝑌 + 𝑢1
𝑃𝑑

• 𝐷𝑢𝑚𝑚𝑦: 𝐷 = 1 𝑖𝑓 𝑐 > 0; 𝐷 = 0 𝑜𝑡ℎ𝑒𝑟𝑤𝑖𝑠𝑒

• 𝛽21 = 𝛽31 + 𝛽41 𝐷

• 𝑙𝑛 𝑀 = 𝛽01 + 𝛽11 𝑙𝑛 𝑃𝑃𝑃 + 𝛽31 ln 𝑌 + 𝛽41 ln 𝑌 𝐷 + 𝛽51 𝐷 + 𝑢1

EMPIRICAL ANALYSIS
Estimating the endogeneity of the Verdoorn Coefficient
• Labor productivity = real economic output per labor hour
𝑎 ≡ 𝑦𝑎 − 𝑙
𝑎 = 𝑎0 + 𝜆𝑦𝑎 Endogeneity

• Solving the problem:

𝑙 = −𝑎0 + 1 − 𝜆 𝑦𝑎
where the estimative of 𝛽12 will be equal to
𝑙 = 𝛽02 + 𝛽12 𝑦𝑎 + 𝑢2
1−𝜆
EMPIRICAL ANALYSIS
Estimating the endogeneity of the Verdoorn Coefficient

• 𝐼𝑛𝑐𝑙𝑢𝑑𝑖𝑛𝑔 𝑡ℎ𝑒 𝑑𝑢𝑚𝑚𝑦 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒: 𝜆 = 𝛽22 + 𝛽32 𝐷

• 𝑙 = 𝛽02 + 1 − 𝛽22 𝑦𝑎 − 𝛽32 𝑦𝑎 𝐷 = 𝛽02 + 𝛽42 𝑦𝑎 + 𝛽52 𝑦𝑎 𝐷 + 𝑢2

• 𝐹𝑖𝑛𝑎𝑙 𝑚𝑜𝑑𝑒𝑙: 𝑙 = 𝛽02 + 𝛽42 𝑦𝑎 + 𝛽52 𝑦𝑎 𝐷 + 𝛽62 𝐷 + 𝑢2

• 𝜆 = (1 − 𝛽42 − 𝛽52 𝐷).

EMPIRICAL ANALYSIS
Econometric Strategy
System Generalized Method of
Moments
• Deals with the problem of
simultaneity
• Suitable for panels with
small T and large N
Pooled Mean Group
Estimator
• Accounts for heterogeneity
in the coefficients of the
explanatory variables across
countries
• Suitable for panels with
large T and large N
Table 1. Summary of data, codes and sources

Estimating Capacity Utilization

Code Variable’s description Source
World Bank national accounts data, and OECD
rgdpg Real GDP growth (annual %)
National Accounts data files.
Percental Variation in
International Labour Organization, ILOSTAT
v_unempl Unemployment, total (% of total
database.
labor force)
prg Potential Rate of Growth Estimated as explained in section 4.0
Variation in the Rate of
v_rcu Estimated as explained in section 4.1
Capacity Utilization
Estimating Elasticity of Demand
World Bank national accounts data, and OECD
rgdp GDP (constant 2010 US$)
National Accounts data files.
Imports of goods and services World Bank national accounts data, and OECD
rimport
(constant 2010 US$) National Accounts data files.
PPP conversion factor, GDP World Bank, International Comparison Program
ppp
(LCU per international $) database.
Estimating the Verdoorn Coefficient
Number of persons engaged (in
emp Penn World Table 9.0
millions)
Average annual hours worked
avh Penn World Table 9.0
by persons engaged
Labor Productivity, in mil.
lp Defined as rgdp/(emp*avh)
2011US$
Growth rate of total working
twhg Defined as the growth rate of emp*avh
hours
Source: Authors’ elaboration.
RESULTS
 Table 2. Testing for the Endogeneity of the Income Elasticity of Demand for Imports
Independent Variable:
OLS SYS-GMM PMG
Log of Real Imports
Log Real GDP 1,750*** (0,078) 1,245*** (0.207) 0,813*** (0,074)
Log PPP 0,050** (0,020) 0,568 (0.364) 0.068*** (0,018)
Interaction GDP(Dummy) -0,012 (0,007) -0,020 (0.046) 0,025 (0,076)
Dummy 0,334* (0,195) 0,564 (1,281) -1099,800 (.)
Constant -21,358*** (2,085) -8,672 (6,142) -
Error Correcting Term - - -0.096*** (0,027)
Nº of Observations 871 871 833
Prob > F 0,000
Nº of Instruments - 11 -
Hansen J Statistic - 11,153 -
Arellano-Bond AR(2) Test - 0,732 -
Note : Standard errors in parenthesis. Significance: * p<0.10, ** p<0.05, *** p<0.01.
Source: Authors’ elaboration.
 Table 3. Testing for the Endogeneity of the Verdoorn Coefficient
Model OLS SYS-GMM PMG
Independent Variable Total working hours growth Total working hours growth Total working hours growth
GDP Growth 0,540*** (0,078) 0,692*** (0.164) 0,723*** (0,042)
Interaction GDPg(Dummy) -0,189*** (0,061) 0,085 (0,233) -0,348*** (0,069)
Dummy 0,004 (0,003) -0,015* (0,009) -3,419*** (0,503)
Constant -0,002 (0,001) -0,002 (0,002) - -
Error Correcting Term - - -0,856*** (0,045)
Nº of Observations 874 874 798
Prob > F - 0,000 -
Nº of Instruments - 16 -
Hansen J Statistic - 11,385 -
Arellano-Bond AR(2) Test - 1,676 -
Note : Standard errors in parenthesis. Significance: * p<0.10, ** p<0.05, *** p<0.01.
Source: Authors’ elaboration.
CONCLUSION
The results point to a demand determination of long-run growth

Moreover, the results also point to the existence of other

adjustment mechanisms falling on the potential rate of growth.

If growth is led by demand, then constraints on demand such as

market uncertainty, credit rationing and balance of payments
disequilibrium are the main barriers to economic development.