THE ROLE OF MACROECONOMIC INSTABILITY ON ECONOMIC

GROWTH RATE: THE CASE OF COLOMBIA, 1950-2009

Johanna Alejandra Pulido Pedraza

alejandra_p.pedraza@yahoo.com

ABSTRACT

The main objective of this paper is to investigate the role of macroeconomic instability

on economic growth in Colombia, by utilizing a production function approach, over the 1950-

2009 period. Additionally, the role of openness and capital formation (both physical and

human) on economic growth are investigated. In doing so, this paper has used modern time

series techniques, such as unit roots, cointegration analysis and error correction models.

Both the descriptive and econometric evidence show that the recurrent macroeconomic

instability episodes seriously and negatively affected the growth potential of the Colombian

economy during the 1950-2009 period. Empirical results also suggest that the growth in

output is positively affected from physical and human capital formation but negatively

affected from openness over the long term. Additionally, it is also found that in the long term,

the output can adapt itself faster to the changes in macroeconomic instability and capital

stock.

Keywords: Macroeconomic instability, Economic growth, Human capital, Physical capital,

Cointegration.

JEL Code: E60, O40

1. Introduction

Colombia has gone through a long way of restructuring not only socially, or

politically, but also economically. Since all these are linked to each other, if one of them does

not go on the right way, it will without a doubt affect the behavior of the other ones.

Therefore, economic growth is only to be achieved when you find and create the right

conditions that include many sectors and participants to work in unity, and in Colombian

history, it is noticeable that these conditions were not so easy to balance or even to find.

Throughout the history, Colombia had many different governments with many different

development plans and objectives. These governments usually tried to enhance the growth

potential of the country and (or) preserve the stability. Nevertheless, these central objectives

could not be achieved at the same time, because many of those plans were just populist

responses to the people in time of elections, to gain votes for re-elections.

The central aim of the paper is to analyze the role of macroeconomic instability on

economic growth in Colombia. In doing so, I follow Ismihan (2009) and estimate

macroeconomic instability index for Colombia and utilize production function approach. This

study also uses modern time series techniques, such as unit root tests and cointegration

methods.

The first part of the paper is based on a descriptive analysis, which focuses on issues

like the security, social and political instability, the macroeconomic performance of Colombia

since the fifties, the role of corruption and institutions on economic growth. The second part

of the paper is based on an empirical analysis and it focuses on the impacts of macroeconomic

instability, capital stock and human capital and the openness to foreign trade on economic

growth by considering the Colombian performance over the 1950-2009 period.

As well, in the second part there is an overview of one of the most important events in

Colombia‟s history which is the change of the constitution in the year of 1991, that brought

many complex regulations not only to Colombian citizens but also to the Colombian

government and to the economic system.

In part three, there is a condensed review of the related literature on the role of

macroeconomic instability on economic growth, Colombian studies on the subject and the

previous uses of the production function approach.

In part four, the empirical model is estimated for the Colombian economy for the

period of 1950 to 2009. Initially unit root test are conducted to determine the order of the

integration of the variables. Then both long-run and short-run analyses are conducted by using

cointegration and error correction models, respectively. Finally, part five provides the

concluding remarks.

2. HISTORY OF COLOMBIAN ECONOMY 1950-2009

From 1950 to 2009, Colombia has had 16 presidents and 16 different development programs

which were adapted by each one of the governments during the course of their mandates.

Even though each of those plans had different goals and implementation instruments, all of

them had one converging point which was the goal to reduce the macroeconomic instability of

Colombia. In order to reach this goal, some of the governments tried to reduce the inflation

and unemployment rate while others tried to diminish the public debt. Apart from the previous

governments, the goal of the last president1, was to decrease the power of insurgency and

violence that created instability, and lack of confidence from the international community in

Colombia which affected the population not only socially but also economically (because of a

low investment rate, the deny of loans and projects with foreign investors).

Many of the previous plans did not achieve their goals, which they proposed for presidential

campaigns. They actually worsened the panorama of Colombia and their intended goals

became the instruments which were used for fixing other problems, the problems which, at

the time, seemed to be more controllable than the governments‟ first proposed goals. As

examples the high inflation rates, an increase in unemployment, the increase in the public debt

in the last two years of Alvaro Uribe‟s administration and the generated sources being used by

this administration for the military sector but not invested for other sectors like education,

infrastructure and health that could improve growth more directly.

2.1. EMPLOYMENT AND LABOR MARKET STRUCTURE

During the fifties, the unemployment rate had remained close to 8%; however, starting

from 1957, the insufficiency of exports that created a wave of unemployment slowed down

the economic growth and created poverty. The unemployment did not stop growing from

1968 until the early eighties, when the Latin American debt crisis took it to higher levels

(13% in 1984). In the crisis from 1999 to 2002, the unemployment rate hit its historical

maximum of 20% of the EAP (Economically Active Population).

According to the unemployment data, the best time of employment was the year 1994

when the unemployment rate was approaching 7% of the EAP. After that year, the recovery of

1 (2002- 2010) Álvaro Uribe Vélez was the last president included in the timeline of the paper

the unemployment was slow and it could not reflect the economic growth that the Colombian

economy achieved between 2003 and 2007.

