ECONOMIC GROWTH, THE BALANCE OF PAYMENTS AND THE REAL EXCHANGE RATE IN A SMALL OPEN ECONOMY: THEORY AND EMPIRICAL EVIDENCE

One of the debates in the recent literature of international trade theory is over the question of the effect of an economy's growth on its balance of payments. Mainly, two conflicting views exist on the subject. One of the views argues that economic growth, by creating excess demand for imported goods, leads to the deterioration of the balance of payments. The other view, on the contrary, basing its argument on the need for stock adjustment in the demand for money as the economy grows, claims that economic growth per se does not lead to the balance of payments deficit. The common premise for both views is that all goods are tradables. Thus both views ignore the price effect that may arise in the presence of nontraded goods.;The present study examines the effect of economic growth on the balance of trade, the balance of payments, the real exchange rate and the domestic consumption level of the traded good in the presence of nontradables in the context of a small open economy with fixed nominal exchange rate and sector-specific capital. The analysis consists of a real model, a monetary model and an empirical study. The real model investigates the impact effects of economic growth on the balance of trade, the real exchange rate and the domestic consumption level of the traded good. The growth effect on the real exchange rate is negative whereas it is positive on the balance of trade and the domestic consumption level of the traded good.;In the monetary model, the relationship between economic growth and the balance of payments is re-examined under the gross substitutability assumption of all goods including money. The comparative static conclusion is in general ambiguous in this case.;In the empirical study, the theoretical results are tested using pooled cross-section and time-series data from some developing countries. The regression results show that all the parameter estimates have the expected signs and are significant at least at the 5 percent level except that of the estimate of the slope coefficient of the real exchange rate.