Review of Political Economy, Volume 15, Number 1, 2003

Supply and Demand in the Theory of

Long-run Growth: introduction to a
symposium on demand-led growth
MARK SETTERFIELD
Department of Economics, Trinity College, Hartford, CT, 06106 USA

Recent developments in growth theory have encouraged a revisionist interpretation of

the field. According to this interpretation long-run growth should be, and always has
been, interpreted as a supply-side process. The focus of this symposium is the macro-
economics of demand-led growth. As a precursor to the contributions that follow, two
central insights of demand-led growth theory are highlighted. First, chronic effective
demand problems create a role for aggregate demand in determining the utilization rates
of productive resources, even in the long run. Second, the demand-led actual rate of
growth influences both the accumulation and productivity of factor inputs, and hence the
economy’s potential rate of growth.

1. Introduction
It was once conventional to date the beginning of modern growth theory to the
work of Harrod (1939).1 Harrod’s analysis is based on the separation of
investment from saving. Specifically, investment varies independently of sav-
ing—a hallmark of Keynesian macroeconomics, with which Harrod’s contribu-
tions have long been associated. This results in an equilibrium or warranted rate
of growth that repels, rather than attracts, the actual rate of growth because of
the perverse macroeconomic effects of individual firms’ investment responses to
microeconomic signals (specifically, their rates of capacity utilization). More-
over, the warranted rate need not coincide with the economy’s maximum or
potential growth rate, which Harrod termed the ‘natural rate.’ Harrod thus
created a dynamic counterpart to Keynes’s short-run theory of income determi-
nation in which aggregate demand plays a central role.
The contribution of Solow (1956) was to ‘solve’ the problems posed by
Harrod by demonstrating that the economy will automatically gravitate towards
an equilibrium rate of growth consistent with the natural rate. This task was
achieved in no small part by his assumptions that saving and investment are
1
See, for example, Harcourt (1972), Jones (1976) Hsieh et al. (1978). The term ‘modern growth
theory’ is used here to delineate contributions to growth theory that postdate the marginalist revolution
from earlier, Classical theories of growth. It is not intended to denote the obsolescence or redundancy
of the latter, which continues to inspire many contemporary contributions to growth theory.

ISSN 0953-8259 print/ISSN 1465-3982 online/03/010023-10  2003 Taylor & Francis Ltd
DOI: 10.1080/0953825022000033107
24 Mark Setterfield

identical and that saving creates investment. As such, both the distinction
between these activities and the independence of investment behaviour that are
characteristic of Harrod and Keynes are lost, together with all of the macroeco-
nomic results that follow from this Harrodian/Keynesian thinking. Thus was
born the first generation of neoclassical growth theory, and thus began what
Palley (1996a) describes as the ‘neoclassical capture’ of growth theory. This is
nowhere more evident than in subsequent textbook discussions of Solow’s
results, which pay more attention to his use of a continuous production function
than to his assumptions about the relationship between investment and saving
(see, for example, Jones, 1976). The variability of the capital–output ratio (which
Harrod regarded as fixed) implicit in a continuous production function certainly
facilitates the adjustment of the warranted rate of growth towards the natural
rate. But the assumption that investment is identical to saving is instrumental in
causing this adjustment. By ruling out the possibility of effective demand
failures at any point in time, it ensures that macroeconomic equilibrium must
coincide with the economy’s supply-determined potential output. This same
assumption also eliminates at a stroke the source of instability in Harrod’s
model—namely, independent (of saving) variations in investment spending.
The neoclassical capture of growth theory continued with the emergence of
neoclassical endogenous growth (NEG) theory in the mid 1980s.2 This second-
generation neoclassical growth theory differs from the first by virtue of its
assumptions about the technical properties of accumulable inputs into the
production process.3 Specifically, the marginal returns to accumulable factors of
production are assumed to be bounded from below, but above zero. This makes
it possible to sustain long-run growth by investing in these factors.4 In Solow,
accumulation alone cannot sustain growth, as the marginal returns to physical
capital are assumed to fall to zero in the long run. Growth is therefore explained
by exogenous variables—the rate of growth of the labour force and the pace of
technical change. In NEG theory, growth is rendered endogenous because it is
explained within the model (usually in terms of its equilibrium solution) and in
terms of variables such as the rate of savings, which are subject to agent choice.
However, NEG theory shares with its Solovian predecessor an unrelenting focus
on the supply side as the wellspring of growth. NEG theory is certainly capable
of connecting demand to the rate of growth,5 but this connection is peripheral.
The behaviour of aggregate demand is generally viewed as an unimportant and
unnecessary constituent of growth analysis in NEG theory.
2
The seminal contributions are those of Romer (1986) and Lucas (1988).
3
As is typical in neoclassical theory, the process of production is treated as a technical phenomenon.
Social relations of production, as described by Classical theorists such as Marx, are not an integral
feature of the analysis.
4
Accumulable factors of production include not just physical capital but also human capital and
‘know how’. The knowledge content of these accumulable factors is thought to justify the assumption
that their marginal returns are bounded from below but above zero, because of the non-rivalrous and
(partially) non-excludable nature of knowledge as a commodity (see, for example, Grossman &
Helpman, 1991)
5
See, for example, Blackburn (1999). Indeed, it would seem that there is very little that NEG theory
is incapable of connecting to the rate of growth. This makes it difficult for NEG theorists to reach
a consensus as to what, exactly, the determinants of growth are (see Fine, 2000).
 Supply and Demand in the Theory of Long-run Growth 25

