Adjusting Theory to Reality: The Role of Aggregate Demand in Kaldor's Late Contributions on Economic...

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Adjusting Theory to Reality: The Role of Aggregate Demand in Kaldor'sLate Contributions on Economic GrowthAntonella Palumboa

a Dipartimento di Economia, Università degli Studi di Roma Tre, Roma, Italy

To cite this Article Palumbo, Antonella(2009) 'Adjusting Theory to Reality: The Role of Aggregate Demand in Kaldor'sLate Contributions on Economic Growth', Review of Political Economy, 21: 3, 341 — 368To link to this Article: DOI: 10.1080/09538250903073362URL: http://dx.doi.org/10.1080/09538250903073362

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Adjusting Theory to Reality: The Roleof Aggregate Demand in Kaldor’s LateContributions on Economic Growth

ANTONELLA PALUMBODipartimento di Economia, Universita degli Studi di Roma Tre, Roma, Italy

ABSTRACT This paper deals with the analysis of growth and development NicholasKaldor formulated in the later part of his career, during the 1970s and 1980s. Kaldor’spassage from a resource-constrained to a demand-driven conception of growth wasclosely connected to his persistent effort to make economic theory more realistic andrelevant, and led him to a complex vision of the growth process, with historical andinstitutional factors playing a fundamental role. However, the particular formulation inwhich Kaldor expressed his ideas about the strategic role of exports in the growthprocess, namely the long-period foreign trade multiplier, cannot fully capture the maincharacterisitcs of his vision of the growth process, and is in some respectscontradictory with that vision. A critical role is played by Kaldor’s conception of thedeterminants of investment, which, as in his full-employment growth models, he treatsas entirely induced by output growth, and hence as not posing limits, in normalconditions, on output expansion.

1. Introduction

It has been suggested (Targetti, 1991, 2005; Turner, 1993; Thirlwall, 1987) thatNicholas Kaldor’s change of attitude towards the analysis of economic growthin the later part of his life was mainly due to his involvement with economicpolicy. His preoccupation with the problems of the real world and his search fora theory that could offer results of direct applicability to reality were the basisfor the modifications both in hypotheses and in analysis, which mark his contri-butions of the 1970s and the 1980s in comparison to his growth models of the1950s and the 1960s. In his own account, Kaldor (1978, pp. xvii–xx) describesthe approach he followed in this later phase as ‘more pragmatic’: no longeraiming at ‘explanations that derive from a comprehensive model of the system,’in his later work he tries to find ‘what kind of regularities can be detected inempirically observed phenomena’ – what he labels the ‘stylized facts’ – to

Review of Political Economy,Volume 21, Number 3, 341–368, July 2009

Correspondence Address: Antonella Palumbo, Dipartimento di Economia, Universita degli Studi diRoma Tre, Via Silvio D’Amico, 77, 00145 Roma, Italy. Email: [email protected]

ISSN 0953-8259 print/ISSN 1465-3982 online/09/030341–28 # 2009 Taylor & Francis

DOI: 10.1080/09538250903073362

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provide explanations of those regularities, and to find ‘solutions (or remedies) forreal problems.’ It was therefore the search for realism that prompted Kaldor toshift his attention to the economy’s sectoral structure, to the crucial role of man-ufacturing in growth and development, and to the cumulative phenomena thatcause most growth processes (or episodes of decline) to be self-sustaining.

This emphasis on the empirical characteristics of the growth processes is alsothe basis for a central feature of Kaldor’s second-phase analysis of growth, namelyhis abandonment of the idea that growth is constrained by labour scarcity and hispassage to a conception of growth as demand-constrained. Only such a conceptionseems to be compatible with Kaldor’s description of the growth process as an openprocess, in which actual outcomes determine future possibilities; furthermore, hesaw that the idea of resource-constrained growth is contradicted by the consider-able flexibility that the stocks of resources (labour and capital) display, given time,in adjusting to the opportunities of expanding production. Accordingly, Kaldorcame to see growth as limited not by the availability of resources but by thedemand for exports (Kaldor, 1970; 1975a; 1978, pp. xx–xxi).1

This paper is concerned with Kaldor’s explanation of growth as a demand-driven phenomenon and with his particular formulation of such principle. Heexpresses the relationship between exports and output in terms of a long-period‘foreign trade multiplier’ which, we shall argue, is open to objection both initself and as a representation of the general vision of growth Kaldor proposes.

A critical role is played by the analysis of investment decisions, which, as inhis growth models of the 1950s and 1960s, Kaldor treats as entirely induced byoutput growth, and hence as not imposing limits, under ‘normal’ conditions, onoutput expansion. This has two implications, which will be explored in detailbelow. In the first place, Kaldor’s construction is open to an interpretation accord-ing to which growth is not genuinely demand-constrained. In the second place,such an analysis of investment decisions, by establishing a too mechanical depen-dence of capital accumulation on output growth, obfuscates the complex nature ofinvestment decisions and seems particularly ill-suited to Kaldor’s objective ofbuilding a theory that is directly relevant to the analysis of reality.

The paper is organized as follows. Section 2 focuses on the full-employmenthypothesis of Kaldor’s early-phase supply-constrained growth models, and on itsimplications for investment behaviour. These models will only serve as a bench-mark for comparison with Kaldor’s later analysis. The main outlines of his laterapproach will be illustrated in Section 3, while Section 4 focuses on the analyticalrepresentation of the exports–output relationship in terms of the foreign trademultiplier. Section 5 focuses on the saving-investment nexus and on Kaldor’s con-ception of investment, by addressing the elements of continuity on these issuesin Kaldor’s thinking over the different phases of his work. Section 6 brings tothe forefront the implications of that analysis which seem in contrast with the

1Kaldor’s switch to a more pragmatic and policy-oriented analysis of growth dates fromhis 1966 Inaugural Lecture at the University of Cambridge (Kaldor, 1966b), whichdealt with the causes of Britain’s slow growth. As will be illustrated below, however, in1966 he still adhered to the idea of labour-constrained growth.

342 A. Palumbo


possibility of regarding growth as demand-constrained, while Section 7 dwellsbriefly upon the policy implications of Kaldor’s analysis. Section 8 concludes.

2. The Tendency to Full Employment in Kaldor’s Growth Models ofthe 1950s and the 1960s

As is well known, the growth models proposed by Kaldor in the 1950s and the1960s (Kaldor, 1957, 1959, 1961; Kaldor & Mirrlees, 1962) analyse economiesgrowing along full-employment growth paths. The hypothesis of full employmentof labour plays a key role in Kaldor’s (1955–56) theory of distribution, based onthe dependence of the rate of profits on the rate of accumulation: the ‘Cambridge’mechanism of variation in the distributive shares cannot in fact work withoutassuming the inelasticity of the long-period level of output with respect tochanges in aggregate demand.2

In these writings, however, Kaldor did not regard the full-employmentassumption as a purely theoretical abstraction. He believed instead that itdescribed, at least approximately, the usual situation of a growing economy(see, for example, Kaldor, 1957, p. 505). At the time, he interpreted the observablesecular tendency of the demand for labour to grow more or less in step with thegrowth in the available stock of labour as reflecting an inherent tendency of thedemand for labour to adjust to existing supply, so that, he believed, ‘forcesmust have been at work . . . in such a way as to yield an equilibrium level ofemployment that was fairly close to, if not equal to, the full-employment level’(Kaldor, 1959, p. 214). Growth could thus be conceived as a resource-constrainedphenomenon, determined by the growth of population and the rhythm of technicalprogress. This tendency to full employment is strictly connected, in Kaldor’s view,to the way investment decisions react to changes in output.3

Kaldor treats investment as a function of output, aimed at building capacityin order to bring the actual capital stock to the desired level (Kaldor, 1957,pp. 600–601). Each increase in output brings about an increase in investment,

2The essential role of the assumption that output is inelastic with respect to demand in theKaldor–Robinson (or ‘Cambridge’) theory of distribution has been noted by Vianello(1985), Ciccone (1986), Kurz (1986, 1990), and Garegnani (1992), among others.While, in Kaldor, such inelasticity derives from the full-employment hypothesis, in theversion of the Cambridge theory proposed by Robinson (1956, 1962) and Kahn (1959)it comes from the hypothesis that normal utilization of capacity prevails continuously.For a critical assessment of the Kaldor–Robinson theory of distribution pointing outthe wide margins of long-run variability of output in response to demand, see especiallyGaregnani (1992). On the origins of the supposed inelasticity of output in the steady-state assumption see Vianello (1985).3The differences between the various growth models presented by Kaldor in the 1950s and1960s are not relevant to the issues discussed in this paper. The models differ with respectto the specification of the various functions, and the exogeneity (as in Kaldor, 1955–56) orendogeneity (as in Kaldor, 1957) of the ‘natural’ rate of growth, but they all have incommon the Cambridge theory of distribution and the full-employment hypothesis, aswell as the justification of the latter.

