The Balance-of-Payments (BoP) constraint is one of the most important determinants of growth in developing economies. More specifically, since developing countries cannot issue the international currency and usually face liquidity constraints in international financial markets, they tend to adjust their current account to the availability of foreign finance. In such a process, both the exchange rate and the GDP growth rate are constrained to produce the adjustment of the current account to the international financial conditions.
Most models of the balance-of-payments (BoP) constraint on growth assume that the income elasticities of exports and imports are given in the long run, so that the growth rate of the GDP of the constrained economy is determined by the growth rate of the world income. In gap models the income elasticity is set equal to one, whereas in Thirlwall's Law and its extensions such a parameter is assumed to be constant but not necessarily equal to one.
The long-run determination of GDP growth by the growth rate of world income does not exclude the possibility of deviations between these two variables in the short run, since capital flows can raise or lower the BoP independently of trade flows. In fact, the most recent versions of the BoP constraint are focused on the link between current-account imbalances, foreign-debt accumulation, international reserves and financial fragility.
The role of real exchange rates is obviously crucial in the operation of the BoP constraint, but in most studies of the topic this is not usually stressed on the assumption that some sort of purchasing-power parity holds in the long-run. In contrast, in short-run models of financial fragility, the real exchange rate plays a central role in the determination of growth and inflation.
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Exchange Rates, Growth and Inflation
