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Inflation and financial deepening
Journal of Development Economics 20 (1986) 125--133. North-Holland
INFLATION AND FINANCIAL DEEPENING* B.J. MOORE Wesleyan University, Middletown, CT06457, USA Received February 1983, final version received June 1984 Financial deepening is defined as increases in the ratio of a country's financial assets to its GDP. Financial asset accumulation simultaneously provides credit to finance real asset accumulation for the development process. The equilibrium long-run ratio of financial assets to GDP may be expressed as a simple relationship of a country's financial savings ratio and its growth rate. The present paper incorporates the effects of inflation on financial deepening. Inflation necessarily entails capital losses on all existing financial asset holdings. It is shown that unless more monetary saving is forthcoming to offset such inflation-induced capital losses, inflation will operate to reduce drastically the degree of financial deepening which a country can obtain. The process is illustrated with respect to the Korean economy.
1. Introduction
Financial deepening is defined as increases in the ratio of a country's financial assets to its GDP [Shaw (1973)]. Money in the real world is not dropped from helicopters. Accepting the debt-intermediation view of inside money, the accumulation of money balances simultaneously provides bank credit to finance tangible asset accumulation [Shaw (1973), McKinnon (1973), Cheng, (1980)]. In an important paper McKinnon (1976) demonstrated that the equilibrium long-run ratio of financial assets to G D P may be expressed as a simple relationship of a country's capital/output ratio, growth rate, savings rate, and the 'money intensiveness' of private savings. MeKinnon solved for the equilibrium ratio of real money balances (M/P) to real income (y). Since this is identically equal to the ratio of nominal money balances (M) to nominal income (py), it appears as if the price level and its rate of change can be ignored. As a result McKinnon failed to incorporate the influence of the inflation rate in his analysis. This inference is incorrect. Unless financial asset values are indexed to the price level, inflation necessarily entails capital losses on all existing financial asset holdings. Unless more monetary saving is forthcoming to compensate for such inflation-induced capital losses, inflation will reduce the equihbfium *Thanks are due to an anonymous referee for suggestions reported in section 4. 0304-3878/86/$3.50 © 1986, Elsevier Science Publishers B.V. (North-Holland) J . D.E .- - E
B.J. Moore,Inflation andfinancial deepening
126
ratio of financial assets to GNP. The purpose of the present paper is to demonstrate how inflation ceteris paribus reduces the degree of financial deepening which a country can attain. This will be illustrated with McKinnon's example of Korea.
2. The equilibrium financial assets/income ratio As is well-known, the H a r r o d - D o m a r growth model finds the 'warranted' growth rate that is consistent with a given capital/output ratio (k) and an economy's savings ratio (s).
K=kY,,
(1)
where K = real capital stock, Y = real G D P , k = capital/output ratio (K/Y).
I=S=sY,
(2)
where / = r e a l investment, S = r e a l . s a v i n g , s = a v e r a g e propensity to save
(S/Y). From eqs. (1) and (2),
g~s
~=y=~=gw,
(3)
where (Iil/K) and (~'/Y) are the proportionate rates of change in the respective variables. The rate of growth of capital and output (gw) is that growth rate 'warranted' by the given capital/output ratio (k) and savings ratio (s), in the sense that if output grows at that rate (gw), the growth of aggregate demand will precisely equal the growth of aggregate supply. McKinnon (1976) recognised that this framework could be adopted to determine the degree of financial deepening in a developing economy. Total saving (S) can be decomposed into foreign saving (SO, private saving (Sv) and public (government) saving (S~) (S = S~ + Sp + SG). Let ~u be the proportion of private saving that is allocated to the accumulation of financial assets (Su), what the McKinnon termed the 'money intensiveness' of private saving. 1 iMcKinnon assumed that in developing economies such as Korea, private savers have relatively limited opportunities to acquire financial assets that are not direct claims on the monetary system. As is well known the banking system is typically by far the largest financial intermediary in developingcountries [Fry (1981)]. For individual households and fn'ms investing (saving) is mainly a choice of acquiring monetary claims or physical assets - consumer durables or producer goods. Since government saving takes place mainly within the government budget to finance public investment, and foreign saving is in the form of supplier credits, direct equity investment, or purchase of government-guaranteed bonds, he also assumed that the 'money intensiveness' of both governmentand foreign saving is negligible [Fry (1980, p. 79)].
B.J. Moore, Inflation and financial deepening
S~=~Sp.