Adjusting Theory to Reality 343


which would normally ‘exceed the increase in saving for any given distribution ofincome’ (Kaldor, 1961, p. 200); thus entailing an excess of aggregate demand,which produces further increases in output and again in investment, in a cumulat-ive process of expansion that Kaldor regards as typical of a growing economy.4

In a number of papers following the first statement of the Cambridge theory ofdistribution (see especially Kaldor 1959, 1961), he explicitly describes this ten-dency in terms of a multiplier-accelerator mechanism that would generate anexplosive dynamics of output if not for the operation of two counteractingfactors: a shortage of labour which sooner or later limits the attainable rate ofgrowth; and the ‘Cambridge’ mechanism in which changes in the price/wageratio adjust the share of saving in output to ensure stability of the full-employmentpath (Kaldor & Mirrlees, 1962, p. 175).

The responsiveness of investment to output thus plays a dual role in Kaldor’searly-phase analysis of growth: it ensures both the endogenous creation of thestock of capital needed for production and the creation of enough aggregatedemand in the course of the expansion process to absorb the increases in capacityoutput. At times, excessive growth of capacity may dry up new investment oppor-tunities and make the system tend towards a stable under-employment equilibrium(Kaldor, 1957, p. 594); but this is only transitory in Kaldor’s view: as soon asexcess capacity disappears and the profitability of investment revives, no under-employment equilibrium can persist, and the economy will start again explodingtowards full employment.5

The justification Kaldor offers for the full-employment assumption is thusentirely different from the neoclassical mechanism based on the role of the rateof interest in bringing about equality between saving and investment.6 This hasa number of implications that are worth pointing out. In the first place, Kaldor(1957, pp. 594–595) regards the mechanism he postulates, because it is basedon the dependence of capacity on output, as perfectly consistent with thealleged ‘Keynesian’ character of his own theory of growth and distribution. Inthe second place, the endogenous creation of capital implies that even in theresource-constrained growth models of the early phase, Kaldor does not see theavailability of capital as a limiting factor in the long period (see Kaldor, 1968,p. 390). In the third place, and perhaps more importantly, while full employment

4Although Kaldor analyses the tendency to full employment in formal terms only afterstating the Cambridge theory of distribution (see Kaldor, 1959, 1961), he had already,in the original exposition of that theory (1955–56) and in his first ‘Model of EconomicGrowth’ (1957), justified the full-employment hypothesis as the result of an inherent ten-dency of the rate of growth desired by entrepreneurs to exceed the natural rate of growth.5For the interpretation of the Cambridge theory of distribution as a stabilizing mechanismof an accelerator-multiplier dynamics in Kaldor’s analysis, see Hahn & Matthews (1964,p. 811); De Francesco (1984, 1986).6Kaldor (1955–56, p. 98) sterilizes the neoclassical mechanism by assuming that thecapital/output ratio is independent of the rate of profit. Elsewhere (Kaldor, 1957,pp. 609–610), he assumes that the capital/output ratio tends to remain constant overtime due to a spontaneous tendency in the system to absorb technical progress in a waythat ensures balanced growth of capital and output.

344 A. Palumbo


in neoclassical theory is the necessary result of the smooth working of the marketmechanisms and may be said to be implicit in the very determination of distri-bution in terms of equilibrium between demand and supply in the factorsmarkets, in Kaldor’s construction full employment is merely the plausibleoutcome of the persistent tendency of investment and output to expand, whichcould well be blocked by some other exogenous constraint before full employmentof labour is reached.7

This may explain why the full-employment assumption was not regarded byKaldor, even at the time, as having universal applicability. While full employmentmight be the norm in advanced or ‘mature’ economies, where capital equipmenthad had enough time to accumulate so as to be usually ‘sufficient or more thansufficient to employ the whole of the available working force’ (Kaldor, 1957,p. 593), the vast reserve of underemployed labour typical of developing econom-ies pointed instead to the existence of some factor limiting growth well before theattainment of full employment of labour. This factor Kaldor identified as eitherthe scarcity of land or the inability of the economy to produce internally mostof the capital goods needed for growth.

The hypothesis that growth in mature economies is constrained by labourscarcity can be found in Kaldor’s works at least until 1966, when he employedit to explain the ‘causes of the slow rate of growth in the United Kingdom’ inhis Inaugural Lecture at the University of Cambridge (Kaldor, 1966b, p. 100).At the time he assumed that the virtual disappearance of surplus labour inBritish agriculture had exhausted all the margins of elasticity of labour supplyfor manufacturing. But when subsequent observation of reality led him to recog-nize the wide elasticity that the stock of labour displays in advanced economies,given sufficient time, in adapting to employment opportunities, he found noparticular difficulties in his own conceptual construction to prevent him fromabandoning the full-employment assumption.8

3. From Labour-constrained to Demand-constrained Growth

Although never organized in a fully spelt-out theory, but rather scattered acrossmany different contributions often addressing practical problems or policy

7The absence in Kaldor’s construction of the theoretical necessity to regard the economyas labour constrained – and the contrast with the neoclassical construction – is alsopointed out by Vianello (2002).8If a particular moment can be identified in which Kaldor confronts the empirical implau-sibility of his idea of growth being limited by labour shortage, it is probably soon after theInaugural Lecture of 1966. In the ensuing debate, Wolfe (1968) and other critics pointedout some figures on unemployment, unfilled vacancies, rate of change of employment andrelative wage movements in Britain that appeared to contradict Kaldor’s idea of themanufacturing sector being faced with a general scarcity of labour and that, accordingto Thirlwall (1987, p. 194), contributed to Kaldor’s subsequent recognition of the elasticityof labour supply as a normal characteristic of developed as well as developing economies.The change of view is clearly stated in Kaldor (1975c, p. 895); see also Kaldor (1978,pp. xix–xx).



issues (see for example Kaldor 1970, 1971, 1975a, 1975b, 1978, 1981, 1982,1983a, 1985, 1989a, 1996), and notwithstanding their unsystematic nature,Kaldor’s reflections on growth and development of the later phase offer on thewhole the outlines of a unitary conception of growth, which can be contrastedto that proposed in the growth models of the early phase.9 The main elementsof this conception are constituted by the emphasis on the prominent role thatthe growth of the manufacturing sector plays in economic expansion, the hypoth-esis of increasing returns in manufacturing, and the analysis of the interdepen-dence between manufacturing and the other sectors.

Kaldor starts from the ‘stylized fact’ of a positive association between thegrowth of manufacturing production and the growth of labour productivity, andassumes that this reveals the crucial role of manufacturing in the growthprocess.10 Manufacturing acts as the ‘engine of growth’ (Kaldor, 1985, p. 70)due both to its capability of building endogenously the physical capital neededfor its own expansion, and to the presence of increasing returns.11 Although thecentral role of manufacturing was already emphasized in the above-quoted Inau-gural Lecture (Kaldor, 1966b), in the later phase it is combined with the idea thatnot only the supply of capital but also that of labour is elastic with respect to therequirements of production.

The reserve of labour for manufacturing is to be found not only in the primaryor ‘land-based’ sectors of the economy, generally characterized (especially indeveloping economies) by disguised unemployment and low productivity(Kaldor, 1981, 1985) but also in the service sector, which even in the mostadvanced economies typically is characterized (in some of its sub-sectors) by acertain share of low-paid and low-productivity jobs, which implies theexistence of ‘a large queue of people in low-paid jobs who move to higher paid

9The literature on the ‘second’ Kaldor is vast. Comprehensive reconstructions are pro-vided by Thirlwall (1987), Targetti (1988, 1991, 2005) and Turner (1993). Some of thedebates raised by Kaldor’s work may be found in King (1994, Parts III & IV); see alsoNell & Semmler (1991); Lawson et al. (1989); Wood (1987); Toner (1999).10The empirical association between growth of industrial output and growth of labour pro-ductivity was originally stated by P.J. Verdoorn (1949) and has come to be known as Ver-doorn’s Law. On the empirical and theoretical controversies surrounding Verdoorn’s Lawsee McCombie et al. (2002). Kaldor (1966b, 1967) reformulates the relationship in termsof three different ‘growth laws’: a positive correlation between the growth of manufactur-ing output and aggregate output growth; a positive correlation between growth of manu-facturing output and growth of manufacturing productivity; a positive correlation betweenaggregate output growth and manufacturing employment growth. For the debate on theempirical validity of Kaldor’s growth laws see Rowthorn (1975), Kaldor (1975c), andthe papers collected in King (1994).11Increasing returns are understood by Kaldor in dynamic terms, i.e. as the increases inproductivity (due to technical or organizational improvements) induced by the extensionof the market and the division of labour. They are associated, in Kaldor’s view, withimperfect competition in manufacturing. On the assumption of a different market structurein agriculture (characterized by competition) and manufacturing, see, for example, Kaldor(1970, pp. 145–147; 1996, p. 45).