The law 789 of 2000 was a labor reform that tried to achieve more flexible labor

relationships that could make the labor market more dynamic. Between the new regulations

that were brought by this law, we can find: The intermediation of labor unions for hiring

personnel, that could pay less than the minimum wage was allowed for the hiring by labor

unions that could pay less than the minimum wage and avoid the payments to the social

security (healthcare, pension funds, vacations and many more). In 2003, the government of

Uribe presented a new labor reform that reduced the sunday night remuneration and

encouraged an increase in employment during those days. It is notorious that the temporary

and precarious employment, outsourcing (tercerizacion) and informality have had a

remarkable growth in recent years. Thus, the formal sector and informal sector look more

similar.

2.2. POVERTY IN COLOMBIA

Poverty is one of the most important problems that most of the Latin American

countries suffer from and Colombia is not an exception where more than half of its population

is living in poverty.

Bolivia is one of the poorest countries in the region because of its lack of access to a

port that would allow them to increase their exportations thus its revenues from trade. The

situation of the citizens of Bolivia is disturbing as Kalmanovitz (2010) shows that the 64% of

the population is in poverty and 35% in indigence. A contrasting example is Chile that is one

of the countries with the lowest levels of poverty, since its economic growth is one of the

most important among the Latin America regions. It is possible to say that economic growth

tends to reduce poverty as it causes access to more resources that can be used in policies that

combat poverty (nutrition, health and education programs).

Colombia reduced the poverty as some important indicators such as censuses suggest,

that were based on the criteria of unmet basic needs (UBN2). Thus, the principal purpose is to

measure the intensity and the level of poverty.

2 UBN indicator is the percentage of persons or households with one or more unmet needs identified as

basic to subsist. The indicator contemplates education, through school attendance, and infrastructure

The Colombian economy went through various economic booms as the one that

increased the employment in the construction sector (that employs families with low incomes)

and that brought bigger salaries to its workers. These wages explain that in more than three

decades the population with two UBN has been reduced from 45% to 11% of the total.

Table 2.1. UBN percentages in Colombia

Año 1 UBN 2 UBN Inadequate

Home

Inadequate

Services

Critical

Overcrowding

Scholar

Absence

1973 70.5 44.9 31.2 30.3 34.3 31.0

1985 54.4 22.8 13.8 21.8 19.4 11.5

1993 35.8 14.9 11.6 10.5 15.4 8.0

2005 27.7 10.6 10.4 7.4 11.1 3.6

Source: DANE, Censos Nacionales

The insufficiency in the economic development of Colombia has become an important

reason of why the informality of labor has increased and affected a majority of the population

occupied. More than half of the population is living in poverty and 15% of the population is

living in indigence. The impotence of the state for resolving this problem is evident because

there are not sufficient investments on programs such as nutrition, health and education.

Therefore, the implementation of stronger and well-funded public programs to combat

poverty, that is evident in the streets of Colombia, is necessary.

2.3. EDUCATION

During the ninetieth century, the public and private sector did not have a lot interest to

invest in education and technical preparation of the population. This is an important reason for

the number of students in primary school being low in the beginning of the twentieth century

and that the average years of study of the population were only 7.5 years.

conditions. (The following indicators are added according to unmet basic needs: inadequate housing,

inadequate services, critical overcrowding, high economic dependence and truancy.)

2.4. INCOME DISTRIBUTION

The most important indicator used to measure the degree of inequality in income

distribution is the Gini coefficient3. Between 1938 and 1988, the Gini coefficient in Colombia

rose, which indicates an increase in income inequality during these fifty years.

By 1930, majority of Colombia‟s population resided in rural areas. According to

Kalmanovitz (2010), peasant workers had an income of 200 pesos in 1938 while employees of

the urban centers received 368 pesos. This shows that there was a gap between the wages of

rural and urban workers. That served as an incentive for the migration to urban areas. Due to

these migrations, the factor productivity grew faster than wages letting the employers and

landlords gain bigger incomes than the employees.

2.5. POVERTY AND INEQUALITY IN INCOME DISTRIBUTION

Colombian development during the twentieth century was providing in an atmosphere

of inequality in the distribution of income and surpluses that benefited businessmen, bankers

and landlords as well as the construction industry, commerce and agroindustry sectors. This is

shown in the national accounts (See Banco de la Republica, Cuentas Nacionales). However,

by the end of the century, almost half of the population was in poverty and one-sixth of it was

in misery, which are shown as major challenges for public policy of the country.

Due to favorable results (by the improvement in the terms of trade and the great

expansion of world trade) in the economic and social development between 2006 and 2010,

the reduction of poverty and indigence in the last 15 years has been the most significant one.

Throughout the twentieth century, taxes were low and in this manner, the capacity of

the state to alter the distribution of public investment and public goods universally was

limited. This scenario began to change when the National Front came to power in 1958. This

administration devoted more resources to basic education, which increased more significantly

with the change given by the Constitution of 1991 (which included greater attention to health

and other social programs).

3 If this indicator is close to 0%, the distribution of income is considered fair, while if it reaches 100%

is interpreted as an extremely unequal distribution.

2.6. CONSTITUTION OF 1991

By the end of the 1980s, Colombia was suffering from slow economic growth. In

order to solve this problem, a set of reforms on the constitution were required. These reforms

were started on 1990. The reforms included enhancing competition, market reforms, the

strengthening of the stability and an increasing the role for the private sector. For the political

and the judicial institutions, a promotion of equality of opportunities was required. A more

equal distribution of the outcomes of the growth across the regions and individuals was also

targeted.

By the end of 1990, a constitutional assembly was given the task of rewriting

Colombia‟s 100 years old constitution. The most important changes made can be listed as a

higher expenditure in education and the health system, a broadened access to the judicial

system and the political processes. In the monetary area, the independency was given to the

central bank. Additionally, fully funded private pension funds were introduced.

