Financial Assets, Inflation Hedges, and Capital Utilization in Developing Countries: An Extension of McKinnon's Complementarity Hypothesis

Abstract

In a highly influential book McKinnon [1973] proposed that interest rate liberalization and low inflation can promote capital accumulation and economic growth in developing countries. An important aspect of McKinnon's work is his formal argument that money (broadly defined to include both cash and bank deposits) and physical capital are more likely to be complements than substitutes under conditions of where interest rate controls or high inflation reduce the real yield on money balances to low or even negative levels [McKinnon, Chapter 6]. McKinnon's formal analysis assumes that household firms and other small enterprises in financially repressed developing economies are faced with significant capital indivisibilities and have no access to credit, so that they are forced to accumulate substantial amounts of noncapital assets before undertaking productive investments. Under financial repression, accumulation of inflation hedges (commodity inventories, for example) may be the least-cost method of building up these noncapital asset balances required for lumpy investments in physical capital. Even inflation hedges may have negative returns (e.g., due to high storage costs), thereby further reducing potential capital accumulation. In this situation an increased yield to money balances (via interest rate liberalization or lower inflation) can lower the cost of accumulating funds for physical capital purchases, so that increased money balances may be associated with a more rapid rate of capital accumulation and hence economic growth. McKinnon's complementarity hypothesis thus emphasizes the use of cash and deposit balances as a conduit for physical capital accumulation by credit-constrained enterprises. However, as noted by Drake [1980, p. 66]: