Inflation, monetary balances and the aggregate production function : the case of Colombia

The role of monetary balances in economic growth has long been a topic of macroeconomic research. This paper examines the role of real money balances in an aggregate production function of a developing economy, Colombia. Colombia is an interesting case to analyze for several reasons. First, although it has experienced high and variable rates of inflation, it has also introduced a competitive system of quasi-monetary balances that have been indexed for inflation. Second, data is readily available, since Colombia has been studied extensively. Therefore, Colombia is one of the few developing countries for which an empirical study can be made of the effects of financial policy on economic growth. Finally, the role that monetary balances may have played in economic growth is of interest because indexed mortgages played a major role in this change in financial policy. These indexed mortgages were similar to introducing a competitive"Trojan Horse"into the Colombian financial system. Other depository institutions were forced to compete with indexed mortgage lenders for deposits. Growth was stimulated by inducing the financial system to minimize the effects of high and variable inflation rates on the cost of monetary balances.