127
(4)
If real income and wealth both grow at the warranted rate (gw), it is possible to calculate the equilibrium money/income ratio implied by this financial savings ratio (~).
S~a=sMY= JQI=gwM=(~)M.
(5)
Rewriting, M
sM
M Y
aMsP gw
~t~S~, •
(6)
or
(7)
Eq. (6) yields the intuitively plausible result that in long-run equilibrium growth, the economy's money/income ratio will be the economy's capital/ output ratio (k), times the proportion of total saving that is allocated to the acquisition of financial assets: {aMSr/S}. Alternatively, eq. (7) states that the long-run equilibrium money/income ratio will equal the ratio of the financial savings rate (xMsp) to the warranted growth rate of income (gw).2 McKinnon developed his analysis with reference to the observed financial deepening experienced in the Korean economy after the financial reform of 1965. Over the period 1965-1972, given the observed high Korean growth rate (10 percent) and high saving ratio (0.25), he inferred that the capital/output ratio was about 2.5 [eq. (3)-]. From the private saving ratio of 0.08, he estimated the percentage of private saving flowing into monetary assets, which he termed the 'money intensiveness' of private saving, as between 50 and 60 percent. From eq. (6) he concluded that the long-run equilibrium money/income ratio was 0.44. On the basis of his data the ratio
2There is a direct intuitive explanation why any given savings ratio (s) and growth rate (g) will imply an equilibrium wealth/income ratio of (s/g). Since s = A W / Y and g = A Y/Y, s/g = A W/3 Y. Providing the savings ratio and the growth rate remain unchanged, the average ratio of total wealth to total income must over time necessarily approach the (constant) marginal ratio of incremental wealth to incremental income W / Y ~ A W / A Y = s / g . The time period required will vary positively with the savings ratio, and inver~ly with the growth rate. If the growth rate were zero, the equih'brium wealth/income ratio implied by any positive savings ratio would be infinite. However, this value would only be approached over an indefinitely long period of time.
128
B.J. Moore, Inflation and financial deepening
of M2/GNP had in fact risen from 11 percent in 1960 to 37.5 percent by 1972 [McKinnon (1976, pp. 79-81)]. Using his framework McKinnon then attempted to trace out the monetary implications of the huge projected increase in private saving propensities, as consistent with the Korean government's plan in the early 1970s for domestic savings mobilization. The goal was to displace foreign saving (then about 11 percent of GDP) completely by an increase in private saving, so that by 1980 the private saving propensity was to rise to 19 percent. McKinnon calculated that if this projected increase in private saving propensities were carried out, the long-run money/income ratio would rise to 104.5 percent in the 1980s. This dramatic increase in financial deepening occurs because the private saving being mobilized utilizes the domestic monetary system as a financial intermediary, unlike the foreign saving it displaces [McKinnon (1976, pp. 8081)]. Table 1 presents the behavior of saving and money/income ratios for Korea over the period to 1980. As shown, the government in fact succeeded in its target of displacing its reliance on foreign saving by a dramatic increase in domestic savings mobilization. Private savings propensities doubled, from 10.8 percent in 1970 to 21.6 percent in 1979. The growth of real output averaged over 10 percent over the decade, and the 'money intensiveness' of private savings, as measured by the ratio (AM2/private savings), while it fell sharply at the end of the decade, on average over the decade was 69 percent. Nevertheless the money/income ratio has clearly not risen as implied by McKinnon's forecast. As shown in line 8, the ratio of M2/GNP reached its highest value of only 40.8 percent in 1973, and by the end of the decade had fallen to about 33 percent? Clearly financial deepening was not rising along the lines forecast by McKinnon's model, despite the high and rising private savings ratio and the high 'money intensiveness' of private saving. Something was evidently operating to hold back financial deepening. 3. Inflation
That 'something' was the high inflation rate. Private saving allocated to the acquisition of financial assets accumulates in units of fixed money denomination. Inflation, by raising the rate of growth of nominal money income, operates to reduce the equilibrium ratio of financial assets to GDP. Alternatively viewed, inflation produces capital losses by reducing the real value of all existing financial asset holdings which must be offset by greater savings. McKinnon's analysis is flawed by his failure to incorporate correctly 3After 1971, in spite of relatively high nominal interest rates on deposits, real interest rates were slightly negative. There was undoubtedly some shifting of saving into other financial assets. Yet even the ratio of total financial assets to G N P failed to rise as expected, and peaked at 75 percent in 1978 (line 9).
