Source of deflation in Colombia: A lower Aggregate Demand

Colombian government has worked on improving the Aggregate Supply through spending on infrastructure, free houses for low income people, subsides for agricultural suppliers and subsides for manufacture suppliers, and it has improved the economic growth. However, the deflation (negative inflation) faced by Colombia in the last two months takes the attention because of this effect can pull down the favorable economic expectation for 2013. This note shows that the source of this deflation is because of lacking of stimulus on Aggregate Demand variables. It means Colombia has been facing an inefficient government spending (government spending is concentrated in few private hands); low growth in suppling money, and high interest rates for consumption. Moreover, if this deflation follows in the next months, it can reduce in deep the GDP growth rate for 2013 and 2014. This fact lets me conclude that my forecast for GDP growth rate in 2013 is between 3.1% and 3.5%; it is below of government and private researchers do; they forecast a GDP growth rate between 3.5% and 4.5%. The challenge for the next months and years to improve colombian economic development is to work on money supply’s channels to improve Aggregate Demand; these channels have to support the supply of public goods such as pensions and health. Finally, it will be interesting the poor economic growth in 2013 and the lower expectations for 2014 under presidential elections.

Author: Humberto Bernal,  

Economist,

e-mail: zhumber@gmail.com

Twitter: Humberto_Bernal

It can be download @ PDF

In the last two months Colombia has shown negative values in her inflation; in October, it was -0.26% and -0.22% in November. The last time that Colombia had negative values in two months consecutively was in 2009 and 2010; by that time, the Gross Domestic Product (GDP) grew in 1.7% and 4.0% respectively; however, there is a big difference in this year (2013), and it is that Colombia inflation can be the lowest ever; it can be around 2.0%, and it is bad news for increasing the employment. This note shows the deflationary (negative inflation) sources and the likely economic scenario that it brings; this economic scenario is below of government and private researchers’s expectations who point an economic growth between 3.5% and 4.5% in 2013. I still believe that Colombia will get an economic growth rate between 3.1% and 3.5% in 2013.

The sources of deflation from classical economic theory view: Colombia case

The deflationary effect come from movements of Aggregate Demand (AD) and Aggregate Supply (AS). In Colombia case, one can point a backward movement of AD (red dashed lines figure 1) and forward movement of AS (blue dashed lines) as the source of this deflation; it means colombians feel pessimist to buy goods and services because of high interest rates, lack of money to buy their stuff (short M1 in the economy), inefficient government spending (government spending is concentrated in few private hands), and households’s negative expectations about economic environment for next months and years. However, the forward movement of AS can mitigate this low economic growth, and deflation effect is kept; as the AS moves forward, it causes higher supply of goods and services, and lower prices; it means negative inflation also. This AS movement comes from lower unemployment rate and higher volume of capital; these facts are shown in colombian economy although unemployment rate is so high still. The AS resources in Colombia are taken by Real Estate activities and to make non tradable goods supported by government mainly. Therefore, Colombia deflation comes from a narrower Aggregate Demand and higher Aggregate Supply, and its result is a low economic growth; from E₁ to E₂ as figure 1 shows.

Figure 1. Aggregate demand and supply under deflationary effect  

Aggregate Demand and Aggregate Supply an econometric model for Colombia

The AD and AS for Colombia show the classical slopes, so the momentary policy and efficient government spending are the instruments to mitigate the deflationary effect and low economic growth in Colombia. When one takes economic data from 1924 to 2012, the results are the classical slopes for AD and AS for Colombia; the AD shows negative slope, and the AS shows a positive slope as table 1 shows (green results). Therefore, to mitigate this deflationary effect and the low economic growth, monetary authorities have to increase the monetary supply growth rate through suppling public goods such as pensions and health; if monetary supply increases in 1.0%, it can bring an increase of 0.20% in colombian GDP. Moreover, if central and local governments increase the efficient public spending in 1.0%, it can bring an increase of 0.34% in colombian GDP as table 1 shows.

Table 1. Aggregate demand and supply for Colombia* 1924-2012

(Annual Data, in logarithms, under 3SLS)

Variables	Aggregate Demand	Aggregate Supply
Price-Col(CPI)	-0.41%	0.15%
Money supply-Col(M1)	0.20%
Gov. Spending-Col	0.34%
Exchange Rate (Col$ per US$)	0.14%
GDP-USA	0.13%
CPI-USA	0.55%
Capital-Col		0.53%
Working population-Col		0.10%
R2	0.99	0.99
Observations	89	89

*Aggregate demand and aggregate supply is the GDP at constant prices.

All variables are significative under 0.01 significance level except GDP-USA which is under 0.1 and Working population-Col.

Source: Stata 12.1. Own calculations.

Deflationary effect on Colombian GDP growth (an equilibrium analysis)

The continuous deflation causes a decline in Colombian GDP growth rate. If the equilibrium values from inflation and GDP growth rate are taken into a time series model called VAR, the result of negative impact on inflation rate brings negative impact on GDP growth rate as the figure 2 shows. It means that one deflation shock of 1.0% causes an annual reduction of GDP growth in about 0.01% for next five years (ceteris paribus). If deflation follows in next months and years, this negative effect on GDP growth rate is higher. Therefore, it is a challenge to economic authorities for improving the economic variables related with AD to avoid this sad scenario of lower economic growth for the next years.

Figure 2. GDP growth response from single negative shock on colombian inflation*

(Annual Data 1924-2012, under time series model VAR)

*Dashed lines are the confidence interval under 0.95%.

Source: Stata 12.1. Own calculations.