During the decade that followed the launch of the reforms, the economy did not

perform well. The fiscal position was weak, the economy was vulnerable and volatile, the

reduction in poverty became slower, and income distribution got worse because of exogenous

factors that played a big role4. When the Asian crisis hit Latin America, Colombia was in a

weak macroeconomic position (An output contraction affected specially the poorest people).

More rapid growth and a new, positive trend in the reduction of poverty were recently

achieved, after the fiscal imbalances were corrected, and the security in Colombia improved,

in the context of a positive external environment.

After the launch of the reforms of 1990, some facts about the performance of the

Colombian economy are:

-The good performance of the 1970s went to mediocre in the 1980s to very poor until

present years. In 1999, Colombia saw its first economic contraction in seventy years.

-Among the large countries in Latin America, Colombia is the only one which has low

4 Among these factors we can point to: an unfavorable international environment, a bad security

situation, and a crisis in the mid 1990‟s following allegations that a drug cartel, had financed a

presidential campaign.

growth (as a matter of fact, a historically low level of growth), weak fiscal balance and high

public expenditure during the decade following the reforms.

-Inflation declined over the years and now hovers at around 4 to 6 percent a year.

2.6.1. Macroeconomic Stability Targeted by the New Constitution of 1991

When the 1991 constitution gave independence to the Republic Bank, the task and the

authority of arranging the exchange rate, the monetary and credit policies were also given to

the Republic Bank, to the board of directors in particular. The constitution also clarifies how

this board should be composed. Five of the members should be elected by the ruling

government for concurrent terms of four years; only two of these five members can be

replaced every four years5. Another member of the board is the minister of finance. Together

with the other five members, the minister of finance selects the governor of the central bank

for four-year terms that can only be renewed twice.

Yet another reform that the change in the constitution brought was the transformation

of the pension system in 1993. The old system required the citizens to pay for the pension

system before being able to use it. The benefits and the amounts of contribution were different

from person to person. The new reform established two subsystems: The first one, as the old

system, required the citizens to pay for the pension system before being able to use it; and the

second one was subsidized by the individual savings and it also involved privately managed

funds (administradoras de fondos de pensiones, or AFPs). The reform also included an

increase in the retirement age, the contribution rates and in the eligibility requirements.

Before 1990, Colombia had many tax reforms but the new one brought by the

constitution of 1991 increased the tax revenues that were used to finance public expenditure

(which was increased due to the many reforms brought by the constitution change).

5 The tenure of the Colombian president is four years, and until 2005, the president was not able to

seek a second term (but the change made by the President Alvaro Uribe in the Constitution via a

constitutional referendum achieved the re-election process to be legal).

2.6.2. Labor Reform by the Constitution of 1991

Nonwage cost increased from about 40 percent of payrolls in the 1980s to 56 percent

in 2004 (Cárdenas and Meicer-Blackman, 2006; Bernal Cárdenas, 2003).6 By 1999, Colombia

had the second-highest nonwage labor costs in the region. A study by the World Bank (2005)

shows that the rise in nonwage costs has constrained the demand for labor while increasing

supply.

FIGURE 2.1. Colombia: Non-wage Labor Costs, 1977- 2005a Percent of salary

Sources: Cárdenas and Mercer-Blackman (2006); Bernal and Cárdenas (2003).

a. Includes parafiscal payroll taxes (contributions to ICBF, SENA, and CCFs),

contributions to social security (health, pensions, severance payments, and professional risks),

paid vacations, and mandatory bonuses.

A new reform was made by 2002, which tried to increase the formalization of

employment (It reduced overtime pay and made the workday and the workweek more

6 Nonwage costs are composed of the following: parafiscal contributions, which sum to 9 percent of

payroll, consisting of 2 percent for SENA (Servicio Nacional de Aprendizaje, the vocational training

program), 4 percent for ICBF (Instituto Colombiano de Bienestar Familiar, the family welfare

program), and 3 percent for the CCFs (cajas de compensación familiar, or family compensation funds), which are private funds involved in a host of activities including cash subsidies, recreation and

cultural activities, and unemployment insurance; contributions to severance funds and paid vacations;

health contributions, which rose from 7 percent to 12 percent in 1993 and to 12.5 percent in 2007; and

contributions to pensions, which rose from 6.5 percent to 13.5 percent in 1993 and to 15.5 percent in 2002, with an additional 1-percentage-point contribution for those with high salaries. Other sources

have estimated these percentages to be slightly different. These nonwage labor costs are calculated

using author-specific definitions of payroll taxes, mandatory bonuses, and so on. For example, according to the World Bank (2005), total nonwage costs were about 47 percent in the late 1980s and

rose to around 60 percent in 2004. ( Steiner, Clavijo and Salazar ,2000)

flexible, changed the apprenticeship contracts, which no longer involve parafiscal

contributions, and reduced the firing costs). Gaviria (2004) estimates that the reduction in

firing costs and overtime pay barely compensates for the increase in pension contributions

enacted at the same time.

3. A BRIEF REVIEW OF RELATED LITERATURE

In this part, first, there will be an explanation of the production function approach that

will be used in the empirical parts of the paper, afterwards there will be a review of the related

literature that uses the former approach. Subsequently, there will be a review of the literature

about the role of macroeconomic instability on economic growth, and how the political

economic factors affect the macroeconomic instability and growth. Finally, there will be a

review of some Colombian studies about the importance of macroeconomic instability and

related factors and their effects on the Colombian economy.