Private savings Govgrnment savings Foreign savings Aggregate gross savings Statistical discrepancy Gross domestic investment MI M2 Total assets (TA) of fmancial system
14.9
has of June 1980. con 12-month time deposits.
a$ources: Bank of Korea, Monthly Economic Statistics, 1979, 1980.
21.6
12.0
14.8
15.0
32.5 7.9 -3.1 3.2
15.5
16.3 13.5 14.7 14.3
70.5 14.0
15.8
16.8 9.7 19.6 16.2
74.6 13.5
19.5 5.6 0.6 25.7 1.6 27.3 14.3 38.5
1977
16.7
21.2 10.6 11.4 12.4
75.8 9.6
19.9 6.5 3.3 29.7 1.5 31.1 13.3 38.8
1978
18.6
21.2 20.3 2.8 12.1
70.7 6.6
21.6 6.6 6.5 34.7 1.2 35.9 11.0 33.2
1979
25.0 --11.5 --4.0 --3.4
64.5
10.4 32.9
1980b
~. %
~-
.~
.~
24.0
~O
~"
22.8
20.4 7.9 2.9 17.8
70.0 11.7
16.9 6.2 2.4 25.5 0.0 25.5 13.0 35.4
1976
Nominal interest rate ¢
14.2 14.6 19.6 20.3
73.2 11.0
14.6 4.0 10.4 29.0 --0.4 29.4 13.1 35.0
1975
~" 16.8 5.8 14.4 15.5
67.1 9.8
18.2 2.3 12.4 32.8 - 1.9 31.0 15.0 39.0
1974
I~-
13.5 9.3 6.5
63.9 14.2
58.5 12.2
19.4 4.2 3.8 27.3 - 1.7 25.6 15.1 40.8
1973
15.7 8.1 10.0
12.1 3.6 5.2 20.9 0.7 21.9 14.0 39.2
1972
10.0 5.4 10.7 26.1 -0.8 25.2 11.9 36.2
1971
11. GDP deflator (P) 12. GDP/P 13. Mz/P 14. TA/P
7.7
10.8 6.5 9.3 26.6 0.2 26.8 12.8 37.2
1970
Annual rates of change (%)
10. AMz
1. 2. 3. 4. 5. 6. 7. 8. 9.
Shares in GNP
Year
Table 1 Korea: Aggregate saving performance and financial deepening, 1970-797
B.J. Moore, Inflation andfinancial deepening
130
the inflation rate into his model. 4 Since financial assets are denominated in fixed money units, while nominal values of the real capital stock and real income are in effect indexed to the inflation rate, a higher inflation rate will clearly operate to reduce the equilibrium level of financial assets to G D P generated by any given savings and real growth rate, and so the degree of financial deepening. Assume for simplification that all prices rise proportionately at the inflation rate (i6). Assume further that the income velocity of money and the real growth rate are invariant to the inflation rate. As a result nominal income and money balances under inflation will then both grow at the rate (gw +/~). SM=SMY= ]QI=(gw + D)M =(s/k + #)M.
(8)
Rewriting,
M s~ ~o~SP~k, Y s/k+# (s+k#J
(9)
or M
O~MSP
Y =gw + ~"
(10)
Eq. (9) states that under inflation the long-run equilibrium money/income ratio will equal the economy's capital/output ratio (k), times the proportion of monetary saving (ausp) to the total increase in nominal wealth, due to savings (s) and capital gains (ilk). Alternatively eq. (10) states that under inflation the equilibrium money/income ratio will equal the ratio of the financial savings rate (a~s0 to the rate of growth of nominal money income
(gw+t~). Applying this formula to the Korean economy, what is the long-run equilibrium money/income ratio implied by a private savings ratio of 20 percent? If the real growth rate and the inflation rate continue at 10 and 20 percent, respectively, (their approximate average values for the decade of the 1970s) and if McKinnon's estimate of 'money intensiveness' of private saving of 0.55 is accepted, the equilibrium M2/GDP ratio is 36.7 percent. If the actual experienced 'money intensiveness' ratio (AM2Sp) of 0.68 is used, the equilibrium money/income ratio becomes 45.3 percent. These are both 4McKinnon solved for the equilibrium ratio of real money balances (M/p) to real income (y). This ratio is also the ratio of nominal money balances to nominal income [(M/p)/y= M/py = M/Y]. It therefore appeared as ff the price level (and its rate of change) dropped out of the analysis and was of no importance. MeKinnon consequently proceeded to deal only with real quantities [McKinnon (1976, pp. 79-82)].