346 A. Palumbo


jobs as openings become available’ (Kaldor, 1985, p. 35).12 For this reason, andfor the possibility of immigration over longer periods, no region or country canbe said to be affected by labour shortage, if not for short periods (Kaldor,1989b, p. 95).

There are thus two reasons why manufacturing acts in Kaldor’s analysis asan engine of growth. In the first place, its output can expand, in response to a posi-tive stimulus to growth, virtually with no resource limits, both by extracting labourfrom other excess-labour sectors, and by internally producing capital as part of theprocess of output expansion. The presence of increasing returns implies that thevery expansion of the scale of production determines an increase in potentialoutput, thus automatically depriving the resource constraint of its meaning(Kaldor, 1972, pp. 194–195). In the second place, when an economy has ahighly developed industrial sector which is capable of producing the capitalgoods needed for growth, the process of expansion of manufacturing output gen-erates a demand for investment that is largely directed back to the manufacturingsector itself (Kaldor, 1979, p. 289). As in his previous growth models, Kaldorthus envisages in the system a built-in tendency to growth, deriving from thedouble-sided relationship between output and investment (although this tendencyis now particularly related to the characteristics of the industrial sector).

Having recognized the long-run elasticity of labour supply, Kaldor does notinterpret any longer the tendential secular balance between the evolution of thelabour force and employment over time as a sign of the existence of forcesmaking for full employment; it is rather labour force that can be seen as adjustingto employment: ‘an economy is not “resource-constrained” merely because it is at“full-employment”’ (Kaldor, 1978, p. viii).

The element capable of determining the economy’s growth path must be, inKaldor’s view, an exogenous factor that may activate the process of cumulativeexpansion of manufacturing output, and this Kaldor identifies in exports, ormore precisely in the external demand for manufactured products (see Kaldor,1970; 1975c; 1978, pp. xx–xxi).13

This emphasis on the role of exports is connected to the ‘realistic’ focus of thesecond phase of Kaldor’s analysis of growth. That exports must have played aleading role in Britain’s economy is borne out, in his view, by empirical evidence,both with reference to the phases of fast export growth and fast output growth inthe course of the 19th century (Kaldor, 1975a, p. 165), and by the disappointingrecord of the two variables in the postwar period. At the same time, again onthe basis of evidence, Kaldor (1971, pp. 12–14) contends that the demand forexports typically directs to manufacturing products in much greater proportionthan other sources of demand.

12The presence of disguised unemployment implies that the sectors transferring labour tomanufacturing need not undergo ‘any measurable loss of output’ in the process (Kaldor,1985, p. 36).13The role of demand in Kaldor’s second-phase analysis is particularly emphasized byThirlwall (1987), who has developed his own analysis of growth as a demand-constrainedphenomenon along Kaldorian lines (see Thirlwall, 1986, 2002).



For this reason, he regards exports as capable of activating a process of cumu-lative increases of manufacturing production and productivity. In the worldeconomy, the countries or regions with more developed manufacturing sectorswill be able to offer industrial products at lower costs, to attract more demandfor their manufactures and, thanks to increasing returns, to reap further productivitygains enlarging the gap with other areas (Kaldor, 1980, p. 228). Thus, ‘successbreeds success’ (Kaldor, 1979, p. 290), in a cumulative process of output expansionwhich Kaldor labels ‘circular and cumulative causation’, a phrase borrowed fromGunnar Myrdal (Kaldor, 1970, p. 143; 1975b, p. 212).14 This process has itscounterpart in the decline and disappearance of the manufacturing sectors ofother economies, giving rise to what Kaldor regards as a typical phenomenon of‘polarization’ showing the possible negative effects of indiscriminate trade liberal-ization (Kaldor, 1975b, pp. 212–213). This implies that growth tends to concen-trate in particular locations; the global economy may therefore be seen as ‘a vastunderdeveloped area with certain “growth points”’(Kaldor, 1967, p. 69).

So described, growth appears as a path-dependent process, where actualrealizations influence future realizations as well as the very evolution of growthpotential in time. In Kaldor’s eyes, neoclassical theory, with its assumptions ofperfect competition and constant returns and the absence of any role for historyand institutions, is wholly incapable of accounting for the essential characteristicsof growth (see Kaldor 1972, 1979); in addition, Kaldor also expresses dissatisfac-tion with his own first-phase analysis of growth (Kaldor, 1978, pp. xxi–xxii) forhaving neglected fundamental structural characteristics of the economy, and fortreating growth as resource constrained. The latter supposition he now rejectedas inconsistent with his basic idea that it is actual production that influences thegrowth of an economy’s productive potential (as is implicit in the very notionof increasing returns).

It is against this attempt at a realistic and complex vision of growth, whichcharacterizes Kaldor’s second-phase contributions, that we will now assess thespecific analytical formulation he gives to the exports–output relationship.

4. Kaldor’s Foreign Trade Multiplier

In what amounts to one of the few pieces of formal analysis to be found in hisworks of the second phase, Kaldor (1970, p. 146) expresses the long-periodrelationship between output and exports by means of a simple formula, accordingto which the level of output (Y) is that multiple of the exogenous level of exports(X) given by the reciprocal of the propensity to import (m):

Y ¼1

mX

14Toner (1999, ch. 6) discusses Kaldor’s second-phase analysis in the more general per-spective of the theory of cumulative causation, and identifies Kaldor’s contribution inthe attempt at ‘marrying’ the theory of cumulative causation with the Keynesian principleof effective demand.

348 A. Palumbo


This relation – known in the literature as the foreign trade multiplier, andoriginally proposed in the 1930s by Harrod in a different context (see below) –does represent, on the assumption of zero autonomous imports, the level ofoutput corresponding to equality between exports and imports. To this relationKaldor attaches the meaning of a causal equilibrium relation, i.e. he regards itas representing the level of real output which tends to be realized, given theexogenous level of exports, in the long period in a growing economy.

This relationship seems worth dwelling upon, both in its theoretical justifica-tions and in its implications, although, given Kaldor’s propensity to progressivelymodify the analytical formulations of his ideas, one must be cautious about attach-ing too much significance to a particular formula. However, not only does Kaldorconsistently propose this formulation of the exports–output relationship in hisgrowth papers of the 1970s and 1980s;15 but in various places (see especiallyKaldor, 1975a, pp. 164–165, quoted in full in Section 7 below) he seems toregard it as conveying his basic intuition about the working of an economicsystem undergoing a process of growth.16

The justification for regarding the foreign trade multiplier as representative ofthe long-period relationship between output and exports lies, according to Kaldor,in the hypothesis that only exports are, in the long period, a truly autonomoussource of demand, and in the supposed existence of a spontaneous mechanism,based on the variations in the level of output, automatically bringing the flows ofimports and exports into equality (Kaldor, 1970, p. 146). Assuming the absenceor irrelevance of price changes (see Kaldor, 1989b, pp. 92–93),17 so that tradeflows are exclusively affected by output changes, Kaldor maintains that, startingfrom a situation of balanced trade, an exogenous increase in the level of exportswould not only increase the level of output through the usual Keynesian multiplier,but also stimulate a flow of additional net investment, producing in turn furtherincreases in output and consumption, and again in investment, in a series of

15See, for some instances, Kaldor (1975b, p. 210; 1981, p. 210; 1989b, p. 92).16The relevant place the foreign trade multiplier occupies in Kaldor’s analysis also showsin his tendency to directly apply it to the interpretation of real phenomena. To quote justone example, in a well-known letter to The Times (12 September 1977), in objecting to athesis according to which the marked rise in the import content of British manufacturingproduction observable in those years did not call for policy action as long as it wasaccompanied by a parallel increase in the share of exports in output, Kaldor argues:‘The fact that the rise in the proportion of exports in the national output overall fullymatches the rise in the proportion of imports in home sales overall is an automatic conse-quence of the operation of the “foreign trade multiplier”; and so far from providing a refu-tation for the case for import controls, it provides the strongest possible support for it. Forit shows that the Harrod theory really works, and that any rise in the share of imports intotal domestic expenditure causes a fall in demand for home output, which in turn leadsto a reduction in both consumption and investment in successive steps until a sufficientcontraction occurs in the gross domestic product relative to exports to make the spon-taneous rise in the one ratio be matched by an induced increase in the other’ (quoted inMcCombie & Thirlwall, 1997, p. 9).17The hypothesis is apparently empirically based; see below, Section 7.



successive steps; and that in the end the cumulative increases in imports so inducedwould imply a balanced trade at a higher level of activity.