3.1. PRODUCTION FUNCTION APPROACH AND ITS APPLICATIONS: A

SELECTIVE REVIEW

The methodology of the production function is extensively used in empirical studies.

The Production function approach usually starts with the specification of a generalized Cobb-

Douglas.

One author who used this methodology in one of his works is Aschauer (1989). After

making a series of transformations, he proceeds to estimate the following equation for the

U.S. economy:

yt – kt = a0 + a1 t + a2 (nt – kt) + a3 (gt – kt) + a4 cut + ut (3.1)

yt – kt = a0 + a1 t + a2 (nt – kt)+ a31(k1t – kt) + a32 (k2t- kt) + a4 cut + ut (3.2)

where yt, kt, nt, gt, and cut are the logarithms of aggregate real production of the

private sector (Yt), the aggregate capital stock of non-residential (Kt), private sector

employment (Nt) of public capital stock (Gt) and the rate of capacity utilization (cut)7,

respectively. k2t and k1t represent the logarithm of the stock of public capital in two different

7 This term is included to take into account the influence of the economic cycle.

sectors of the economy8. a2, a3, a31, a32 and a4 are the output elasticities with respect to n, g, k1,

k2, and cu respectively. a0 + a1t is a term that seeks to collect technical progress. Finally, u t is

the error term in the econometric estimation.

The main aim of Aschauer (1989) is to analyze the role of different types of public

expenditures on output. After the estimation of the previous equation, Aschauer (1989)

reached to the proceeding conclusions: First, that the public investment of the government has

an important effect on economic growth9, and second, that the investment in infrastructure

(roads, water, electricity and gas) has a bigger impact on the productivity of the economy than

the government spending and the military public investments.

The main idea behind the work of Aschauer (1989) can be summarized as follows.

The level of productivity of the economy increases due a rise in the rate of return of private

capital10

that is created by the public investment, which in turn stimulates spending in private

investment and thus economic growth.

For another example of the application of the methodology of the production function,

we have Ghura‟s (1997) study, which investigated the factors that affected the economic

growth between 1963 and 1996 in Cameroon.

Ghura used the following Solow-Swan type of aggregate production function,

modified to include different types of capital stocks (private and government physical capital

stocks and human capital stock). The modified production function that Ghura uses in the

study is shown below:

Yt = Αt (Kp

t)α g

t)β (Zt)

Zt = Ht Lt (3.3)

Where Y is output; A represents technology; Kp

is private physical capital stock;

g is

the government physical capital stock; and Z is labor (L) adjusted for human capital

development (H).

8 Depending on the number of sectors it could include a k3t, k4t, etc.

9 That leads him to assert that a large proportion of the decline in the productivity of U.S. GDP during

the seventies can be explained by the decline in public investment spending. 10

The positive impact of public investment on private investment is greater than the negative

crowding-out effect, (See Aschauer 1989 for more detail).

The author finds that physical and human capital accumulation, as well as economic

policies, influenced the economic growth of Cameroon significantly. Additionally the private

and public investments have a positive influence on the economic growth. According to the

empirical results, an increase of 1 percentage point in private investment creates an increase

of 1.4 percentage point in the economic growth of Cameroon, this increment is larger than the

one experienced by Cameroon in the case that the public investment increases.

Ramirez (1998) studied the relation between public and private investment spending,

economic growth and productivity for the Mexican economy for the period from 1950 to

1990. Ramirez specified the public capital stock in a modified neoclassical production

function. The author finds that the growth in public and private investment spending has a

positive effect on the rate of productivity growth and the increment in government

consumption, in some cases, affects the rate of productivity growth negatively, which implies

that the composition of the government expenditure is important for the growth rate of the

economy and its productivity. The error correction models that the author performed gave a

positive feedback in terms of the simulation of the historical data on productivity growth for

the Mexican economy.

Khan and Kumar (1997) studied the role of public and private investment of growth for

95 developing countries for the period from 1970 to 1990 using a Cobb-Douglas production

function. The countries included in the paper account for 90% of GDP of developing

countries and this allows a broader consideration of the hypothesis that the public and private

investments have different effects on developing countries. The authors concluded that private

investment during the 1980s had a larger impact on growth than public investment, and that

the effects of public and private investment on growth and their rates of the return differ

significantly between the regions. For Latin America and Asia, the difference between these

effects is more apparent than for Africa, Europe and the Middle East. There is as well an

important difference across income groups, where the rates of return of public investment are

higher for low-income countries than for high-income countries. Finally, the authors conclude

that increasing competition and the exposure to foreign technology will have dynamic effects

on growth and that giving more importance to education will stimulate private investment and

a sustainable long-term economic growth.

3.2. INSTABILITY AND GROWTH

Ocampo (2005) provides an explanation about the macroeconomic stability concept,

by considering elements like price stability, fiscal policies as well as real economies that are

working well, debt ratios that are payable by the governments, public and private sector

balance sheets.

One of the most important indicators of lack of stability in an economy is the inflation

rate. A high inflation negatively affects the economy via capital accumulation and

productivity expenditures. A high inflation also raises the demand for dollars in the economy

at the cost of reducing the demand for domestic currency and the loss of the seigniorage

revenue (Ismihan, 2003).

So what happens when the level of instability of the economy increases? Well this

would affect the economic growth negatively through certain mechanism such as uncertainty

that decreases the rate of productivity of the economy and also the rates of private investment

and will create a wave of capital flight that will decrease the capital accumulation (Ismihan,

2003).