B.J. Moore, Inflation and financial deepening
131
relatively close to the observed values, and show the powerful effect of high inflation rates in reducing the degree of financial deepening. 5 4. The responsiveness of interest and savings to the inflation rate The above analysis assumed for simplicity that the savings rate and the money intensiveness of savings were both invariant to the inflation rate. Since inflation reduces the real return expected on money balances, economists have traditionally assumed that inflation will reduce the money intensiveness of private saving, and possibly the savings rate itself. This will reinforce the above effects of inflation in reducing the degree of financial deepening and further raise the income velocity of money. There is now considerable evidence that total financial saving in LDC's responds positively to the interest rate offered on financial assets [Moore (1983)]. Whenever the monetary authorities attempt to keep real interest rates positive in the face of inflation, nominal interest rates will rise pari passu with the inflation rate. Such interest income would then serve to offset the inflation-induced capital losses on financial assets. There is also some evidence that saving ratios differ by functional income form, and are higher for property than for labor income. If differential saving out of interest income were sufficiently high, it would be possible in principle for wealth owners to offset completely the effects of inflation in reducing their financial asset/income ratios. Let r represent the average nominal interest rate on financial assets, so that r M will represent total interest income. Now let sh represent any differential propensity to save out of interest income. Substituting in eq. (8), the financial savings relation becomes !
°
°
Su = su Y + surM = M = (gw + p)M.
(11)
Rewriting, M / g = s u / ( g w + ~--s'ur).
(12)
Note that if nominal interest rates are maintained equal to the inflation rate (r=f~), and if differential saving out of interest income equals unity (sh=l), eq. (12) simplifies to McKinnon's original equation (7). Financial deepening would then be invariant to the inflation rate. As shown in table 1, the monetary authorities in Korea, in sharp contrast to most LDC's, have attempted to prevent substantial negative real interest rates, by dramatically boosting the level of nominal interest rates paid on ~If the inflation rate weTe zero, the implied equilibrium money/income ratios would be 110 and 136 percent, respectively.
B.J. Moore, Inflation and financial deepening
132
bank deposits as the inflation rate increased [Moore (1983)]. The fact that the ratios of financial assets to G D P has not risen along the path predicted by McKinnon, but were closer to the paths predicted by eq. (10), demonstrates that Korean wealth holders have not in fact saved a differentially greater proportion out of their interest income. As a result they did not succeed in maintaining their financial wealth/income ratios invariant to the experienced high inflation rate. 5. Conclusion
From the Harrod-Domar growth model, the warranted rate of growth of an economy (gw) may be derived from an assumed given capital/output ratio (k) and savings ratio (s),
gw=s/k. Inverting this expression, an economy's warranted real wealth/income ratio may alternatively be derived from an assumed given savings ratio (s) and growth rate (g).
W/Y=k=s/g. An economy's financial asset/income ratio represents assets denominated in fixed money values. Inflation raises the growth rate of nominal income, and reduces the real value of financial assets. As a result the equilibrium financial assets/income ratio consistent with any given savings and real growth rate is necessarily reduced.
M/Y=su/g + p. It is the high inflation rates experienced throughout the decade of the 1970s that have kept down the degree of financial deepening in developing economies, even in LDC's like Korea with very high savings ratios. By reducing financial deepening, and so the real volume of credit, inflation reduces the ability to finance capital formation. Through this channel inflation has a negative effect on the growth rate of an economy.
References Cheng, Hong-Sheng, 1980, Financial deepening in Pacific Basin countries, Economic review (Federal Reserve Bank of San Francisco, San Francisco, CA) Summer, 43-54. Fry, Maxwell J., 1981, Inflation and economic growth in Pacific Basin developing economies, Economic Review (Federal Reserve Bank of San Francisco, San Francisco, CA) Fall, 8-18.
B~I. Moore, Inflation and financial deepening
133
McKinnon, Ronald I., 1973, Money, capital and economic development (The Brookings Institution, Washington, DC). McKinnon, Ronald I., 1976, Saving propensities and the Korean monetary reform, in: R. McKinnon, ed., Money and finance in economic growth and development (Marcel Dekker, New York) 75-91. Moore, B., 1983, The effects of higher real interest rates in selected Asian LDC's: Some additional evidence, unpublished manuscript. Shaw, Edward S., 1973, Financial deepening in economic development (Oxford University Press, New York).