Inspired by these developments, it has now become conventional to write

the history of modern growth theory in terms of a seamless development of
supply-oriented, neoclassical growth analysis, which begins with Solow (1956)
and leads directly to NEG theory.6 The work of Harrod, together with the later
Cambridge growth theory of Robinson (1956), Kaldor (1955–6, 1957) and
Pasinetti (1962), and more recent Kaldorian (see, for example, Kaldor 1970,
1985; Thirlwall, 1979; McCombie and Thirlwall, 1994) and Kaleckian (see, for
example, Rowthorn, 1982; Dutt, 1984; Blecker, 2002) contributions are ignored
altogether.7 The upshot of all this is that growth is now commonly represented
as an unambiguously supply-side process. Hence Stern (1991, p. 123) defines
growth theory as being ‘about the accumulation of physical capital, the progress
of skills, ideas and innovation, the growth of population, how factors are
combined and managed and so on … [and] therefore, principally, about the
supply side.’ There is no hint that demand may play a role in either the
development or subsequent utilization of the productive forces he names.

2. Demand-led Growth
The contributions to this symposium challenge the supply-side vision of growth.
Demand-led growth theory identifies a twofold impact of demand on growth
rates. First, there exists a potential for effective demand failures, even in the long
run. Second, demand conditions influence the development of productive re-
sources (and hence the potential output of the economy) over time. Demand
matters, therefore, not just because of its chronic influence on the utilization
rates of productive resources (and hence the proximity of the actual to the
potential output path of the economy), but also because of its impact on the
quantity and productivity of inputs, and hence the potential output path itself.

2.1. Demand and the Utilization of Productive Resources in the Long Run
According to demand-led growth theory, there is no supply-determined equilib-
rium towards which the level of output inevitably and inexorably converges.

6
This observation is borne out by even the most cursory examination of contemporary textbooks
on growth theory. See, for example, Barro & Sala-i-Martin (1995), Aghion & Howitt (1998) and Jones
(1998).
7
NEG theory can be thought of as part of a colonizing project, in which economic theory, and social
science more generally, are being re-written (with the aid of the sort of revisionist history described
above) in the image of neoclassical economics and its singular methodological emphasis on the
atomistic, optimizing, individual agent (Fine, 1999, 2000). Some mainstream economists have
recently begun to acknowledge, celebrate and encourage this imperialism (see, for example, Lazear,
2000).
Harrod’s exclusion from contemporary histories of growth theory is rendered somewhat ironic
by the fact that, in NEG theory, the engine of endogenous growth is Harrod’s constant marginal
capital—output ratio (see, for example, Hussein & Thirlwall, 2000). This, coupled with the fact that
Kaldor is the true modern progenitor of endogenous growth theory (Palley, 1996b; Hussein &
Thirlwall, 2000), cements the idea that the key difference between neoclassical and Keynesian growth
theories is their treatment of demand, and not assumptions about technical properties of the
relationship between inputs and outputs.
26 Mark Setterfield

