Abstract
This Selected Issues paper and Statistical Appendix analyzes economic developments in Colombia during 1996–99. Output growth slowed sharply in 1996 and early 1997, but subsequently rebounded owing to stronger exports, a temporary boom in world coffee prices, and an easing of credit policy. Despite efforts at addressing the fiscal imbalances, the nonfinancial public sector deficit widened further to more than 4 percent of GDP in 1997. Monetary policy during 1996 and most of 1997 was geared toward stimulating domestic demand.
II. The Costs of Moderate Inflation in Colombia7
12. Between 1955 and 1972, inflation in Colombia was relatively low. Since 1973, however, Colombia has experienced persistent inflation, which in the 1990s, has been mostly in the range of 18-23 percent (Figure 1). Yet, Colombia has also been known for its prudent macroeconomic policies, to which have been attributed its record of sustained economic growth and manageable external debt, in contrast to the experience of other Latin American countries. Fiscal deficits were kept low (before widening sharply in recent years), while the monetary authorities kept an eye toward an alarm signal of 30 percent inflation: when inflation exceeds that level (as in 1977 and 1990), monetary policy would be tightened to counteract it (Echeverry, 1996).
Colombia: Consumer Price Inflation
(In percent)
Citation: IMF Staff Country Reports 1999, 006; 10.5089/9781451808735.002.A002
Sources: Banco de la Republica; and Fund staff estimates.Colombia: Consumer Price Inflation
(In percent)
Citation: IMF Staff Country Reports 1999, 006; 10.5089/9781451808735.002.A002
Sources: Banco de la Republica; and Fund staff estimates.Colombia: Consumer Price Inflation
(In percent)
Citation: IMF Staff Country Reports 1999, 006; 10.5089/9781451808735.002.A002
Sources: Banco de la Republica; and Fund staff estimates.13. Perhaps because moderate inflation has been accompanied by sustained growth and because of widespread indexation (mostly informal) in the economy, there has not been a vocal constituency within Colombia for stronger measures to reduce inflation, but inflation is now among the highest in the region. It has been suggested (e.g., Partow, 1995b) that the uptrend in Colombian inflation since 1973 has been partly responsible for the slowdown in real GDP growth. On the other hand, because inflation has been moderate and relatively stable, it has also been argued that its negative effect on growth could not have been substantial.
14. This chapter reviews the evidence regarding the effects of moderate inflation in Colombia on economic welfare and economic growth. In the general literature on inflation, it has been pointed out that even in the case of anticipated inflation, economic welfare is lower due to the costs that arise from the need to economize on real money balances and to revise prices, and from the losses due to less than full indexation of tax systems and contracts. Furthermore, when inflation is unanticipated, these costs also arise: (i) unplanned redistribution of income and wealth; (ii) distortions to economic agents’ decisions arising from increased uncertainty regarding future inflation; and (iii) misallocation of resources due to the unwarranted dispersion of relative prices.
A. Trends, Analyses, and Welfare Costs
15. As Figure 1 shows, inflation steadily trended upward over the period 1970-92, but the trend has since edged downward. Several reasons why inflation has persisted in the 18-23 percent range have been: the crawling peg exchange rate adopted in 1967; the indexation of the system of housing finances (UP AC); the indexation of tax brackets; partial indexation of wages; and widespread indexation in other sectors (albeit not as formalized as it had been in, say, Brazil). Indexation produces inflationary inertia, increases the sensitivity of inflation to negative supply shocks, and thwarts needed changes in relative prices. In the end, inflation is a monetary phenomenon, and there have been several analyses of the monetary causes of moderate inflation in Colombia.
16. Cárdenas and Partow (1998) argue that inflation in Colombia has been moderate to high primarily because inflation control has not been the only objective of monetary policy. Over the period 1963-91, monetary policy was often geared towards stabilizing the business cycle. On the other hand, whenever the rate of inflation exceeded 30 percent, strong action against inflation would be taken. Cárdenas and Partow (1998) argue that the central bank’s governing board lacked the “conviction … that the fight against inflation was worth the effort.” Since the central bank was made more independent in 1992, money growth has been lower. Nevertheless, they conclude that although the more independent central bank has shown less tolerance for inflation, the new monetary policy framework continues to place weight on output and employment stabilization in addition to inflation reduction; consequently, the decline in inflation since 1992 has been gradual and difficult to achieve.8
17. Complementarily, Echeverry (1996) looks at the reaction of monetary policy to shocks to foreign exchange reserves and concludes that several times during the 1980s, other objectives were put ahead of inflation reduction (e.g., output and employment and the health of the financial sector). He also notes that the inertial character of Colombian inflation may have been overemphasized, creating an impression that could result in an overestimation of the costs of disinflation.