The long-period level of output would thus be determined exclusively by thelevel of exports and the propensity to import. This also implies a strict relationshipbetween the rates of growth of the two variables.18

If Kaldor’s formulation is thus meant to emphasize the capability of exportsto stimulate the other components of demand and hence to generate a virtuouscircle of growth, it must be noted that the assumed coincidence between thelong-period level of output and that ensuring imports–exports equality both isinessential to an export-led explanation of growth, and reflects a different prin-ciple, according to which exports act as a limit on output expansion rather thanas a stimulus to it.

As is known, exports do exert a dual influence on the level of output, both bybringing about increases in production thanks to their effects as a source ofdemand, and by allowing for increases in production by relaxing the so-calledexternal constraint, thanks to their role as a source of the international means ofpayments needed to pay for imports.19 If no other source of foreign exchange isavailable, so that equilibrium in the balance of payments must necessarily entailequality between exports and imports, the level of output Y ¼(1/m)X representsthe maximum output that can be produced without incurring external deficits.20

Kaldor’s foreign trade multiplier implies that in the generality of cases,following an increase in exports, all the additional output that could potentiallybe produced (because of the possibility of financing the additional imports itentails) is actually produced, so that the same mechanism by which the variouscomponents of demand, and overall production, react to the autonomouschanges in exports, would also ensure the generation of a flow of imports sufficientto balance the autonomous increase in exports.

It is thus worth analysing in greater detail this mechanism and the assump-tions on which it is based. Kaldor regards not only consumption but all com-ponents of demand other than exports as dependent on output in the longperiod. Investment is determined by an accelerator mechanism ensuring theadjustment of capital stock to the requirements of production. FollowingKaldor’s (1970, p. 146) verbal exposition, it can be expressed as I ¼ vDY or

18Formally, Kaldor (1981, p. 211) expresses the rate of growth of output (y) as dependenton the rate of growth of exports (x) and the income elasticity of imports(p ¼ dM=dY Y=M) according to the formula y ¼ x/p. Originally stated by Thirlwall(1979) and known in the literature as Thirlwall’s Law, this formula is defined by Thirlwallhimself (2002, p. 60) as the ‘dynamic analogue’ of the foreign trade multiplier.19The dual role of exports is at the basis of the so-called theory of ‘balance-of-payments-constrained’ growth, which shares with Kaldor’s analysis the idea that the long-periodlevel of output also ensures equilibrium in the balance of trade, and its representationthrough the foreign trade multiplier (see for example Thirlwall, 1979; McCombie &Thirlwall, 1994). For a critique of this theory pointing out confusion between the ‘externalfinancing constraint’ and the ‘effective demand constraint’, see Medeiros & Serrano(2001) and Palumbo (forthcoming).20Neglecting the effects of price changes, if the variables are to be interpreted in real terms.

350 A. Palumbo


I ¼ vyY, where v is the ‘normal’ or desired capital/output ratio and y the prospec-tive rate of growth of output.21 Even government expenditure is, in Kaldor’smodel, entirely dependent on income, and is such as to adjust automatically totax revenue.22 Imports are assumed to have no autonomous component, and tobe a simple linear function of output, M ¼ mY.23

On these assumptions, the relationship connecting output to the exogenouslevel of exports becomes a ‘supermultiplier’ (Kaldor, 1970, p. 146), i.e. a multi-plier that also takes into account the effects of output variations on all thecomponents of demand.24 Neglecting taxation and public expenditure,25 theexports–output relationship can formally be expressed as

Y ¼1

1 � c � vy þ mX

where Y and X are, respectively, the levels of output and exports, c the marginalpropensity to consume, vy the coefficient relating investment to output, m the pro-pensity to import. Following Serrano (1995, p. 81), we may term the sum cþvy asthe ‘marginal propensity to spend.’

Kaldor contends that this long-period supermultiplier relationship betweenexports and output takes the simple form Y ¼(1/m)X. As is apparent, thismeans that he actually assumes that 12c, the propensity to save, equals vy, thepropensity to invest; or, equivalently, that the propensity to spend equals unity.

To assume, as Kaldor does, the endogeneity of all components of demandother than exports is not in itself sufficient to obtain the result that the long-period

21The capital stock is assumed to be of infinite durability, so that depreciation is nil and allinvestment is net. The rigid form we give to the specification of the accelerator is justifiedby the fact that Kaldor normally employs the term accelerator in this particular meaning(i.e. to indicate a linear relationship of dependency of net investment on the rate of changeof output; see Kaldor, 1951, 1957). The coefficient v is assumed to be fixed over time,which is compatible with the presence of technical progress. The normal degree of utiliz-ation of capacity implicit in the normal v is defined as different from (i.e. lower than) full.22Of this admittedly extreme assumption Kaldor does not offer any particular justification.In Kaldor (1970) he seems to assume that government voluntarily adjusts expenditure tothe level of tax revenue.23Both imports and exports are unresponsive to price changes. All variables are understoodin real terms.24Kaldor borrows the notion of supermultiplier from Hicks (1950), who employed it toexpress the long-period relationship between output and autonomous investment in a ‘reg-ularly progressive economy’ characterized by a constant rate of growth of autonomousdemand (and output), and thus by equality between current and prospective rates ofgrowth of output. While he considered Hicks’s analysis of the multiplier-accelerator inter-action useful for long-period (equilibrium) analysis, Kaldor (1951) was (at least originally)highly critical of it as an analysis of the trade cycle. We discuss the matter further inSection 5.25Thanks to Kaldor’s peculiar assumption about the endogenous nature of public expen-diture and its automatic equality to tax revenue, the two variables play no role whatsoeverin the adjustment process.



level of output coincides with the one ensuring imports–exports equality.In principle, the induced cumulative increase of imports brought about by thereaction of the various components of demand to the expansion of output mighteither exceed or fall short of the initial increase in exports. The necessary con-dition of equality between aggregate demand and aggregate supply only impliesthat at the end of the multiplier process the sum of the cumulative increases inimports and in saving equals the sum of the cumulative increases in investmentplus the initial exogenous increase in exports. The additional necessary hypothesisin order for equality of trade flows to be an automatic result of the multiplier-accelerator mechanism is that the sum of investment flows generated during theprocess of expansion is such as to perfectly balance the flow of saving generatedby normal capacity output (Kaldor, 1983a, p. 69). As a consequence, eachadditional unit of income would end up being entirely spent, either on consump-tion or on investment,26 so that imports would be the only true leakage from themultiplicative process. This is why their increase, in the end, exactly matches theinitial exogenous increase in exports.

It is thus necessary to examine the justifications Kaldor offers for such astrong assumption of full coincidence between investment decisions and savingdecisions. Before that, it seems however worth reflecting briefly on the significantchange in interpretation that Kaldor’s exports–output relationship implies withrespect to the meaning of the foreign trade multiplier as originally put forwardby Harrod, notwithstanding Kaldor’s contention (for example in 1975b) that itsimply represents a restatement and an extension of the original Harrodiannotion to the long period.

Harrod’s analysis (see Harrod, 1933, 1957) may be considered as an appli-cation of Keynesian principles and analytical tools to open economies.27 Hismain purpose was to challenge the traditional theory of the adjustment of thebalance of payments based on gold flows and changes in relative external/internalprices, by showing how crucially that ‘classical doctrine’ rested on the unwar-ranted assumption of full employment and to show, by contrast, the relevanceof the level of output and its short-period variations (a factor altogether neglectedby the traditional view) in influencing such adjustment (Harrod, 1957, p. 135).

It is for the purpose of isolating the influence of output variations on thebalance of payments that Harrod constructs a very simplified model – the

26The same holds true if public expenditure and taxation are reintroduced in the modelsince, on Kaldor’s assumptions, each unit of income subtracted from disposable incomethrough taxation would automatically be spent on goods and services by the government.27Although some of the basic ideas on international trade were already expressed byHarrod in the first edition (1933) of his book International Economics, it is especiallyfrom the second edition of 1939 that he develops a Keynesian analysis of the relationshipbetween the balance of payments and the level of activity and explicitly defines the foreigntrade multiplier. See King (1998) for a survey of other attempts, all dating back to the early1930s, at analyzing the relation between foreign trade and the level of activity in terms ofexport multipliers. The role that R.F. Kahn may have played in shaping Harrod’s ideas onthe foreign trade multiplier is suggested by an exchange between Harrod and Kahn of 1932reproduced in Besomi (2003, Vol. I, pp. 144–146).

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foreign trade multiplier in question – in which the influence of gold flows andchanges in prices are completely ruled out, while adjustment in the balance oftrade (in a fixed exchange regime) is obtained exclusively through variations inthe level of output. In the extreme assumptions of no capital flows, no investmentand saving, and no government expenditure, so that exports are the only com-ponent of autonomous demand, consumption the only possible use of income,and imports the only alternative to the consumption of domestically producedgoods, equality between imports and exports is the condition ensuring equalitybetween aggregate supply and aggregate demand, and Y ¼ (1/m)X representsthe only level of output ensuring this equality and automatically guaranteeing azero balance of trade as a result of the tendency of output to adjust to aggregatedemand.

