Despite the important role of demand constraints in development theory, the growth literature since the 1980s has been dominated by models that exclusively focus on supply constraints as an explanation for the differential growth performance across nations. The main policy question, however, is whether the stylised facts of growth fit the theoretical predictions of supply-oriented models.

One of the objectives of this paper is to develop an empirical hypothesis to test whether supply-oriented models correctly predict long-run growth shifts in developing countries. Both neoclassical and endogenous growth models assume that there is always sufficient demand to match greater supply capacity – saving always finds investment outlets and cannot be constrained by deficient demand. Formally, this implies that saving determines investment across different growth regimes, so that permanent shifts from slow-growing regimes to fast-growing ones result from pure supply-side shocks.

The analysis also offers an alternative hypothesis in which growth shifts are explained by demand shocks. Demand-driven models in the post-Keynesian/structuralist tradition postulate that entrepreneurs base their investment decision on expected future demand. Sluggish growth may dampen expectations of future demand and suppress investment below the rate required to achieve the natural or optimum growth rate. In short, empirical support for demand-oriented models would show that investment determines saving through per capita income changes during slow growing regimes.                 

Data/Methods

Given the prime importance of the saving-investment causality debate for policy analysis, this paper proposes a novel methodology to test causality in a trivariate model that includes the saving rate, investment rate and per capita income. The analysis draws a clear theoretical distinction between the saving-investment causality debates in an open- and closed-economy context. This theoretical distinction, in turn, allows saving and investment equations to be identified in a structural cointegrating vector autoregressive framework, and long-run causality inferences can be drawn in a systematic way taking into account the various constraints borrowers face from both domestic and foreign lenders.

The foregoing methodology is used to re-examine the causes of India’s extraordinary growth transition since the early 1980s. It is argued, however, that growth narratives of the Indian economy have tended to focus on supply-side explanations, while the role of demand in its growth transition has generally been neglected.

Results

In sharp contrast to the standard accounts, the results in this paper show that demand played a crucial role in India’s growth transition – both during the 1980s and post-1991 liberalisation period. In the ‘slow’ growing period before 1980, demand imposed a permanent constraint on growth, with investment determining saving. A sustained growth transition would therefore have required a permanent shock to demand. The results further show that the shock to demand was large enough to fully absorb India’s productive potential. Because the pre-conditions necessary to sustain large increases in demand (as observed in India) are not characteristic features of many developing countries, the Indian experience provides valuable policy lessons for other stagnant economies with demand constraints.