18. There have also been studies of the welfare costs of inflation, which arise even if inflation is perfectly anticipated.9 At their most basic, these take the form of so-called “shoe-leather costs”: to avoid holding cash, which loses value, people would make more frequent trips to the banks or attempt to synchronize spending with receipts of income. However, these stratagems entail transactions costs, as well as foregone benefits (e.g., the time that could have been used for leisure), reducing the welfare of economic agents. Riascos (1997) estimates that 20 percent inflation (as opposed to zero inflation) costs Colombia approximately 1.5 percent of annual consumption. Carrasquilla et al. (1994) conclude that a reduction from 22 percent to 5 percent inflation would raise social welfare by around 8 percent. Finally, Posada (1997) calculates that even a perfectly anticipated inflation rate of 20 percent costs Colombia 3 percent of GDP per year in welfare losses.
B. Inflation Uncertainty and Relative Price Dispersion
19. There are two ways in which high or moderate inflation could be associated with uncertainty in general. First, high or moderate inflation is often associated with inflation uncertainty, that is, increased uncertainty regarding future inflation. Because many economic decisions (saving, investment, labor supply, etc.) are dependent on the formation of expectations regarding prices, inflation uncertainty tends to distort decisions regarding the allocation of resources. Furthermore, the increased uncertainty regarding the ex post real rate of interest could make financial instruments riskier, driving providers of capital to raise ex ante interest rates, making it more difficult for otherwise viable projects to pass rate-of-return hurdles, and thus depressing capital formation and perhaps growth.
20. Ball (1992) has suggested an explanation for the positive relationship between high or moderate inflation and inflation uncertainty: as inflation increases, the public becomes more uncertain about the central bank’s attitude toward inflation. When inflation is low, everybody wants to keep it low, but at higher levels, central banks that are committed to low inflation would try to reduce it, whereas those with a weaker commitment to reducing inflation may attempt to benefit from the short-run trade-off between inflation and unemployment. Hence, when inflation is high, the central bank’s response to inflation becomes less certain; in such a situation, policy changes become more likely and the outcomes of such changes become more uncertain.
21. Second, inflation could reduce the informational efficiency of the price system by raising the dispersion of relative prices. If there exist fixed costs to changing prices (“menu costs”) and these costs vary among firms, then an increase in inflation would lead to staggered price changes across the economy, and thus to an increase in relative price dispersion. Alternatively, the increased inflation uncertainty associated with high or moderate inflation could make firms’ output responses relatively inflexible; consequently, prices have to bear the brunt of adjusting to shifts in demand and supply and will have to move around a lot, also increasing relative dispersion. Although some degree of relative price dispersion is unavoidable in a market economy, large changes in relative prices that are unrelated to fundamental demand and supply conditions could generate inefficiencies by “muddling” economic agents’ perception of price signals, akin to the situation under inflation uncertainty.
22. One measure of inflation uncertainty is the variability of inflation. Figure 2 indicates a positive relationship between inflation and its variability (as measured by its standard deviation) for the period 1955-97; hence, it would seem to be getting harder to forecast inflation in Colombia as it increases. However, the observed variability of inflation may not be an entirely valid proxy for uncertainty (which is not directly observable) because economic agents could well have forecast variability. It has, therefore, become standard in the literature to use the following procedure: (i) estimate a forecasting equation of inflation that allows the variability of inflation to differ in each period (the so-called ARCH model); and (ii) from the estimated equation, extract the estimated variability as a measure of uncertainty. In effect, this methodology somewhat stacks the deck against finding a positive relationship between inflation and inflation uncertainty; nevertheless, a positive relationship was still found to hold between inflation and this alternative measure of uncertainty.10
Colombia: Standard Deviation and Average Level of Inflation
Citation: IMF Staff Country Reports 1999, 006; 10.5089/9781451808735.002.A002
Source: Fund staff estimates.Colombia: Standard Deviation and Average Level of Inflation
Citation: IMF Staff Country Reports 1999, 006; 10.5089/9781451808735.002.A002
Source: Fund staff estimates.Colombia: Standard Deviation and Average Level of Inflation
Citation: IMF Staff Country Reports 1999, 006; 10.5089/9781451808735.002.A002
Source: Fund staff estimates.23. Figure 3 shows the behavior over time of the extracted measure of inflation uncertainty, as well as of actual inflation. There seem to have been three periods when inflation uncertainty was particularly high: the mid-1960s, the late 1970s, and the late 1980s. It can be noted that these have also approximately been periods when inflation levels have peaked. In fact, regression results suggest that a 10 percent increase in inflation leads to a 4.6 percent increase in uncertainty regarding future inflation, which is a substantial effect.