INFLATION AND FINANCIAL DEEPENING* B.J. MOORE Wesleyan University, Middletown, CT06457, USA Received February 1983, final version received June 1984 Financial deepening is defined as increases in the ratio of a country's financial assets to its GDP. Financial asset accumulation simultaneously provides credit to finance real asset accumulation for the development process. The equilibrium long-run ratio of financial assets to GDP may be expressed as a simple relationship of a country's financial savings ratio and its growth rate. The present paper incorporates the effects of inflation on financial deepening. Inflation necessarily entails capital losses on all existing financial asset holdings. It is shown that unless more monetary saving is forthcoming to offset such inflation-induced capital losses, inflation will operate to reduce drastically the degree of financial deepening which a country can obtain. The process is illustrated with respect to the Korean economy.
1. Introduction
Financial deepening is defined as increases in the ratio of a country's financial assets to its GDP [Shaw (1973)]. Money in the real world is not dropped from helicopters. Accepting the debt-intermediation view of inside money, the accumulation of money balances simultaneously provides bank credit to finance tangible asset accumulation [Shaw (1973), McKinnon (1973), Cheng, (1980)]. In an important paper McKinnon (1976) demonstrated that the equilibrium long-run ratio of financial assets to G D P may be expressed as a simple relationship of a country's capital/output ratio, growth rate, savings rate, and the 'money intensiveness' of private savings. MeKinnon solved for the equilibrium ratio of real money balances (M/P) to real income (y). Since this is identically equal to the ratio of nominal money balances (M) to nominal income (py), it appears as if the price level and its rate of change can be ignored. As a result McKinnon failed to incorporate the influence of the inflation rate in his analysis. This inference is incorrect. Unless financial asset values are indexed to the price level, inflation necessarily entails capital losses on all existing financial asset holdings. Unless more monetary saving is forthcoming to compensate for such inflation-induced capital losses, inflation will reduce the equihbfium *Thanks are due to an anonymous referee for suggestions reported in section 4. 0304-3878/86/$3.50 © 1986, Elsevier Science Publishers B.V. (North-Holland) J . D.E .- - E
B.J. Moore,Inflation andfinancial deepening
126
ratio of financial assets to GNP. The purpose of the present paper is to demonstrate how inflation ceteris paribus reduces the degree of financial deepening which a country can attain. This will be illustrated with McKinnon's example of Korea.
2. The equilibrium financial assets/income ratio As is well-known, the H a r r o d - D o m a r growth model finds the 'warranted' growth rate that is consistent with a given capital/output ratio (k) and an economy's savings ratio (s).
K=kY,,
(1)
where K = real capital stock, Y = real G D P , k = capital/output ratio (K/Y).
I=S=sY,
(2)
where / = r e a l investment, S = r e a l . s a v i n g , s = a v e r a g e propensity to save
(S/Y). From eqs. (1) and (2),
g~s
~=y=~=gw,
(3)
where (Iil/K) and (~'/Y) are the proportionate rates of change in the respective variables. The rate of growth of capital and output (gw) is that growth rate 'warranted' by the given capital/output ratio (k) and savings ratio (s), in the sense that if output grows at that rate (gw), the growth of aggregate demand will precisely equal the growth of aggregate supply. McKinnon (1976) recognised that this framework could be adopted to determine the degree of financial deepening in a developing economy. Total saving (S) can be decomposed into foreign saving (SO, private saving (Sv) and public (government) saving (S~) (S = S~ + Sp + SG). Let ~u be the proportion of private saving that is allocated to the accumulation of financial assets (Su), what the McKinnon termed the 'money intensiveness' of private saving. 1 iMcKinnon assumed that in developing economies such as Korea, private savers have relatively limited opportunities to acquire financial assets that are not direct claims on the monetary system. As is well known the banking system is typically by far the largest financial intermediary in developingcountries [Fry (1981)]. For individual households and fn'ms investing (saving) is mainly a choice of acquiring monetary claims or physical assets - consumer durables or producer goods. Since government saving takes place mainly within the government budget to finance public investment, and foreign saving is in the form of supplier credits, direct equity investment, or purchase of government-guaranteed bonds, he also assumed that the 'money intensiveness' of both governmentand foreign saving is negligible [Fry (1980, p. 79)].