So as noted before an economy needs stability to be able to enhance a long-term

growth pattern, and to induce the investment (public and private as well).

3.2.1. Empirical Evidence

Cardoso (1993) analyzed the private investment in Latin America and its reaction to

instability, growth and to real exchange rate depreciation as well as to the terms of trade. The

author uses quadrennial panel data for Argentina, Brazil, Chile, Colombia, Mexico and

Venezuela for the period from 1970 to 1985. Cardoso finds that the variation of private

investment share in output is explained as 74% by the growth, the share of public investment

in GDP, and the log of terms of trade.

Also the author confirms the hypothesis of complementarity between the private and

public investments, and that the improvement on the variable of terms of trade affected the

investment positively. Additionally, Cardoso found that the real exchange rate and the real

rate of depreciation had no effect on investment. Finally, and most importantly, Cardoso

(1993) found a negative effect of economic instability on private investment.

A seminal paper by Fisher (1991) investigated the connection between the

macroeconomic policies and growth. The author came to the conclusion that the stability in

the macroeconomic environment is necessary for growth and for it to be sustained for longer

periods. Moreover, the economic strategies that the government pursue and the size and role

of the government (in the provision of physical and social infrastructure especially for human

capital) is crucial.

Ismihan (2003) conducted an empirical study for the case of Turkey for the period

from 1963 to 1999 by including variables like real GNP, real private fixed investment, real

public investment, real public fixed infrastructural investments and the macroeconomic

instability index. He reached to the conclusion that the two types of public investment have

asymmetric effects on the macroeconomic performance and that the instability that affected

the macroeconomic environment, had a negative effect on the capital formation and on the

economic growth. Ismihan (2003) also concluded that the macroeconomic instability is a

severe problem which damages the relations between public and private investments in the

long-term.

Ismihan (2009) provides another empirical study about the role of the macroeconomic

instability on the potential growth rate of the Turkish economy from 1960 to 2006. This study

uses the production function approach and concludes that the Turkish economy suffered from

a significant output loss during the chronic instability episodes, between 1970s and 2001.

However, Turkey from 2002 to 2006 had a high growth mainly due to the reduction in

macroeconomic instability. Finally, he concluded that if the Turkish government wants to

continue high growth rates it is necessary to speed up both human and physical capital

formation while maintaining stability.

Another example of the relationship between macroeconomic stability and economic

growth is given by Sanchez-Robles (2006) who studied relations such as the macroeconomic

instability (composed by inflation, public deficit and various types of public expenditure as a

share of the GDP) and market distortions for the Spanish economy for the period from 1962

to 1995. The findings of the author can be summarized as follows:

Investment/GDP is highly correlated with the economic growth in the short and long

run (this indicates that the capital accumulation has an important role in the economic

growth of Spain in the last decades),

The inflation rate affects the economic growth negatively,

The total public expenditure as share of the GDP affects the economic growth

negatively in the long-run (this is especially the case of unproductive expenditure),

The public deficit/GDP also affects the economic growth negatively,

Distortions in some markets (especially foreign exchange and oil market) appear to

affect the economic growth negatively,

As a final conclusion the macroeconomic instability and the markets distortions have a

negative correlation with economic growth. Sanchez-Robles give the advice that the

macroeconomic stability and the liberalization of markets are necessary for the

Spanish economic growth.

3.3. THE ROLE OF POLITICAL ECONOMY FACTORS IN

MACROECONOMIC INSTABILITY AND GROWTH

Instability in political and economical environment has important effects over the

economic growth of a country. A paper by Rodrik (1999) has pointed out that democracy is an

important variable of economic growth. When a country suffers from lack of democracy, it

affects the output of the country negatively. However, when the citizens force the government

to be more democratic, this will encourage better policies that could benefit the society.

Rodrik (2000) analyzes wether it is wise to use the integration policies as a development

strategy for the developing countries. Even integration has positive sides for economic growth

in developing countries, it also brings within highly demanding institutional prerequisites (the

institutional changes are expensive and these changes involve the expenditure of scarce

human resources, administrative capabilities and political capital that could actually take these

capitals away from more urgent priorities). Rodrik concludes that “openness is not an

adequate substitute for a developing strategy” (2000: P2) and that even many economists

know that trade comes with many gains, these gains actually tend to be small. Even with the

evidence on trade protection should not be preferred for trade liberalization. The author

suggests that a strategic use of international trade and capital flows is necessary (especially

the developing economies should open their capital accounts in an organized and progressive

manner) as part of a strategy of development, not as substitute for it.

Institutions and their role in economic growth has become an important subject of study

by many economists and as Douglass North defines “efficient institutions motivate self-

interested individuals to act in ways which contribute to collective welfare” (qtd. Szirmai,

2012, pp. 35).

For instance, Baily (1994) suggests that institutions play an important role in the growth

and in the stagnation of growth in the economies. Baily explains that in Latin America the

capital accumulation did not guarantee economic growth because some of the investments in

infrastructure never became operational (steel facilities specially) and in human capital

accumulation even there were bigger investments, the skills of the work force sometimes are

not well utilized because of inefficient companies that in some cases are regulated by the

government. In the study, Baily analyzed five developing economies (Argentina, Brazil,

Colombia, Mexico and Venezuela) in comparison with developed economies and their

performance in four industries (steel, processed food, retail banking and telecommunications).