Given the extreme unrealism of the hypotheses, Harrod’s foreign trademultiplier cannot obviously serve more than an illustrative purpose, that of high-lighting a force (the influence of the level of output and its variations on thebalance of payments) that must somehow operate in the system even in morecomplex conditions than those stated in the simplified case.

By relaxing in successive steps the initial strict hypotheses, Harrod offers amore realistic and complex view of the relationships between the level ofoutput and the balance of trade. Once investment and saving are reintroduced(see Harrod, 1957, pp. 127–130), the multiplier of autonomous demand losesthe simple form 1/m, the propensity to save appears among the leakages andthe amount of investment among the autonomous components of demand.28

Thus, the equilibrium of trade flows no longer follows from the equilibriumbetween aggregate supply and aggregate demand: ‘there is nothing in the natureof things why . . . there should not be an active or passive balance on currentaccount’ (Harrod, 1957, p. 130).

The multiplier effects of exports are thus clearly distinguished from theireffects on the balance of trade, while no automatic mechanism operates ingeneral circumstances to ensure the tendency of imports and exports to equality.29

In analysing the various possible resulting combinations between level of employ-ment and balance of trade, and in assessing both the effects of imbalances and thepolicy measures that may be taken to correct them, Harrod characteristically doesnot rule out the effects of price changes but considers them as operating togetherwith the effects of the variations in output. Although there may be various reasonswhy adjustment through prices may not work effectively,30 what is relevant is that

28Following Keynes, and in line with the short-period character of his analysis, Harrodtreats the level of investment as generally given independently of output. However, hementions a possible dependence of investment on the level of activity that mightamplify the multiplier effects of exports (Harrod, 1957, pp. 136, 158).29In Kalecki’s analysis of the exports–output relationship, put forth at about the same time(Kalecki, 1934), there is no presumption that the demand effects of exports are such as toautomatically produce equilibrium in trade flows.30For example, price inelasticity of imports and exports (Harrod, 1957, p. 153), behaviourof the banking system that could neutralize the effects of the gold flows on the domestic



the variations in output are seen as just one force, albeit a powerful one, operatingamong others on the balance of trade.

It is now apparent how different Kaldor’s long-period foreign trade multiplieris from the original short-period Harrodian construction. While in Harrod there isno necessary identification between the zero-balance-of-trade level of outputand the equilibrium level of output – outside the extreme assumptions describedabove – Kaldor’s analysis assumes just such an identification. While in Harrod themultiplier 1/m represents the effects of exports on output in the absence of invest-ment and saving, in Kaldor it represents the sum of all the effects of exports onoutput when investment has had the time to fully react to the exports stimulus.While in Harrod the foreign trade multiplier plays the limited role of an admittedlyspecial construction aimed at illustrating a particular force, in Kaldor it representsthe general form the exports–output relationship takes in the long period. All thesedifferences are accounted for by Kaldor’s assumption of automatic equalitybetween saving and investment. It is thus necessary to analyse the bases of suchan assumption.

5. Saving and Investment in Kaldor’s Analysis

Although the analysis of the saving-investment nexus is not extensively dealt within Kaldor’s second-phase contributions, a justification for the assumption of fullcoincidence between the two magnitudes is to be found in his contention thatinvestment decisions and saving decisions are taken essentially by the sameactors, i.e. firms, and that saving decisions are not autonomous from investmentdecisions, because they are entirely determined by the necessity of financing thelatter (Kaldor, 1975a, pp. 164–165). The share of saving in aggregate incomewould therefore automatically adjust to changes in the incentive to invest.Instead of basing such flexibility on the changes in normal distribution entailedby the Cambridge theory of distribution, Kaldor seems to assume that firms volun-tarily modify either (i) the proportion of profits devoted to saving by changing theretained share of profits, or (ii) their profit margins, by setting prices on the basis ofa mark-up principle, in either case adjusting the proportion of income saved tochanges in investment decisions.31

This mechanism is not fully specified by Kaldor, and we will not enter hereinto all the analytical questions it seems to raise. Taking it for granted, we willwonder what this mechanism entails as regards the determinants of growth.

The equality 12c ¼ vy implies that y, the current and prospective rate ofgrowth of output which maintains equilibrium between the flows of capacity

quantity of money (p. 112), or limited scope for price variations due to the initial low levelof activity (p. 134).31A mechanism of this kind seems to have been first put forward by Kaldor (1966a, appen-dix), initially as a reformulation of the Cambridge theory of distribution taking intoaccount the specific saving behaviour of the corporate sector. More fully spelt-out theoriesof the determination of profits on the basis of the need of the firms to finance investmentmay be found in Eichner (1973, 1976) and Wood (1975).

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and demand, equals in Kaldor’s model the value (12c)/v, i.e. Harrod’s (1939)warranted rate. With exogenous propensity to save, such a rate would be uniquelydetermined by supply factors (the propensity to save and technology). This wouldcontradict the statement that the system’s growth rate is determined by demandfactors, and particularly by the autonomous growth of exports.

Kaldor’s assumption of automatic adjustment of saving to investmentdecisions (with the variability in the saving share it entails) does howeverprovide the degree of freedom necessary for the autonomous growth of exportsto determine the growth path of the system. A change in the rate of growth ofexports, which entails a change in the prospective rate of growth of aggregatedemand and in the share of net investment in output, would in fact be accommo-dated by a change in the saving share, through a change in the proportion ofretained profits or in profit margins. Along the new growth path, trade flowswould again be balanced. With an unchanged propensity to import, the share ofexports in output would also be unchanged, while the necessary change in theshare of investment would be exactly compensated by the parallel and contrarychange in the share of consumption.

If the mechanics of the model were to be taken literally (and if the mechanismof adjustment between investment decisions and saving decisions Kaldor proposescould be taken to work), the whole burden of adjustment would fall on consump-tion, which must contract (in share, and possibly in volume) when the rate ofgrowth of exports increases, and expand (both in share and in volume) whenthe growth of exports decelerates, thus acting so as to absorb residually any gapbetween capacity output and the investment induced by the prospective growthin exports. That one component of demand has to absorb residually any capacityoutput is implicit in the above-seen condition that the propensity to spend mustequal one, which amounts to saying that domestic demand, instead of posinglimits to the production of normal capacity output, passively adjusts to it.

In actual fact, even if such an implication on the behaviour of consumptiondirectly derives from the mechanics of the model elaborated by Kaldor, it is inreality quite extraneous to the account of the growth process he proposes. Thereason for assuming that domestic demand does not set limits to productionmay be found, in his analysis, not in a supposed tendency of consumption toexpand automatically to offset any reduction in the stimulus to invest (a tendencyhe never states verbally and that would have no theoretical justification in hisanalysis), but rather in his conception of investment and particularly in the ideathat, in a growing economy, the desired flow of investment typically does notfall short of, and often tends to exceed, the flow of saving corresponding tonormal utilization of installed capacity, and would thus be more than sufficientto absorb it. The qualification that exports are likely to represent the ‘critical con-straint’ on output only in the context of a growing economy (Kaldor, 1983a, p. 69)seems relevant in this respect, because it is only in that context that he seesreasons to assume the presence in the system of a continuous stimulus toexpand investment.

At the basis of Kaldor’s second-phase analysis of growth is a conception ofinvestment remarkably akin to what he had proposed in the supply-constrainedmodels of the early phase. It consists of two propositions: the first, that outside



the Keynesian short-period analysis of output determination with given capacity,investment cannot be regarded as exogenous but is rather to be seen as dependenton output; the second, that induced investment typically does not fall short of, andusually exceeds, the additional saving induced by the same increase in output, withgiven distribution.

A similar conception is also at the basis of the analysis of investment whichKaldor had proposed in the 1940s and 1950s in his contributions to the debateon the trade cycle (Kaldor, 1940, 1951, 1954), before the Cambridge theory ofdistribution was worked out. In those earlier writings, the principle that thedemand for investment increases with the level of production, and typicallymore than in proportion to the latter, constituted, in interaction with the multiplier,the basic force giving rise to the endogenous mechanism of cyclical fluctuationsof output.

