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)| false “ Vogel, R.C., and S.A. Buser, Inflation, Financial Repression and Capital Formation in Latin America,” in Money and Finance in Economic Growth and Development: Essays in Honor of Edward S. Shaw, ed. by ( Ronald I. McKinnon New York: Marcel Dekker, 1976), pp. 35- 70.
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Mr. Molho, an economist in the Central Banking Department, is a graduate of Yale University.
A detailed discussion of various rationales for a policy of low interest rates is given in Shaw (1973, pp. 92-112). For a survey of empirical studies on investment behavior in advanced countries, see Jorgenson (1971). Empirical studies on the interest sensitivity of savings and investment in developing countries were much more scarce until the early 1970s, in part as a result of data limitations. For discussions of the relevant literature, see Mikesell and Zinser (1973) and Leff (1975).
Even though McKinnon described an extreme case of financial repression, with no possibilities of external finance, his argument is intuitively appealing under much more general circumstances. For example, in the U.S. economy, with its highly sophisticated financial system, housing investment is subject to similar considerations. External financing is typically available for only a fraction of the price of a house, and some savers may need a few years to accumulate sufficient funds for a downpayment. For these savers, high money market rates may encourage accumulation of liquid assets for the purpose of buying a house. Even if higher rates do not generate more saving, they may increase investment by making more expensive houses affordable.
Gupta (1984, p. 3), for example, argues that “neither McKinnon nor anyone else has offered any rationale” for McKinnon’s assertion that “ ‘private saving (investment) is… sensitive to the real return on holding money,’” although this assertion is at the center of McKinnon’s argument. Van Wijnbergen (1983, p. 433), in a similar vein, refers to McKinnon’s analysis as eloquent but occasionally vague. For specific references to misunderstandings of McKinnon’s complementarity hypothesis, see footnote 18.
Fry (1982), for example, asserts that complementarity is incompatible with the debt-intermediation view. Gupta (1984) also refers to the two hypotheses as competing theories, although he makes an attempt to integrate them in one empirical model.
Financial repression is defined to entail artificially low deposit and loan rates that give rise to excess demand for loans and to nonprice credit rationing (McKinnon (1973, Ch. 7) and Shaw (1973, Ch. 4)).
This pattern of savings accumulation is by no means peculiar to financially repressed economies. Self-financing may be optimal even in economies with highly developed capital markets when borrowing rates are sufficiently high.
In principle, C3 may be a random variable if there is uncertainty with respect to interest rates. Constraints (5) and (6) can then be interpreted to hold for expected values. The cases with and without risk will be considered separately in the following analysis.
The detailed solution of the model and the derivation of the results presented in the following subsections (“The Case of Certainty” and “The Case of Uncertainty”) are available from the author on request.
This case is perhaps the most appropriate one for illustrating the nature of complementarity between deposits and capital described by McKinnon, who assumes that “all economic units are confined to self-finance, with no useful distinction to be made between savers (households) and investors (firms)—-These firm-households do not borrow from, or lend to, each other” (McKinnon (1973, p. 56)).
In addition to riskiness, divisibility, and the rate of return, there are other characteristics, such as taxability, liquidity, and transaction costs, that may make one asset dominate the other in consumers’ preferences. The model abstracts from taxes, and liquidity is not very important because the investor knows with certainty when he will be selling his assets. Thus, the rates of return, which can be defined to be net of transaction and other related costs, ultimately determine which asset will be held.
The implicit assumption here is that rd does not rise enough to overtake rk. If rd > rk, then the model implies that all wealth is shifted into deposits and that investment in physical capital falls to zero; this is one of the points made by Khatkhate (1980).
The partial equilibrium framework here is not well suited to a rigorous treatment of this issue. The other side of negative real deposit rates may be artificially cheap credit. The net effect of interest rate changes on capital formation, then, depends on how this subsidized credit is used. If borrowers allocate subsidized credit to investment spending exclusively, then low rates need not hamper capital formation. If, in contrast, credit finances consumer expenditures or capital flight, higher rates may be expected to promote domestic investment. Such general equilibrium considerations are outside the scope of this paper, but some of these issues are discussed informally in Section II.