In this study, the author concluded that a shortage of capital was not the only reason for low

productivity in the afore-mentioned countries: in some cases the investments were wasted or

given to a particular sectors instead of diversifying them. Baily also found that the shortage of

skilled production labor was not a significant reason for the low productivity (what is

necessary is that the companies should have trained their employees better). Finally, Baily

affirms that if the Latin American countries pay more attention to creating better and more

efficient institutions this could create a better long-term growth.

An important cause of instability is the political institutions. If a country has many

political parties; this will have a negative effect over the macroeconomic stability (because of

the large transfers of funds from the government to the parties as well as the diversity of ideas

and plans launched).

Reinhart (2004) found as well, that the more democratic the institutions are, the better

the perception of the risk of lending to that country by institutional investors is.

According to Rajan and Zingales (2003), trade openness is a mechanism for limiting

the redistribution of the wealth towards the elites because if a country opens its trade, it will

raise the cost of the monetary policies (inflation) and it will be harder for particular

individuals to justify the self distribution.

3.4. ECONOMETRIC STUDIES FOR THE COLOMBIAN ECONOMY: AN

OVERVIEW

Macroeconomic instability, poor public investment, inequality in the distribution of

wealth and corruption within the political institutions (where the primary budgets are

managed) are frequently the problems related to Latin American countries.

One author who studied the role of corruption in Colombia was Rojas (2004), who

concluded that the corruption is one of the problems that must be fixed in a developing

economy like Colombia, because it has a negative effect over the economic growth. A recent

example is that the last mayor of Bogota (Colombia‟s Capital) was involved in the so-

publicized hiring carousel (carrusel de las contrataciones) that cost to the city more than 2

billions of pesos (RCTV) and the destruction of the roads and also the dismissal of Samuel

Moreno from the administration (and the new relocation of contracts that were already paid to

not so ideal companies for the development of infrastructure in Bogota) which ended up

reducing the output of Bogotá that is one of the major contributors of the economic growth in

Colombia .

In addition, there are studies about the role of the infrastructure on economic growth

and one example is the paper of Strauch (2002) for the Republic Bank. Strauch concludes that

the total public investment has no significant impact on economic growth. However, if there

is an increase in public investment in the areas of electricity, gas, water, education, mining

and manufacturing, it is possible to obtain higher levels of production.

Unlike other studies, public investments in infrastructure, especially the one directed to

construction of roads, did not have a strong positive impact on economic growth; on the

contrary, it was slightly negative. The above conclusion may be that in this study, unlike other

studies, public investments in roads correspond to monetary disbursements made by the

government and not to the number of existing roads.

A study that researches the effects of external public debt is the one made by

Salamanca and Monroy (2008) that used a TAR non-linear model for the period from 1994 to

2007 to explain how the external debt of Colombia could affect the private investments. The

authors came to the conclusion that there is no linearity between them and that there is an

inverse relationship between the growth of investment and the growth of the external public

debt. They also provide evidence that the long-term inverse relationship between the variables

is symmetric and that in the short-term the relationship is asymmetric. Finally, they concluded

that recessions affect the investments in a more permanent way, when the economy is in a

state of external excessive indebtedness.

In the topic of macroeconomic instability and its effect on growth in the case of

Colombia, we can find the research made by Cardenas and Urrutia (1995). This study

concludes that, for the Colombian economy, the macroeconomic stability is a necessary,

though not a sufficient, condition to achieve social progress. The best instruments for reaching

economic stability are the institutions and policies and that the social benefits generated by

fiscal and economic stability are worth the costs for being able to reach it.

4. THE ROLE OF MACROECONOMIC INSTABILITY ON GROWTH RATE IN

COLOMBIA: AN EMPIRICAL INVESTIGATION

In this section, the empirical model is estimated for the Colombian economy for the

period of 1950 to 2009. Initially unit root tests are conducted to determine the order of the

integration of the variables. Both long-run and short-run analyses are performed by using

cointegration and error correction models, respectively.

4.1. THE MODEL

To investigate the role of macroeconomic instability on economic growth rate in

Colombia between 1950 and 2009, its used the approach of the production function and

specified the following Cobb Douglas model11

:

Yt = e Θ

0 + Θ

1 Z

1t + Θ

2 Z

2t +…..+ Θ

m Z

mt Ktα Ht

β (4.1)

where Yt represents real GDP, Kt represents capital stock, Ht represents human capital,

the parameters α (β) represent the output elasticity of physical (human) capital and Zt (i=1,

11

For more detail, see Ismihan (2009).

2,…., m) may represent openness, research and development expenditures12

, and

macroeconomic instability which may affect the level of total factor productivity.

Following Ismihan (2009), its obtained the below log-linear model:

Ln Yt = Θ0 + Θ1MIIt + Θ2Openkt + α Ln Kt + β Ln Ht (4.2)

where MII is the macroeconomic instability index; Openk is the openness, Ln X is the

natural logarithm of X and the other variables – Y, K, H- are the variables that are mentioned

before.13

And Θ1* 100 and Θ2 * 100, represent output semi-elasticities with respect to MII and

Openk, respectively.

4.2. THE EXPECTED SIGNS

According to the literature reviewed in part 3, the expected signs of the variables of

the model are as follows:

MII: Θ1 < 0; Macroeconomic instability index is expected to have a negative effect on

output (Yt).

Openk: Θ2 > or < 0; Despite the gains from the trade liberalization, if it is not handled

properly by the government, (or inconsistent with development strategies) it may have

adverse effects on the economy. Therefore, the sign is not clear (see part 3)

Ln Kt: 0 < α < 1; The capital stock is expected to have a positive effect on output (Yt).