Instead, at any point in time, the utilization of existing productive resources is

determined by demand conditions that are relatively autonomous from the
conditions of supply. The actual output path of the economy (i.e. its growth
trajectory) is therefore demand-determined.8 The sequence of short-run outcomes
associated with the demand-determined utilization of productive resources traces
out the economy’s long-run growth path, without displaying any tendency to
gravitate automatically towards the potential output path of the economy. The
latter, then, does not possess the properties of a strong attractor, as it does in
neoclassical growth theory.
The idea that demand conditions determine the utilization of productive
resources in the long run has not met with universal approval, even amongst
non-neoclassical theorists. For example, a common feature of classical macrody-
namics is the notion that the economy must operate at its ‘normal’ rate of
capacity utilization in long run. This normal rate is defined independently of
demand conditions by firms’ preferences with respect to the rate at which their
physical plant and equipment is utilized.9 Put simply, the argument is that if the
normal rate of capacity utilization is not achieved, firms will continue to work
for change until their preferred normal rate of utilization is realized. But is the
normal rate of capacity utilization really defined independently of demand
conditions? The ‘normal’ rate may simply be the average actual rate of capacity
utilization (Dutt, 1999), or it may display hysteresis in response to changes in the
actual rate of capacity utilization (Lavoie, 1996). These arguments rebuff
Classical claims with respect to the behaviour of the capacity utilization rate and,
in the process, re-assert the endogeneity of the utilization rate to demand
conditions, even in the long run.

2.2. Demand and the Development of Productive Resources in the Long

Run
The potential growth rate of the economy depends on the growth of physical
capacity, labour resources, and factor productivity. But according to demand-led
growth theory, each of these—and hence the potential rate of growth itself—is
affected by the demand-determined actual rate of growth. This hypothesis is not
new. It was Adam Smith who first remarked that the division of labour depends
on the extent of the market. What contemporary demand-led growth theorists
have done is codify and expand upon Smith’s basic insight.
In the first place, if expanding demand involves increasing investment
spending, it will have a direct effect on capacity and (to the extent that technical

8
By defining the economy’s potential output at any point in time, the conditions of supply must, of
course, define a ‘ceiling’ that the actual output path cannot exceed. Growth can be supply-constrained,
then. The tenor of the comments above is designed to suggest that, whilst possible in principle, the
idea of a supply constraint on growth is seldom binding in practice. Moreover, the potential output
path of the economy is influenced by its (demand-determined) actual output path, for reasons that
will be made clear subsequently.
9
Note that this argument applies strictly to the utilization of physical capital. There is no
corresponding argument that the utilization rate of labour will also gravitate towards a pre-determined
‘normal’ rate.
 Supply and Demand in the Theory of Long-run Growth 27

progress is embodied in capital) productivity. Moreover, any expansion of

demand and output today will influence firms’ investment plans and their ability
to execute these plans—and hence the availability and productivity of capacity
tomorrow. The impact on planned investment works through accelerator effects
and through the positive influence of rapid demand and output growth on the
state of long-run expectations, which makes firms more willing to adopt illiquid
positions that increase their exposure to the downside risks associated with
fundamental uncertainty.10 The expansion of demand and output may also affect
the type of investment that firms plan. According to Lamfalussy (1961), firms are
more inclined to engage in ‘defensive investment’ (designed to protect market
share) than ‘enterprise investment’ (designed to introduce transformative change
in capacity and/or the technique of production) during periods of slow growth.
Evidence suggesting that R&D expenditures are positively influenced by the rate
of growth (see Schmookler, 1966; Brouwer & Kleinknecht, 1999) offers support
for this idea.
Moreover, there are issues of finance. Independent of their effects on
planned investment, demand and output growth can influence whether or not
investment plans get transformed into actual investment. Slow growth, which
diminishes profitability, may hamper the ability of firms to draw on
retained earnings to finance investment and adversely affect their perceived
credit-worthiness in the eyes of financial institutions. The latter are also likely to
have a higher liquidity preference, and therefore be less inclined to make
financial commitments to illiquid investments in industrial capital, during peri-
ods of slow growth.
Demand-led output growth can also affect the development of productive
resources through its influence on learning by doing. As the expansion of
demand and output increases productive activity, it will also increase the amount
of learning by doing, and hence the level of factor productivity that is associated
with this productive activity. Finally, demand-led growth can directly affect the
quantity and productivity of labour resources. The expansion of demand
influences both the size and allocation of the labour force, through its influence
on patterns of migration between regions and between sectors of the economy.
Cornwall (1977) argues that vacancy rates rather than relative wages are the key
determinant of labour supply; as greater aggregate demand and output increase
the demand for labour, the supply of labour also increases. This increased labour
supply may arise from changes in labour force participation rates in the short
run. In the long term, it is sustained by the impact of employment growth on
regional migration patterns. At the same time, an environment of unbalanced
growth causes labour resources to be reallocated among different sectors of the
economy (agriculture, industry and services) in which the levels and rates of
growth of labour productivity differ. This process of sectoral labour reallocation
impacts the overall (economy-wide) rate of productivity growth, and in a manner