B.J. Moore, Inflation and financial deepening
S~=~Sp.
127
(4)
If real income and wealth both grow at the warranted rate (gw), it is possible to calculate the equilibrium money/income ratio implied by this financial savings ratio (~).
S~a=sMY= JQI=gwM=(~)M.
(5)
Rewriting, M
sM
M Y
aMsP gw
~t~S~, •
(6)
or
(7)
Eq. (6) yields the intuitively plausible result that in long-run equilibrium growth, the economy's money/income ratio will be the economy's capital/ output ratio (k), times the proportion of total saving that is allocated to the acquisition of financial assets: {aMSr/S}. Alternatively, eq. (7) states that the long-run equilibrium money/income ratio will equal the ratio of the financial savings rate (xMsp) to the warranted growth rate of income (gw).2 McKinnon developed his analysis with reference to the observed financial deepening experienced in the Korean economy after the financial reform of 1965. Over the period 1965-1972, given the observed high Korean growth rate (10 percent) and high saving ratio (0.25), he inferred that the capital/output ratio was about 2.5 [eq. (3)-]. From the private saving ratio of 0.08, he estimated the percentage of private saving flowing into monetary assets, which he termed the 'money intensiveness' of private saving, as between 50 and 60 percent. From eq. (6) he concluded that the long-run equilibrium money/income ratio was 0.44. On the basis of his data the ratio
2There is a direct intuitive explanation why any given savings ratio (s) and growth rate (g) will imply an equilibrium wealth/income ratio of (s/g). Since s = A W / Y and g = A Y/Y, s/g = A W/3 Y. Providing the savings ratio and the growth rate remain unchanged, the average ratio of total wealth to total income must over time necessarily approach the (constant) marginal ratio of incremental wealth to incremental income W / Y ~ A W / A Y = s / g . The time period required will vary positively with the savings ratio, and inver~ly with the growth rate. If the growth rate were zero, the equih'brium wealth/income ratio implied by any positive savings ratio would be infinite. However, this value would only be approached over an indefinitely long period of time.
128
B.J. Moore, Inflation and financial deepening
of M2/GNP had in fact risen from 11 percent in 1960 to 37.5 percent by 1972 [McKinnon (1976, pp. 79-81)]. Using his framework McKinnon then attempted to trace out the monetary implications of the huge projected increase in private saving propensities, as consistent with the Korean government's plan in the early 1970s for domestic savings mobilization. The goal was to displace foreign saving (then about 11 percent of GDP) completely by an increase in private saving, so that by 1980 the private saving propensity was to rise to 19 percent. McKinnon calculated that if this projected increase in private saving propensities were carried out, the long-run money/income ratio would rise to 104.5 percent in the 1980s. This dramatic increase in financial deepening occurs because the private saving being mobilized utilizes the domestic monetary system as a financial intermediary, unlike the foreign saving it displaces [McKinnon (1976, pp. 8081)]. Table 1 presents the behavior of saving and money/income ratios for Korea over the period to 1980. As shown, the government in fact succeeded in its target of displacing its reliance on foreign saving by a dramatic increase in domestic savings mobilization. Private savings propensities doubled, from 10.8 percent in 1970 to 21.6 percent in 1979. The growth of real output averaged over 10 percent over the decade, and the 'money intensiveness' of private savings, as measured by the ratio (AM2/private savings), while it fell sharply at the end of the decade, on average over the decade was 69 percent. Nevertheless the money/income ratio has clearly not risen as implied by McKinnon's forecast. As shown in line 8, the ratio of M2/GNP reached its highest value of only 40.8 percent in 1973, and by the end of the decade had fallen to about 33 percent? Clearly financial deepening was not rising along the lines forecast by McKinnon's model, despite the high and rising private savings ratio and the high 'money intensiveness' of private saving. Something was evidently operating to hold back financial deepening. 3. Inflation
That 'something' was the high inflation rate. Private saving allocated to the acquisition of financial assets accumulates in units of fixed money denomination. Inflation, by raising the rate of growth of nominal money income, operates to reduce the equilibrium ratio of financial assets to GDP. Alternatively viewed, inflation produces capital losses by reducing the real value of all existing financial asset holdings which must be offset by greater savings. McKinnon's analysis is flawed by his failure to incorporate correctly 3After 1971, in spite of relatively high nominal interest rates on deposits, real interest rates were slightly negative. There was undoubtedly some shifting of saving into other financial assets. Yet even the ratio of total financial assets to G N P failed to rise as expected, and peaked at 75 percent in 1978 (line 9).