Ln Ht: 0 < β < 1; The human capital is expected to have a positive effect on output

(Yt).

4.3. THE DATA

The data used in this study are Colombian annual data from 1950-2009. The

definitions of the variables used in the model are provided below:

12

Unfortunately, the data on research and development expenditures are not available in the Colombian statistical institutions for the whole period. 13

The data sources and definitions can be found at the Annex.

Ln Y: Natural logarithm of real GNP,

Ln K: Natural logarithm of capital stock,

Ln H: Natural logarithm of human capital,

OpenK: Openness (Trade to GDP ratio),

MII: Macroeconomic instability index.

In the following sub-sections, the variables that are used in the model are explained.

Furthermore, the data set used in this model can be found at the annex of the paper as well

their construction, the definitions and their sources.

4.3.1. Ln Y

Figure 4.1 provides the time plot of the Log real GDP. The data is taken from the Penn

World Table (Version 7.0).

As shown in the Figure 4.1, Log GDP had a steady rising pattern over the years, that

only suffer a setback for some periods. For example, the years from 1997 to 1999, which can

be explained by the crisis of corruption, which started when there were allegations that some

of the funds of the presidential campaign of Ernesto Samper were given by the drug cartels.

FIGURE 4.1 Time plot of Ln Y

23.5

24.0

24.5

25.0

25.5

26.0

26.5

27.0

50 55 60 65 70 75 80 85 90 95 00 05

LNY

4.3.2. MII

The Macroeconomic Instability is one of the most important variables in this model

that can affect growth in a negative manner (and it is one of the central objectives of the

thesis). As shown in Figure 4.2, the index continuously moved from peaks to troughs and

many of those movements have to do with political and economic events, for example:

From 1948 to 1958, the increase in the macroeconomic instability was due to a civil

war that left more than 200.000 deaths, which affected the administration ruling between

those years and did not allow the plans of the presidencies to be able to correct the instabilities

that the country was passing trough. Another important fact is that from 1953 to 1964 the

violence between the two political parties (Liberal Party and Conservative Party) increased

the political instability in Colombia. Drug cartels that emerged in the late 1970s, gain more

power during the 1980s and 1990s. The Medellín Cartel under Pablo Escobar and the Cali

Cartel, in particular, exerted political, economic and social influence in Colombia during this

period.

After the promulgation of the Constitution of 1991, the country has continued to be

plagued by the effects of the drug trade, guerrilla insurgencies like FARC and paramilitary

groups such as the AUC who have engaged in an internal armed conflict. President Andrés

Pastrana and the FARC attempted to negotiate a solution to the conflict between 1999 and

2002. The government set up a "demilitarized" zone, but repeated tensions and crises led the

Pastrana administration to conclude that the negotiations were ineffectual.

During the presidency of Álvaro Uribe, the government applied more military pressure

over the FARC and other outlawed groups. This military pressure, supported by the United

States, caused many of the security indicators to improve. Reported kidnappings decreased

(from 3,700 in 2000 to 172 in 2009 (Jan.-Oct.)) as did intentional homicides (from 28,837 in

2002 to 15,817 in 2009 according to the police 28,534 to 17,717 according to the health

system during the same period).

FIGURE 4.2: Time plot of MII

.0

.1

.2

.3

.4

.5

.6

.7

50 55 60 65 70 75 80 85 90 95 00 05

MII

4.3.3. OPENNESS (TRADE TO GDP RATIO)

This variable (Openk) shows the openness of a country via its trade with the rest of the

world. According to the economic theory if a country is more open, it will make its output to

grow quickly due to the specialization that it brings within (because of competition with more

specialized countries). However, for the Colombian case we could say that when the economy

is more open to international commerce, the output actually decreases. This seems to be a

result of the inconsistency between the integration and development strategies. For example,

there is a significant difference between the merchandise exported and imported between

countries, meanwhile Colombia specializes in primary sectors as the production and

extraction of agricultural products as raw materials and not so many in the secondary sector as

the technical production or tertiary sectors for the provision of services, other countries with

which Colombia trades (United States, Europe, and many other countries in Latin America)

actually specializes in the secondary and tertiary sectors that has more added value than those

of primary sectors. This, in turn, means that Colombia‟s gains from trade are smaller than its

counterparts. The data of openness was taken from the Penn World Table (Version 7.0).

As shown in Figure 4.3, the most important change starts at 1991, when the

constitution of 1991 opens the Colombian economy to the global economy and hence to a

rising trade.

FIGURE 4.3: Time plot of Openk

15

20

25

30

35

40

45

50 55 60 65 70 75 80 85 90 95 00 05

openk

4.3.4. Ln H

As shown in Figure 4.4, there is an improvement in human capital over time, which

means that people are able to remain at school for longer time (for educational attainment),

which gives them better capacities that could affect the final output. Data is taken from DNP

(Departamento Nacional de Planeacion).

FIGURE 4.4: Time plot of Ln H

8.0

8.4

8.8

9.2

9.6

10.0

50 55 60 65 70 75 80 85 90 95 00 05

LNH

4.3.5. Ln K

As shown in Figure 4.5, there is a rising trend on the capital stock of Colombia for the

sample period. The data used for the calculation of this variable is taken from the Penn World

Table (Version 7.0)) is an author calculation.