At the time, Kaldor explicitly rejected the idea that the dependency of invest-ment on output could be formulated in terms of the ‘accelerator principle’, under-stood as a linear relationship between the level of investment and the rate ofchange of output, according to the desired capital/output ratio. For any realistichypothesis about the accelerator coefficient, Kaldor (1940, p. 80) contended, the mul-tiplier-accelerator interaction inevitably gives rise to explosive dynamics so that ‘theeconomic system would always be rushing either towards a state of hyper-inflationwith full employment, or towards a state of complete collapse with zero employment,with no resting-place in between.’32 Since real economies show a much less dramaticform of instability, and since the amount of investment firms desire to undertakecannot depend solely on the rate of change of output, but must necessarily be influ-enced by the current level of capacity utilization, a less rigid specification of theinvestment function is called for. In his comment on Hicks’s (1950) model of thetrade cycle – based on a rigid accelerator mechanism which in interaction withthe multiplier produces a regular cycle around a long-period trend by encounteringupper and lower limits to the amount of investment33 – Kaldor (1951) was highlycritical of the use of the accelerator as a representation of the short-period mechanismby which investment reacts to changes in output, because it presupposes full adjust-ment between output and capital both in the initial and the final position, an assump-tion that he found unwarranted for the analysis of short-period fluctuations. Tocapture the variability of the reaction of investment to output in the differentphases of the cycle, he proposed instead a non-linear specification of the investmentfunction, where investment depends on the level of output rather than on its rate of

32According to Kaldor (1951, p. 836), for the multiplier-accelerator mechanism to giverise to an explosive dynamics it is sufficient to assume that the investment coefficienthas a value above unity, which in his opinion is usually the case if it is regarded as deter-mined by the desired capital-output ratio (see also Arndt, 1951, p. 396).33In Hicks (1950) the long-period trend of growth is determined by the growth of auton-omous investment, with the relationship between autonomous investment and output givenby the supermultiplier. The explosive tendency is reversed and transformed into a regularcycle thanks to the existence of a ceiling, given by full employment, and a floor given bythe zero value of gross investment (or by the existence of autonomous investment).

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change (Kaldor, 1940, 1951).34 Even though he was critical of the rigid linear speci-fication entailed by the accelerator, however, Kaldor’s own analysis shares with thelatter the basic proposition that in normal conditions (thus excluding the cases inwhich the economy is near full employment or deep in depression) the size of thechange in investment associated with any change in output ‘is likely to exceed(perhaps several times) the value of the additional output’ (Kaldor, 1954, p. 56),while the change in saving cannot be but a fraction of the change in output, thusbeing normally smaller than the change in induced investment.35

If our reconstruction is correct, this basic conception of the overreaction ofinvestment to output changes will remain broadly the same in the subsequentphase of Kaldor’s analysis, when, combined with the Cambridge mechanism bywhich saving adjusts to investment through variations in distribution, it ledKaldor to regard the system as endowed with an endogenous stimulus to expan-sion, and to view the full employment ceiling not as an unstable position thatnecessarily leads to cyclical contraction, but as a condition that, thanks to theflexibility of the saving share, may be maintained over time.36

Both in the analysis of the cycle and in his subsequent growth models Kaldoroffers an additional argument in support of his hypothesis. This is the idea that, for agiven capital stock, each increase in output entails an increase in the realized flow ofprofits per unit of capital (i.e. in the current or ‘realized’ rate of profit), and that entre-preneurs tend to project into the future such increases in current profitability, andexpand their investment outlays accordingly (Kaldor, 1940, p. 79; 1954, p. 54).37

This argument however seems to rest on an unwarranted identification betweenthe current and expected rate of profit. In any period, with a given capital stock

34For other analyses of the cycle assuming a non-linear investment function, see Kalecki(1936–37) and Goodwin (1951).35Kaldor eventually acknowledged that his own specification of the investment function,though less rigid, is not substantially different from the accelerator, so that ‘it is perfectlyeasy to translate one technique into another without any difference in the results’ (Kaldor,1954, p. 55, fn. 2).36The strict affinity between the analysis of the cycle and the conception of investment ofhis growth models is stated by Kaldor, for example, in 1958 in a letter to James Tobin(King’s College Archives, NK/1/31/453): ‘if the forces making for expansion are suffi-ciently powerful to secure a growth in output and in output capacity year by year they willbe powerful also in causing expansion of the level of activity to the full employment pos-ition . . . The reason for this is analogous to that underlying the trade cycle models i.e., thecombined operation of the accelerator and the multiplier leads to an unstable equilibrium.When short period output is elastic, slump equilibrium is stable because the accelerator isinoperative. A boom equilibrium is also stable because short period output is inelastic andincreases in demand are absorbed in rising prices and profit margins, but a Harrod typegrowth model is unstable if it is based on the postulate of continuous under-employment.’37Kaldor maintains that normally the utilization of capacity is well below the maximumfeasible one; and that a greater flow of output out of the same stock of capital is obtainablewithout incurring increasing costs. In one paper (Kaldor, 1954, p. 55), he explicitly regardsprofit per unit of output as given, so that each increase in the actual output/capital ratioautomatically increases the actual rate of profits.



which is the result of past investment decisions, the flow of realized profits per unitof capital (the current or realized rate of profit) is affected by the current degree ofutilization of capacity, and may well increase with output as an effect of increases inutilization. However, the size of the productive capacity that entrepreneurs arecurrently installing is necessarily commensurate to their expectations about thelevel of demand, so that they cannot but expect to utilize it normally. Thus,the expected rate of profit cannot but be the normal one (or at least strictlydepend on it), unless one assumes that entrepreneurs are consciously planning toinstall more or less capacity than they expect to need (Vianello, 1989, p. 180).38

Kaldor justifies his hypothesis on the basis of an ‘optimistic’ attitude on thepart of entrepreneurs, i.e. a propensity to be easily influenced by what they cur-rently observe, so as to project into the future the high and growing level ofprofits they currently experience. Without this optimistic attitude, Kaldor (1954,p. 70) observes, ‘no variant of the output-investment relationship, such as theacceleration principle or any other assumption, would work, and the systemwould tend to settle down to a stable long-term equilibrium.’ Kaldor (1954,pp. 65–71) regards this optimistic attitude of entrepreneurs as the element thatproduces not only the cyclical movement of the economy but also an inherent ten-dency to growth. An economy in which entrepreneurs are highly reactive tochanges in output is one in which the upper limit (corresponding either to fullemployment or to full capacity utilization in the capital goods sector) is frequentlyreached, which implies pressure on capacity limits and thus a stimulus to thegrowth of capacity over time and the adoption of technical innovations thatraise the productive potential of the economy.

In the specification of the investment function which is to be found in hisfirst growth model (Kaldor, 1957), both elements are present. Investment isregarded as dependent both on the rate of growth of output and on the variationof the realized rate of profit with respect to the previous period; in steadygrowth, when the rate of profit is constant, the latter term disappears and invest-ment is determined according to a rigid accelerator rule. For the fact of referringthe analysis to the long period, which he identifies as a situation of full adjustmentbetween capacity and output,39 Kaldor here abandons his reservations on therigidity of the accelerator.40

38For the distinction between the normal, expected and realized rates of profit, and theiranalytical roles, see Garegnani (1992, pp. 60–62) and Vianello (1989, pp. 176–179).Unlike the normal rate of profit, the expected one may be different for each entrepreneur.Those introducing innovative and superior methods of production, for example, mayexpect to realize a greater than normal rate of profit. However, the innovative entrepre-neurs too will base their expectations on the idea that the capacity they are installingwill be normally utilized (Ciampalini & Vianello, 2000, p. 373).39If the identification between long-period positions and full adjustment between capacityand output is recognized as unwarranted, the rigid specification of the accelerator provesinadequate to represent investment behaviour also with reference to the long period. Seebelow, Section 8.40‘In earlier articles on the trade cycle [1940, 1951] I strongly criticised the use of theacceleration principle in connection with trade-cycle models, because it assumes a

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But in this analysis, as in his 1954 paper, he maintains that the tendency of theeconomy to fully exploit the growth potential can be stated only if ‘a certainminimum “buoyancy” in entrepreneurial behaviour’ (Kaldor, 1957, p. 601) isassumed. The optimistic attitude of entrepreneurs, i.e., the above-seen tendencyto project into the future the increases in profitability currently observed, playsthe essential role of providing the system with all the effective demand requiredto match the growth in potential supply.

It is thus this attitude of entrepreneurs (the ‘compulsion for accumulation’, inthe words of Tobin, 1989, pp. 37–38) which explains why Kaldor sees growth as acontinually self-sustaining process, where new investment expenditures, taken upin the hope that new growth opportunities will appear in the future, tend generallyto fill the gap between capacity and demand.

Our contention is that a broadly similar conception of investment decisions isalso at the basis of Kaldor’s elaborations of the later phase. Once he abandons theidea that the growth of the labour force sets the exogenous constraint on growth,Kaldor continues to regard the expansion of investment and output (in reaction toexogenous changes in exports) as a continuous self-fuelling process, and such asto generate, in normal circumstances, an amount of domestic demand sufficient toabsorb capacity output. It is for this reason that he does not regard the insufficiencyof investment as a serious obstacle to the growth process, and maintains that ‘thelimitation of effective demand due to over-saving is a short-run (or cyclical)phenomenon’ (Kaldor, 1975a, p. 165).