Private savings Govgrnment savings Foreign savings Aggregate gross savings Statistical discrepancy Gross domestic investment MI M2 Total assets (TA) of fmancial system
14.9
has of June 1980. con 12-month time deposits.
a$ources: Bank of Korea, Monthly Economic Statistics, 1979, 1980.
21.6
12.0
14.8
15.0
32.5 7.9 -3.1 3.2
15.5
16.3 13.5 14.7 14.3
70.5 14.0
15.8
16.8 9.7 19.6 16.2
74.6 13.5
19.5 5.6 0.6 25.7 1.6 27.3 14.3 38.5
1977
16.7
21.2 10.6 11.4 12.4
75.8 9.6
19.9 6.5 3.3 29.7 1.5 31.1 13.3 38.8
1978
18.6
21.2 20.3 2.8 12.1
70.7 6.6
21.6 6.6 6.5 34.7 1.2 35.9 11.0 33.2
1979
25.0 --11.5 --4.0 --3.4
64.5
10.4 32.9
1980b
~. %
~-
.~
.~
24.0
~O
~"
22.8
20.4 7.9 2.9 17.8
70.0 11.7
16.9 6.2 2.4 25.5 0.0 25.5 13.0 35.4
1976
Nominal interest rate ¢
14.2 14.6 19.6 20.3
73.2 11.0
14.6 4.0 10.4 29.0 --0.4 29.4 13.1 35.0
1975
~" 16.8 5.8 14.4 15.5
67.1 9.8
18.2 2.3 12.4 32.8 - 1.9 31.0 15.0 39.0
1974
I~-
13.5 9.3 6.5
63.9 14.2
58.5 12.2
19.4 4.2 3.8 27.3 - 1.7 25.6 15.1 40.8
1973
15.7 8.1 10.0
12.1 3.6 5.2 20.9 0.7 21.9 14.0 39.2
1972
10.0 5.4 10.7 26.1 -0.8 25.2 11.9 36.2
1971
11. GDP deflator (P) 12. GDP/P 13. Mz/P 14. TA/P
7.7
10.8 6.5 9.3 26.6 0.2 26.8 12.8 37.2
1970
Annual rates of change (%)
10. AMz
1. 2. 3. 4. 5. 6. 7. 8. 9.
Shares in GNP
Year
Table 1 Korea: Aggregate saving performance and financial deepening, 1970-797
B.J. Moore, Inflation andfinancial deepening
130
the inflation rate into his model. 4 Since financial assets are denominated in fixed money units, while nominal values of the real capital stock and real income are in effect indexed to the inflation rate, a higher inflation rate will clearly operate to reduce the equilibrium level of financial assets to G D P generated by any given savings and real growth rate, and so the degree of financial deepening. Assume for simplification that all prices rise proportionately at the inflation rate (i6). Assume further that the income velocity of money and the real growth rate are invariant to the inflation rate. As a result nominal income and money balances under inflation will then both grow at the rate (gw +/~). SM=SMY= ]QI=(gw + D)M =(s/k + #)M.
(8)
Rewriting,
M s~ ~o~SP~k, Y s/k+# (s+k#J
(9)
or M
O~MSP
Y =gw + ~"
(10)
Eq. (9) states that under inflation the long-run equilibrium money/income ratio will equal the economy's capital/output ratio (k), times the proportion of monetary saving (ausp) to the total increase in nominal wealth, due to savings (s) and capital gains (ilk). Alternatively eq. (10) states that under inflation the equilibrium money/income ratio will equal the ratio of the financial savings rate (a~s0 to the rate of growth of nominal money income
(gw+t~). Applying this formula to the Korean economy, what is the long-run equilibrium money/income ratio implied by a private savings ratio of 20 percent? If the real growth rate and the inflation rate continue at 10 and 20 percent, respectively, (their approximate average values for the decade of the 1970s) and if McKinnon's estimate of 'money intensiveness' of private saving of 0.55 is accepted, the equilibrium M2/GDP ratio is 36.7 percent. If the actual experienced 'money intensiveness' ratio (AM2Sp) of 0.68 is used, the equilibrium money/income ratio becomes 45.3 percent. These are both 4McKinnon solved for the equilibrium ratio of real money balances (M/p) to real income (y). This ratio is also the ratio of nominal money balances to nominal income [(M/p)/y= M/py = M/Y]. It therefore appeared as ff the price level (and its rate of change) dropped out of the analysis and was of no importance. MeKinnon consequently proceeded to deal only with real quantities [McKinnon (1976, pp. 79-82)].