Colombia: Inflation and Inflation Uncertainty
(In percent)
Citation: IMF Staff Country Reports 1999, 006; 10.5089/9781451808735.002.A002
Source: Fund staff estimates.Colombia: Inflation and Inflation Uncertainty
(In percent)
Citation: IMF Staff Country Reports 1999, 006; 10.5089/9781451808735.002.A002
Source: Fund staff estimates.Colombia: Inflation and Inflation Uncertainty
(In percent)
Citation: IMF Staff Country Reports 1999, 006; 10.5089/9781451808735.002.A002
Source: Fund staff estimates.24. Figure 4 shows the behavior over time of relative price dispersion in Colombia.11 Econometric analyses indicate that both lagged inflation and inflation uncertainty are positively associated with dispersion. The former suggests that “menu costs” (the fixed costs of changing prices) have played a role in generating dispersion, while the latter suggests that inflation uncertainty, by “muddling” economic agents’ perceptions of price signals, has also caused relative prices to diverge. Interestingly, the results indicate that the latter effect has had a larger role. The persistence of inflation at double-digit levels could have induced firms to adapt by finding ways to reduce the fixed costs of changing prices in order to keep up with inflation; more directly, the presence of indexation schemes could have mitigated “menu costs.”
Colombia: Relative Price Dispersion
(In percent)
Citation: IMF Staff Country Reports 1999, 006; 10.5089/9781451808735.002.A002
Source: Fund staff estimates.Colombia: Relative Price Dispersion
(In percent)
Citation: IMF Staff Country Reports 1999, 006; 10.5089/9781451808735.002.A002
Source: Fund staff estimates.Colombia: Relative Price Dispersion
(In percent)
Citation: IMF Staff Country Reports 1999, 006; 10.5089/9781451808735.002.A002
Source: Fund staff estimates.C. Inflation and Growth in Colombia
25. What have been the consequences for economic growth of the increased inflation uncertainty and relative price dispersion associated with inflation in Colombia? It seems intuitive that the uncertainty generated by inflation would depress capital formation and, in turn, the rate of economic growth. There have been several studies on the relationship between inflation and growth in Colombia, but the results have been mixed. Uribe (1994) finds that, for the period 1951-92, neither the level nor the variability of CPI inflation have had a statistically significant effect on growth. He attributes this to the fact that whereas inflation was low but relatively volatile in the 1950s and 1960s, it has been high but relatively stable since the 1970s. By contrast, Partow (1995a), studying the same period, finds that inflation has had a negative and statistically significant effect on real GDP growth, and that it takes about ten years for the negative effect to wear off. In a related study, Partow (1996) finds that the standard deviation of inflation has had a positive and statistically significant effect on private investment.12
26. An econometric analysis of inflation, uncertainty (both inflation uncertainty and relative price dispersion), private gross fixed capital formation, and real GDP growth was conducted on annual data (for 1955-97). The main results are as follows:13 First, inflation has consistently been a statistically important variable in explaining growth in Colombia. Second, relative price dispersion has had some role in explaining growth, but inflation uncertainty has not had a major role in explaining either investment or growth. Third, increases in either inflation, inflation uncertainty, or relative price dispersion, depress investment growth within one year, but modestly stimulate it within two years; and have a negative impact thereafter. Fourth, the effect of inflation on real GDP growth is negative and persistent: nine years after an upward shock to inflation, real GDP growth remains below what it would have been without the shock.
D. Conclusions
27. Colombia’s inflation experience is striking in that, since 1973, it has experienced moderate, persistent, and relatively stable inflation. The steady increase from low rates in the 1950s has been attributed to the sidelining of inflation as a policy priority, in the pursuit of other goals such as output and employment stabilization. Since the establishment of a relatively more independent monetary authority in 1992, however, inflation has gradually slowed.