The hypothesis of overreaction of investment to changes in output, and itsexpression in terms of the multiplier-accelerator mechanism, seems therefore tobe a relevant element of continuity between the two phases of Kaldor’s thinkingon growth, and one that has implications on the general conception of growth thatemerges from Kaldor’s later-phase contributions.

6. The Role of Demand in Kaldor’s Construction

As we argued in Section 3 above, Kaldor’s second-phase analysis of growth ismeant to illustrate the strategic role of exports and the powerful mechanism ofoutput expansion that the growth of exports may trigger. Its formal expression,the long-period foreign trade multiplier, highlights the endogenous process ofcreation of demand and capacity that follows an autonomous increase inexports. However, it is exactly in describing the reaction of the induced

constant relationship between output and capital (or rather between output and outputcapacity), whereas the recognition of a changing relationship between these two seemedto me essential for an understanding of the cyclical mechanism. I recognised, however,the validity of the principle “as between alternative positions of long period equilibria”[1951, p. 838]. For the purpose of a long-run model of economic growth it is legitimateto divide time into “periods” long enough for the capital stock in any one period to befully adjusted to the output expected for that period at the beginning of that period;which means that the “acceleration principle” is an appropriate principle to apply tocharacterise investment behaviour for such “periods”’(Kaldor, 1957, p. 601, fn. 1).



components of demand to output expansion that Kaldor’s analysis seems torule out, in the generality of cases, the possibility that demand acts as thetrue constraint on output expansion.41 External demand and internal demandplay, in this respect, very different and asymmetric analytical roles inKaldor’s construction, the former setting the pace at which the entire systemgrows, the latter adapting passively to absorb the whole of capacity output.Rather than showing the limits that insufficiency of aggregate demand maypose to growth, Kaldor’s construction appears instead to illustrate the quitedifferent principle described in Section 3 above, i.e. the necessity of checkingany domestic stimulus to growth that would create an unsustainable situationin the balance of payments. On this interpretation, the limit to growth wouldcome not from the insufficiency of aggregate demand, but from the insufficiencyof means to pay for imports.

At least some parts of Kaldor’s analysis give support to this interpretation.As one instance, we will consider here the main conclusions of his two-sectormodel of development. The model, which is but a stylized expression ofKaldor’s basic idea, typical of the second phase, that the establishment of amodern industrial sector plays a crucial role in the process of development, high-lights the relations of mutual dependence between agriculture and industry.42

Agriculture, representative of the land-based or primary sectors, is characterizedby disguised unemployment and slower productivity growth, and provides manu-facturing with raw materials and wage goods; manufacturing, characterized bymodern techniques and faster productivity growth, produces the capital goodsneeded in both sectors.43

Agricultural output is limited by availability and productivity of land. Man-ufacturing output, in a closed economy, is instead limited by the fact that part ofthe inputs required for manufacturing production come from agriculture, whichmakes it necessary to sell part of the manufacturing product to agriculture inexchange for agricultural products.

As agricultural output (‘corn’, for simplicity) is limited by the availabilityof land, this also places a limit on the agricultural demand for manufacturingproducts (‘steel’). Since, in Kaldor’s view, the terms of trade between agricultureand industry tend to be fixed as long as the labour requirements per unit of

41The inability of the foreign trade multiplier to underpin a theory of demand-led growth isalso noticed by Ricoy (2004). A similar critical remark is also raised by Dutt (1992) indiscussing Thirlwall’s (1986) ‘Kaldorian’ model of growth.42A verbal description of Kaldor’s two-sector model of development may be found invarious contributions of the second phase (Kaldor 1966b, 1967, 1975a, 1981, 1983b,1996). For a more formal analysis see Thirlwall (1987, chs 7 & 8), Targetti (1988, chs7 & 8) and Thirlwall’s (1986) own model.43The presence in reality of the tertiary sector does not alter, according to Kaldor (1966b,1996), the essential nature of the process of development as exemplified by the model. Heexplains the growing importance of that sector in advanced economies as an effect ofoverall growth induced by the expansion of manufacturing, due to the high income elas-ticity of the demand for services.

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industrial output are given, all of the burden of adjustment is placed onquantities.44 This implies that industrial output is a fixed multiple of thedemand for industrial products coming from agriculture – a multiple determinedby the corn content of each unit of steel (Kaldor, 1966b, pp. 113–114).45

Manufacturing output is thus entirely determined by the volume of‘external’ demand and by the internal propensity to ‘import’ agriculturalgoods, with a relation formally identical to the foreign trade multiplierdescribed above. The factor limiting manufacturing output is ultimately to besought, in this construction, in the requirements of agricultural goods perunit of industrial product, and in the related necessity to sell part of manufac-turing output to agriculture; thus, essentially, in technological factors thatimpose a requirement of balanced growth on the two sectors. Overall outputis limited by the factors limiting agricultural output, so that growth is ulti-mately constrained, in the case of a closed economy (which also representsthe way the entire world economy works, see Kaldor, 1981, p. 218), by therhythm at which land-saving innovations are introduced into agriculture, forthe latter determine the rhythm of expansion of agricultural output and agricul-tural demand for manufactured goods.

Once applied to the analysis of open economies, this same analytical con-struction produces the result that the growth of the manufacturing sector ofeach single country is limited by the demand of its products coming fromabroad. But the logic of the model implies that it is ultimately in the factors ofsupply, i.e., the rapidity with which the production of commodities in the worldprimary sector grows, and the rapidity with which the natural-resource contentof manufacturing productions declines, that the limits to growth are to be found(Kaldor, 1981, pp. 220–223; 1983b, p. 236).

44‘[I]t is the peculiarity of industrial labour that the supply price of labour in terms of foodcontains a strong conventional element. . .. This makes the prices of industrial goods interms of agricultural products . . . virtually independent . . . of the supply/demand situ-ation in agriculture’ (Kaldor, 1979, p. 287, emphasis in the original). The absence ofperfect competition in manufacturing also contributes to the inflexibility of relativeprices.45Kaldor’s model echoes the analysis of exchange and mutual dependency betweentown and country to be found in the classical economists and especially in RichardCantillon (I am grateful to F. Serrano for this suggestion). See the following passagefrom The Wealth of Nations (Smith, 1776, bk. III, ch. I, par. 4): ‘The inhabitants ofthe town and those of the country are mutually the servants of one another. Thetown is a continual fair or market, to which the inhabitants of the country resort inorder to exchange their rude for manufactured produce. It is this commerce whichsupplies the inhabitants of the town both with the materials of their work, and themeans of their subsistence. The quantity of the finished work which they sell to theinhabitants of the country necessarily regulates the quantity of the materials andprovisions which they buy. Neither their employment nor subsistence, therefore, canaugment but in proportion to the augmentation of the demand from the country forfinished work; and this demand can augment only in proportion to the extension ofimprovement and cultivation.’



7. Policy Implications of Kaldor’s Analysis

This ambiguous conclusion about the role of demand finds confirmation at least insome of the policy implications that Kaldor extracts from his analysis.46 While, onthe one hand, he stresses the open nature of the growth process and the fundamen-tal role of the demand for exports in determining the economy’s growth path, onthe other hand, his conception of investment as over-reacting to increases in outputinduces him to neglect the limits to growth coming from the domestic sources ofaccumulation.

The idea of the self-sustaining nature of growth processes by no meansentails, in Kaldor’s view, the conclusion that the market has self-regulatingproperties. According to his analysis, the scope for policy action is insteadwide. In line with the strategic role he assigns to foreign trade, he advocatedall sort of policies both to foster exports and to reduce the propensity toimport, from export subsidies to import controls, and industrial policies todevelop or sustain the exporting sectors.47 As for exchange rate management,he gradually became very sceptical about its effectiveness, on the ground thatchanges in the exchange rate would generally be offset by changes in relativeprices (1978, pp. xi–xxi). For poor countries, he especially advocated policiesto foster industrialization, which he saw as a necessary condition for development(see Targetti, 2005, pp. 1196–1197) and international measures for stabilizationof the terms of trade between commodities and manufactures (see for exampleKaldor, 1983b).

On the contrary, he did not consider the standard Keynesian demand manage-ment policies to be the most appropriate ones for sustaining long-term growth(Kaldor, 1971). It is especially in dealing with the problems of the Britisheconomy that Kaldor uses the foreign trade multiplier as a tool of applied analysis.In discussing ‘Britain’s chronic unemployment problem,’ Kaldor (1982, p. 85)does not attribute it to ‘excessive savings relative to spontaneous investment’but rather to ‘her unsatisfactory foreign trade performance.’ ‘For it can beshown,’ he contends,

on the basis of Harrod’s foreign trade multiplier, that unemployment can be‘explained’ by the potential excess of imports at full employment over theactual level of exports.48 The Keynesian methods of demand management canachieve full employment by substituting Government loan expenditure for theadditional exports that would be needed to secure full employment; but theycan only do so at the cost of increasing imports above the level of exports,i.e. by creating a negative foreign trade balance.