10
The influence of demand and output growth on the quantity of investment may be complicated
and even exacerbated by discontinuities due to the ‘lumpiness’ or indivisibility of capital.
Indivisibilities mean that particular vintages of capital and the techniques of production they embody
only become viable at certain discrete levels of output. Otherwise, capital is chronically underutilized.
28 Mark Setterfield

that is sensitive to both the overall growth rate and the sources of this growth
(Cornwall, 1991; Cornwall & Cornwall, 1994).

2.3. Reconciling the Rates of Growth of Supply and Demand

It should be obvious by now that, whereas neoclassical growth theory posits the
operation of Say’s law in the long run (demand adjusts passively towards
supply-determined potential output), demand-led growth theory postulates the
operation of ‘Say’s law in reverse’ (Cornwall, 1972). Through changes in
utilization rates and the impact of demand on the availability and productivity of
factor inputs, supply adjusts to accommodate the growth of demand, which is the
proximate source of the growth of output.
However, this emphasis on the demand side and the resulting conception of
growth as a demand-led process does not imply that the supply side can be
neglected altogether. Apart from the importance of detailing the processes by
which supply responds to demand, there is the question of how, if at all, the rates
of growth of demand and supply come to be reconciled. Is the elasticity of
supply with respect to demand always equal to one, which a casual interpretation
of the ‘Say’s law in reverse’ dictum seems to imply and which must be the case
if an economy subject to steady growth is to avoid either growing excess
capacity or growing excess demand? When proponents of demand-led growth
theory explicitly address this question, their answer is usually negative.11 It is
therefore important to investigate not just the response of supply to the growth
of demand, but also the relative magnitude of this response, and the question as
to what (if any) processes exist that can reconcile the rates of growth of demand
and supply so that steady growth is possible without either continually increasing
excess capacity or continually increasing excess demand.12

3. Overview of the Symposium

The papers that follow are rooted in different traditions and focus on different
issues in the theory of demand-led growth. The paper by Marc Lavoie con-
tributes to the neo-Kaleckian tradition in growth theory, which was pioneered by
Harris (1974), Asimakopulous (1975), Rowthorn (1982) and Dutt (1984) and
derives from the Cambridge growth theory of Robinson (1956).13 Central to this
tradition are two results—the paradox of thrift (an increase in the propensity to
save reduces the rates of profit and growth) and the paradox of costs (an increase
in real wages increases the rates of profit and growth). These results typically
depend on a controversial discrepancy between the actual and target rates of
profit. Lavoie’s contribution is to develop a mechanism, based on the conflict

11
See Cornwall (1972) and the paper by Palley in this symposium.
12
This is important even if capitalist growth is understood as being episodic, so that steady growth
is confined to discrete historical periods (such as the post-war Golden Age). Even these growth
episodes are of sufficient duration to render absurd theoretical outcomes that result in continually
increasing excess capacity or demand.
13
See Blecker (2002) for a survey of the history and development of neo-Kaleckian growth theory.
 Supply and Demand in the Theory of Long-run Growth 29