28. Perhaps because inflation has been moderate and positive real GDP growth has been sustained, there has not been much pressure within Colombia for a faster pace of inflation reduction. However, Colombia would do well to pursue such a reduction. For one thing, inflation even at moderate levels, causes welfare losses due to inefficiencies occasioned by the need to economize on money holdings. Estimates are that these welfare losses amount to 3 percent of GDP. For another, to the extent that inflation is associated with increased uncertainty and the consequent “muddling” of price signals, distortions of economic agents’ decisions, and misallocation of resources, it could have negative effects on real GDP growth. Econometric analyses for Colombia show that there is a positive relationship between inflation and either inflation uncertainty or relative price dispersion. Furthermore, there is a negative and persistent effect of inflation on real GDP growth. Hence, although Colombia has done remarkably well since the 1950s, considering its moderate and persistent inflation, it could have done better. That Colombia’s inflation and growth performance now lags that of other Latin American countries bears testimony to this.
References
Ball, Laurence, 1992, “Why Does High Inflation Raise Inflation Uncertainty?” Journal of Monetary Economics Vol. 29, pp 371–88.
Caballero, Ricardo J., 1991, “On the Sign of the Investment-Uncertainty Relationship,” American Economic Review Vol. 81, pp. 279–88.
Cárdenas, Mauricio, and Zeinab Partow, 1998, “Does Independence Matter? The Case of the Colombian Central Bank,” Working Paper (Santafé de Bogotá: FEDESARROLLO).
Carrasquilla, Alberto, Arturo Galindo, and Hilde Patrón, 1994, “Costos en Bienestar de la Inflación: Teoría y Una Estimación para Colombia,” Borradores Semanales de Economía No. 3 (Santafé de Bogotá: Banco de la República).
Echeverry, Juan Carlos, 1996, “The Rise and Perpetuation of a Moderate Inflation: Colombia 1970-91,” Borradores Semanales de Economía No. 50 (Santafé de Bogotá: Banco de la República).
Ma, Henry, 1998 (forthcoming), “Inflation, Uncertainty, and Growth in Colombia,” IMF Working Paper (Washington, D.C.: International Monetary Fund).
Partow, Zeinab, 1995a, “Una Investigación Empírica Sobre el Impacto de la Inflación en el Crecimiento Económico de Colombia, 1951-1992,” Borradores Semanales de Economía No. 17 (Santafé de Bogotá: Banco de la República).
Partow, Zeinab, 1995b, “La Relación Inflación-Crecimiento: Un Resumen con Algunas Implicaciones Para Colombia,” Borradores Semanales de Economía No. 23 (Santafé de Bogotá: Banco de la República).
Partow, Zeinab, 1996, “Incertidumbre Económica e Inversión Privada en Colombia,” Borradores Semanales de Economía No. 56 (Santafé de Bogotá: Banco de la República).
Posada, Carlos Esteban, 1997, “Otro Costo de Una Inflación Perfectamente Prevista,” Borradores Semanales de Economía No. 77 (Santafé de Bogotá: Banco de la República).
Riascos, Alvaro J., 1997, “El Costo en Bienestar de la Inflación en Colombia,” Working Paper (Santafé de Bogotá: Banco de la República).
Uribe, Jose Dario, 1994, “Inflación y Crecimiento Económico en Colombia: 1951-1992,” Borradores Semanales de Economía No. 1 (Santafé de Bogotá: Banco de la República).
Prepared by Henry Ma.
In this connection, 1997 marked the first time that the official inflation target (18 percent for that year) has been met since such targets began to be announced in 1991.
The relationship between inflation and uncertainty, and its effects on economic growth are discussed below in Section C.
Detailed results of the econometric analyses mentioned in this and subsequent sections are in Ma (1998).
Relative price dispersion for each period is computed as the weighted sum of the squared differences between the aggregate inflation rate and the rate of change of each component of the consumer price index. The component groups and their weights are: food (35 percent), housing (33 percent), clothing (9 percent), and miscellaneous items (23 percent).
Caballero (1991) has pointed out that for a negative relationship to hold, certain stringent mathematical conditions regarding the firm’s profit function have to be fulfilled. A priori, the sign of the relationship cannot be determined, and is an empirical question.
Detailed results are in Ma (1998, forthcoming).