An alternative way of modeling the borrowing constraint would be to assume a maximum debt-equity ratio. Although this might seem more plausible than a nominal ceiling on borrowing capacity, the latter has been chosen because it makes the algebra much more tractable.
Vogel and Buser (1976) allow for three risky assets. Their one-period model, however, cannot adequately account for the conduit role of deposits.
The possibility that the expansion of the operations of financial intermediaries may be associated with a decrease in investment spending in the short run has been extensively discussed by Tobin and Brainard (1963) and, more recently, by van Wijnbergen (1983).
These aspects of McKinnon’s model have been subject to some misunderstanding. Vogel and Buser (1976, p. 36), for example, write that
Money and capital cannot be complements when they are the only two assets held in the portfolio and when the constraint on total assets is fixed. Thus, it is not surprising that the complementarity hypothesis has been overlooked in growth models where money is grafted onto the economy as the second of only two assets. However, the consideration of additional classes of assets introduces the possibility of limited complementarity. For McKinnon and Shaw, the additional assets considered are stores of goods or finished inventories labeled as inflation hedges.
As was shown above, temporal considerations may account for complementarity between money and capital in the absence of any other assets. Similarly, van Wijnbergen’s (1983) criticism of McKinnon (1973) is based on a one-period portfolio-balance model, which is unsuited for capturing the intertemporal complementarity that is at the core of McKinnon’s argument.
The balance-sheet constraint that can be obtained by aggregating equation (5) over all individual savers implies that the aggregate demand for money can be determined as a residual once the aggregate savings and demand for capital functions have been determined. The balance-sheet constraint can also be used to determine the interrelationships among the partial derivatives of the savings and asset demand functions.
See, for example, Abe and others (1975 and 1977), Akhtar (1974), Fry (1978), Galbis (1979), Gupta (1984), Qureshi (1981), Vogel and Buser (1976), and Yoo (1977). A survey of some of these and of other relevant studies is also included in Gupta (1984).
One possible reason for the exclusion of this variable may be the practical difficulties associated with its measurement. For a survey of the theoretical and empirical issues relating to the measurement of the rate of return on capital in developing countries, see Leff (1975).
This disregard may in part stem from the nature of the original presentations of the McKinnon-Shaw arguments, which were based on growth models describing steady-state equilibria, but data limitations may also account for researchers’ aversion to specifications with long lags.
Gupta (1984), for example, estimated investment functions for a number of developing countries, including only current financial savings and the current interest rate as explanatory variables; a more appropriate specification would also seek to relate current investment to past financial savings and past rates of return on financial assets, in accordance with the theoretical model presented here.
An example of the possibilities for misinterpretation of the empirical evidence on the complementarity hypothesis is Fry’s attempt to determine which of the McKinnon-Shaw models is more relevant by estimating different versions of the money demand function on data from ten Asian countries. Fry (1978, p. 470) started with McKinnon’s specification of real money demand as a function of real income, the real deposit rate, and the investment-income ratio. He estimated this function by regressing money demand on the contemporaneous explanatory variables, a procedure that yielded a negative and statistically significant coefficient for the investment-income ratio. The sign of this coefficient was interpreted as evidence refuting the complementarity hypothesis. According to the model presented here, however, complementarity would imply a positive association between current demand for money and intended future investment. To the extent that investment is self-financed, current investment might be associated with a decumulation of money balances, making the above result compatible with the complementarity hypothesis.
In industrialized countries, interest rate increases may be associated with a negative wealth effect for holders of bonds and stocks. Deposits, however, are not subject to such risk of capital loss. Unlike more illiquid assets, deposits have a fixed current nominal worth that can be fully realized upon withdrawal.
For a systematic analysis of how the effects of interest rates on investment depend on the debt-equity ratios of firms, see Sundararajan (1985).
Such experiences were all too common in the hyperinflations that preceded and followed World War II in several European countries. It is not surprising that, after seeing the value of paper assets reduced to practically nothing on various occasions, many Europeans are still reluctant to hold large sums of financial assets and have a special affinity for traditional inflation hedges such as gold.