46No attempt will be made here to summarize all aspects of Kaldor’s extensive contri-butions to economic policy of his later years. For more comprehensive accounts seeThirlwall (1987); Targetti (1988, ch. 9).47He also advocated a policy of taxation aimed at encouraging the transfer of labour fromthe service sector to manufacturing.48The calculations contained in a footnote make it clear that Kaldor employs directlythe foreign trade multiplier in order to determine actual output and its relation to full-employment output.

362 A. Palumbo


It may be noted incidentally that, as soon as he applies the model to the analysis ofactual processes of growth in real economies, Kaldor implicitly relaxes the strictand rather artificial assumption that exports are the only source of autonomousdemand, while retaining the hypothesis that investment has to be seen asendogenous (Kaldor, 1989b, p. 98).

In this analysis, Kaldor is clearly addressing the difficulty for Britain of main-taining equilibrium in the balance of trade rather than the difficulty of havingenough aggregate demand in the system to absorb full employment output. Theinsufficiency of exports is in this case to be seen properly as a problem ofdemand (and output) composition, rather than as a problem of an insufficientlevel of aggregate demand: besides providing the means to pay for imports,exports may in fact, due to their greater manufacturing content, also stimulatethe growth of productivity more than other sources of demand, thus allowingfor a higher rate of growth.49

The foreign trade multiplier is thus apt to represent, although in simplifiedterms, the principle of the external constraint, i.e. the situations in which growth isheld in check by the inability to pay for imports, as has been the case for Britain inthe postwar period. But the fact that Kaldor interprets it as the general form of theexports-output relationship in the long period induces him to unduly generalizethat experience and to disregard the constraints to growth that may derive from insuf-ficient internal demand, thus downplaying the role of domestic demand promotion ingrowth policies.50 The differences between Keynes’s and his own conclusions aredescribed by Kaldor (1975a, pp. 164–165) in the following terms:

Keynes, writing in the middle of the Great Depression of the 1930s, focussed hisattention on the consequences of the failure to invest (due to unfavourablebusiness expectations) in limiting industrial employment below industry’sattained capacity to provide such employment; and he attributed this failure toexcessive saving (or an insufficient propensity to consume) relative to the oppor-tunities for profitable investment. Hence . . . the importance he attached to thesavings/investment multiplier as a short-period determinant of the level of pro-duction and employment. In retrospect I believe it to have been unfortunate thatthe very success of Keynes’s ideas in connection with the savings/investmentmultiplier diverted attention from the ‘foreign trade multiplier’ which, overlonger periods, is a far more important and basic factor in explaining thegrowth and rhythm of industrial development. For over longer periods Ricardo’spresumption that capitalists only save in order to invest, and hence the pro-portion of profits saved would adapt to changes in the profitability of investment,seems to me more relevant; the limitation of effective demand due to over-saving is a short-run (or cyclical) phenomenon, whereas the rate of growth of

49Here too we see some affinities with Kaldor’s first-phase models of growth. In the 1957model, for example, the composition of demand is regarded as a relevant factor indetermining the rate of growth of the system, since a higher share of investment inoutput – a characteristic, according to Kaldor (1957, p. 618), of the economiesendowed with greater ‘technical dynamism’ – would entail higher rates of growth ofproduction and productivity.50For a similar remark, see Toner (1999, p. 157).



‘external’ demand is a more basic, long run determinant of both the rate ofaccumulation and the growth of output and employment in the ‘capitalist’ or‘industrial’ sectors of the world economy.

8. Conclusions

The preceding discussion might be taken to suggest that Kaldor’s second-phaseanalysis is simply a variant of his previous conception of resource-constrainedgrowth, with the role formerly played by full employment of labour now playedby the availability of means to pay for imports. This conclusion, however,would push our previous critical considerations too far. What we tried to show,rather, is the contradictory nature of Kaldor’s analysis, and especially the contra-diction between his insights on the complex and open nature of the growth processand the analytical expression he gives his ideas.

All of his contributions of the second phase are permeated by the effort toaddress the questions posed by the actual working of the growth process in realeconomies. As shown for example by the discussion sparked by his 1966 inaugurallecture (Wolfe, 1968; Rowthorn, 1975; Kaldor, 1968, 1975c), he passionatelyadvocated the use of empirical evidence as a way of selecting the most usefuland relevant among theoretical hypotheses and was prepared to change his mindin the face of observed facts, and, if necessary, even to reject his previous beliefs.

With his hypothesis of increasing returns in manufacturing he accounts forthe endogenous nature of much of technical progress, and for the high rates ofgrowth of production and productivity that are typically associated with industri-alization. With his model of cumulative causation he tries to explain why countriesand regions grow at different rates, and why some economies enter phases of sus-tained growth and others remain entrapped in poverty and stagnation. By givingpride of place to aggregate demand he accounts for the widespread phenomenaof under-employment and waste of resources that characterize capitalistic econ-omies, and by singling out exports as a strategic factor he also highlights therole the external constraint may have in various real circumstances in hinderinggrowth and development.

However, as we have endeavoured to show, the long-period foreign trademultiplier is a poor formulation of Kaldor’s most interesting ideas about growthand development. As a representation of the general form of the exports–outputrelationship in the long period, it is open to criticism for the over-simple andmechanical link it establishes between the two variables. As a representation ofthe principle of export-led growth, it requires such strict assumptions – theabsence of any autonomous component of demand other than exports, theinduced nature of all other components of demand, and especially the full coinci-dence between investment decisions and saving decisions – that can hardlydescribe the way in which real economies work. It cannot properly representthe idea that the interactions between changes in demand and changes in capacityplay a fundamental role in the dynamics of growth processes, since no simpleformula can account for such complex interactions, and no hypothesis ofinduced demand automatically responding to exogenous stimuli can adequatelyrepresent the possibility of demand failures. In considering exports as a wholly

364 A. Palumbo


exogenous factor, it fails to give adequate representation to the idea that expansionin domestic production and capital accumulation may positively influence(through increasing returns) the very growth of exports.

The main problem of Kaldor’s analysis lies however with his conception ofinvestment, and its direct implication that as far as the long-run tendencies of thesystem are concerned there is no place for potential discrepancies between savingand investment decisions preventing the production of capacity output. Thisentirely overturns, for the long period, the very foundation of Keynes’s theoryof output determination, i.e. the possibility that the savings generated by anyattained level of capacity output may exceed the investment decisions thatwould justify its production.

Such a conception of investment as a completely induced phenomenon offersat best a partial and one-sided account of the motives guiding investmentdecisions, and one that does not fit well with the rest of Kaldor’s second-phaseanalysis. In the real world, not only are investment decisions likely to dependon a complex set of factors, such as the introduction of technical innovations orthe desire to conquer new markets, which cannot be reduced exclusively to thecapacity adjustment principle; but, moreover, the representation of the latter prin-ciple in terms of the accelerator is open to objection in itself. As Kaldor’s owncritical analysis had already shown in the 1950s (see Section 5 above), thesimple accelerator rule for determining investment entails full adjustmentbetween output and capacity both in the initial and in the final positions, some-thing that seems to be in contradiction with the very conception of growth asdemand-driven51 and with the idea that the growth potential is determined byactual growth. Although the growth of capacity over time is regulated by thetrend of expected demand, there can be no presumption that each unit of capacityoutput so installed will be met by sufficient demand. Actual output growth drivespotential output growth only if it is allowed to diverge from the latter (Setterfield,2002, pp. 4–5), which may imply variability of the average degree of capacityutilization in the long run (Garegnani, 1992; Trezzini, 1995).52

A theory in which the stimulus to invest is considered rarely, if ever, insuffi-cient to sustain the production of capacity output is a theory that neglects one rel-evant source of demand failures, thus providing a one-sided account of the growthprocess. The mechanical formula of the foreign trade multiplier and the rigidaccelerator rule for the determination of investment, with its implied conditionof continuous adjustment between capacity and demand, seem thus wholly incap-able of providing effective representation of Kaldor’s rich analysis of the second

51For a critical analysis of the rigid accelerator as entailing normal utilization of capacitysee Trezzini (1995, 1998).52As shown by Ciccone (1986), Garegnani (1992), Palumbo & Trezzini (2003), the long-period positions of the system, defined as those positions characterized by normal pricesand uniform rate of profit, need not be characterized by full adjustment between output andcapacity, since the tendency towards normal prices only requires that a uniform normalrate of profit be expected on investment flows in any productive sector and thus allowsfor discrepancies between output and total capacity.



phase, and seem particularly ill-suited to represent one of its main characteristics,namely the idea that growth is not a pre-ordained trajectory but an open processwith different possible outcomes.

Acknowledgments

Comments and suggestions by F. Vianello and two anonymous referees aregratefully acknowledged.

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