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relatively close to the observed values, and show the powerful effect of high inflation rates in reducing the degree of financial deepening. 5 4. The responsiveness of interest and savings to the inflation rate The above analysis assumed for simplicity that the savings rate and the money intensiveness of savings were both invariant to the inflation rate. Since inflation reduces the real return expected on money balances, economists have traditionally assumed that inflation will reduce the money intensiveness of private saving, and possibly the savings rate itself. This will reinforce the above effects of inflation in reducing the degree of financial deepening and further raise the income velocity of money. There is now considerable evidence that total financial saving in LDC's responds positively to the interest rate offered on financial assets [Moore (1983)]. Whenever the monetary authorities attempt to keep real interest rates positive in the face of inflation, nominal interest rates will rise pari passu with the inflation rate. Such interest income would then serve to offset the inflation-induced capital losses on financial assets. There is also some evidence that saving ratios differ by functional income form, and are higher for property than for labor income. If differential saving out of interest income were sufficiently high, it would be possible in principle for wealth owners to offset completely the effects of inflation in reducing their financial asset/income ratios. Let r represent the average nominal interest rate on financial assets, so that r M will represent total interest income. Now let sh represent any differential propensity to save out of interest income. Substituting in eq. (8), the financial savings relation becomes !
°
°
Su = su Y + surM = M = (gw + p)M.
(11)
Rewriting, M / g = s u / ( g w + ~--s'ur).
(12)
Note that if nominal interest rates are maintained equal to the inflation rate (r=f~), and if differential saving out of interest income equals unity (sh=l), eq. (12) simplifies to McKinnon's original equation (7). Financial deepening would then be invariant to the inflation rate. As shown in table 1, the monetary authorities in Korea, in sharp contrast to most LDC's, have attempted to prevent substantial negative real interest rates, by dramatically boosting the level of nominal interest rates paid on ~If the inflation rate weTe zero, the implied equilibrium money/income ratios would be 110 and 136 percent, respectively.
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bank deposits as the inflation rate increased [Moore (1983)]. The fact that the ratios of financial assets to G D P has not risen along the path predicted by McKinnon, but were closer to the paths predicted by eq. (10), demonstrates that Korean wealth holders have not in fact saved a differentially greater proportion out of their interest income. As a result they did not succeed in maintaining their financial wealth/income ratios invariant to the experienced high inflation rate. 5. Conclusion
From the Harrod-Domar growth model, the warranted rate of growth of an economy (gw) may be derived from an assumed given capital/output ratio (k) and savings ratio (s),
gw=s/k. Inverting this expression, an economy's warranted real wealth/income ratio may alternatively be derived from an assumed given savings ratio (s) and growth rate (g).
W/Y=k=s/g. An economy's financial asset/income ratio represents assets denominated in fixed money values. Inflation raises the growth rate of nominal income, and reduces the real value of financial assets. As a result the equilibrium financial assets/income ratio consistent with any given savings and real growth rate is necessarily reduced.
M/Y=su/g + p. It is the high inflation rates experienced throughout the decade of the 1970s that have kept down the degree of financial deepening in developing economies, even in LDC's like Korea with very high savings ratios. By reducing financial deepening, and so the real volume of credit, inflation reduces the ability to finance capital formation. Through this channel inflation has a negative effect on the growth rate of an economy.
References Cheng, Hong-Sheng, 1980, Financial deepening in Pacific Basin countries, Economic review (Federal Reserve Bank of San Francisco, San Francisco, CA) Summer, 43-54. Fry, Maxwell J., 1981, Inflation and economic growth in Pacific Basin developing economies, Economic Review (Federal Reserve Bank of San Francisco, San Francisco, CA) Fall, 8-18.
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McKinnon, Ronald I., 1973, Money, capital and economic development (The Brookings Institution, Washington, DC). McKinnon, Ronald I., 1976, Saving propensities and the Korean monetary reform, in: R. McKinnon, ed., Money and finance in economic growth and development (Marcel Dekker, New York) 75-91. Moore, B., 1983, The effects of higher real interest rates in selected Asian LDC's: Some additional evidence, unpublished manuscript. Shaw, Edward S., 1973, Financial deepening in economic development (Oxford University Press, New York).