According to the balance-of-payments constrained growth model, an expansion of aggregate domestic demand is effective in increasing the long-run rate of growth of an economy to the extent that the performance of the external sector validates it. While the performance of the domestic economy is intertwined with that of the external sector, the balance-of-payments constraint on growth does not make these relationships explicit. This document addresses this issue and proposes a framework to make explicit the investment requirements with balance-of-payments constrained growth. This is done in two steps.
The document first develops a theoretical framework to explicitly bring to light the investment requirements consistent with the balance-of-payments constraint. Second, it proposes a stock-flow model comprising five sectors (households, firms, government, commercial banks, and the external sector) to analyse the relationships between the external sector and commercial banks and the performance of the domestic economy, including investment.