theory of inflation, that reconciles the actual and target rates of return in a
Kaleckian growth model, without forfeiting either the paradox of thrift or the
paradox of costs.
A standard Kaleckian growth model is first developed. Both the paradox of
thrift and the paradox of costs are present, but the actual and target rates of
return need not be equal in the long run. When mechanisms that cause the target
rate of return to adjust towards the actual rate are introduced, this problem is
solved, but at a cost. The paradox of thrift and/or the paradox of costs are wont
to disappear.
Lavoie then introduces the conflict theory of inflation, in which inflation is
a function of inconsistencies in the nominal income aspirations of workers and
firms. He shows that when this model of inflation is combined with the standard
Kaleckian growth model, the latter exhibits the paradox of thrift. Moreover,
when a mechanism that causes the target rate of return to adjust towards the
actual rate is introduced, not only are these rates of return equalized in the long
run, but the rate of capacity utilization remains endogenous. This ensures that the
model also exhibits the paradox of costs.
In a paper that picks up from the contributions of Cornwall (1972), and
revisits one of the key issues in the theory of demand-led growth discussed
earlier, Thomas Palley argues the importance of modelling not just the rate of
growth of demand, but also the rate of growth of supply and (crucially) the
interaction between the two. This helps render explicit the ‘Say’s law in reverse’
property of demand-led growth models, and also draws attention to the need for
the rates of growth of supply and demand to be reconciled if an equilibrium
growth path is to be sustainable in the long run. Palley begins by reviewing a
number of different models of the supply side, each of which renders a different
set of possibilities for reconciling supply and demand growth in the long run. He
then demonstrates the importance of these considerations in the context of a
neo-Kaldorian balance-of-payments-constrained growth (BPCG) model (Thirl-
wall, 1979). The BPCG model is shown to be over-determined, giving rise to
two rates of growth (a rate of growth of demand and a rate of growth of supply)
whose equivalence is a special case. Palley then proposes various resolutions to
this problem, based on demand- or supply-side responses to changes in the rate
of capacity utilization. For example, it is postulated that the income elasticity of
demand for imports may be a negative function of excess capacity. This is
because, as excess capacity falls, bottlenecks in domestic industry become more
prevalent, and these supply constraints increase the proportion of incremental
income that is spent on imports. As a result, the rate of growth of demand that
is consistent with a given rate of growth of world income (as determined by
Thirlwall’s law) adjusts towards the rate of growth of demand consistent with
supply growth, as determined by the rate of growth of the labour force and
Verdoorn’s law.
The focus of the paper by Sergio Cesaratto, Franklin Serrano and Antonella
Stirati is technical change and full employment in a growing economy. The
authors argue that, contrary to received wisdom, unless technical change is
accompanied by exogenous events or policy interventions that stimulate auton-
omous demand, long run effective demand failures are likely and technical
30 Mark Setterfield

change will not be consistent with the maintenance of a full employment growth
path.
According to neoclassical theory, technical change impacts unemployment
in the long run only to the extent that it affects the value of the natural rate of
unemployment or NAIRU—by exacerbating skill mis-match problems, or raising
the equilibrium real wage set by insiders, for example. If these ‘imperfections’
can be expunged from the labour market, technical change will only have a
transitory effect on unemployment.
Cesaratto, Serrano and Stirati contend that a long-run theory of effective
demand is necessary in order to identify the precise effects of technical change
on unemployment. To this end, they develop a ‘super multiplier’ analysis in
which the rate of growth of autonomous demand determines the rates of growth
of effective demand and productive capacity. This model is then used to study
the impact of technical change on the process of accumulation and hence the rate
of unemployment. Cesaratto, Serrano and Stirati show that technical change is
unlikely to increase the demand-led actual rate of growth and, to the extent that
it does, its effects are mediated by factors such as the distribution of income and
the system of credit creation. Moreover, there is no guarantee that any increase
in the actual rate of growth will be commensurate with the supply-side impact
of technical change on the potential rate of growth, as must be the case (ceteris
paribus) if the rate of unemployment is to remain constant. The authors conclude
by suggesting that more emphasis should be placed on the demand side in
analyses of European unemployment, and less attention paid to institutional
features of European economies that allegedly impede adjustment to technical
change.

4. Final Remarks
The essential purpose of demand-led growth theory is to demonstrate the
importance of effective demand in the determination of long-run growth out-
comes. As such, it serves as an important antidote to the supply-side vision of
the long run propagated by neoclassical growth analysis. But demand-led growth
theory also raises issues connected with the distribution of income, the balance
of payments, technical change and the reconciliation of demand and supply in
the long run that are either peripheral to, or entirely absent from, neoclassical
growth theory. It is to the further investigation and development of these
issues—as well as to the championing of effective demand as an essential
constituent of growth theory—that the papers in this symposium are devoted.

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