FIGURE 4.5: Time plot of Ln K

24.8

25.2

25.6

26.0

26.4

26.8

27.2

27.6

50 55 60 65 70 75 80 85 90 95 00 05

LNK

4.4. UNIT ROOT TESTS

The regression analysis based on time series data implicitly assumes that the

underlying time series are stationary (The classical t test, F test and many more are based on

this assumption). Otherwise regression results would be spurious (Gujarati, 2004).

A test of stationarity (or nonstationarity) that is widely popular are the unit root tests.

Stationarity can be checked by finding out if the series contains a unit root. The Dickey-Fuller

and Augmented Dickey-Fuller (ADF) tests can be used for this purpose.

Note that Figures 4.1 to 4.5 show the time plots of the variables appearing in the

model. Is notorious that in all the figures there is an upward trend, suggesting the mean of the

series have been changing. This may imply that the series are not stationary. However, in

order to confirm this conclusion, it is necessary to make formal tests of stationarity. The

formal unit root test results are provided in Table 4.114

.

14

Note that an ADF test that will show whether there is unit root or not. If the series have a unit root, it

means that the series is non-stationary, but if the time series does not have a unit root, it means that the

series are stationary.

TABLE 4.1: ADF Unit Root Test Results

Variables

ADF Test

Level First difference

Without Trenda With trend

b Without trend

a

LnH -0.354419(4) c -3.492149(4) -2.912631(4)

[0.9096] d [0.0372] [0.0000]

LnK -2.913549(4) -3.489228(4) -2.913549(4)

[0.9715] [0.0050] [0.0030]

LnY -2.91173(4) -3.487845(4) -2.912631(4)

[0.7528] [0.5491] [0.0000]

openk -2.91173(4) -3.487845(4) -2.913549(4)

[0.9648] [0.8251] [0.0048]

MII -2.91173(4) -3.487845(4) -2.915522(4)

[0.1349] [0.0901] [0.0000]

a ADF regressions include an intercept but not a linear trend

b ADF regressions include both an intercept and a linear trend

c Numbers in parentheses are the order of augmentations (p*) chosen by the Akaike Information

Criterion (AIC)

d The angular parentheses values are the p-values

According to the results found in Table 4.1, (without considering deterministic trend in

ADF regressions) Ln Y, Ln K, Ln H, Openk and MII, have unit roots. However, when the

ADF regressions had a trend, only Ln Y, Open and MII have unit roots at 5 % significance

level. Ln K and Ln H seem to be trend stationary. Taking a first difference, all the variables

are stationary (in difference form).

In sum, the variables Ln Y, MII and Open are non-stationary that is they have unit

roots but Ln K and Ln H are most likely to be characterized as trend stationary.

4.5. COINTEGRATION RESULTS

There is a possibility that the regression of a nonstationary time series variables on

another nonstationary time series variables may produce a spurious regression. Since most of

the the variables possess unit roots meaning that they are I (1), now the cointegration analysis

is performed to avoid a spurious regression. This is highly important in empirical analysis

with time series data, as nicely summarized, by Gujarati, below:

“Economically speaking, two variables will be cointegrated if they have a long-term,

or equilibrium relationship between them. The valuable contribution of the concepts of unit

root, cointegrations and so on, is to force us to find out if the regressions‟ residuals are

stationary" (Gujarati, 2004; 822). As Granger, notes “A test for cointegration can be thought

of as a pre-test to avoid „spurious regression‟ situations” (Cited in Gujarati, 2004; 822)

Since the model has more than two variables, the Johansen15

multivariate technique is

used for a cointegration analysis. This technique is now well known and widely used in

multivariate cointegration analysis. For the model (4.2), the performed Johansen test can be

found at Table 4.2.

Table 4.2: Johansen Test Results

Test of Cointegration Rank

Eigenvalues 0.691393 0.333936 0.221329 0.098411 0.018630

Null Hypotheses r=0 r≤ 1 r≤2 r≤3 r≤4

Max Statistic 69.36554 23.97582 14.75986 6.112203 1.109548

95% Critical Value 33.87687 27.58434 21.13162 14.26460 3.841466

Trace Statistic 115.3230 45.95743 21.98161 7.221751 1.109548

95% Critical Value 69.81889 47.85613 29.79707 15.49471 3.841466

From the results of the Johansen Cointegration tests (Trace and Max tests), it is clear

that there is one cointegration between the variables. For equation (4.2), the signs of the

variables are not in the right direction in the estimation results with the Johansen technique

(not reported), therefore, is preferred the use of the FM–OLS technique that considers the

endogeneity between the variables and non-stationarity. The following results are obtained:

Ln Y = 0.479+ 0.806 Ln K + 0.457 Ln H – 0.225 MII – 0.011 OPENK (4.3)

(0.409) (9.407) (3.757) (-3.829) (-7.130)

[0.684] [0.000] [0.000] [0.000] [0.000]

R2= 0.997

Note: Inside the parenthesis are the t-values, and inside the brackets are the p-values.

15

For more information about the Johansen technique, see Ismihan(2003; 164).

According to the regression equation (4.3), the variables have the right signs and they

are consistent with the theorical expectations. And from the p values, all the variables are

statistically significant.

Considering these results the growth in the output will increase 0.86 percent if capital

stock increases by 1 percent via investment, and the output will increase by 0.46 percent if the

human capital (via a better education and a larger number of years at school) increase by 1

percent. However, if the Colombian economy open its commerce 1 percentage point this will

bring a negative16

effect over the economy decreasing the growth also in 1.1 percentage

points, and if macroeconomic instability increases by a 0.1 point (via public deficit, external

debt, inflation, change in the exchange rate) then the Colombian growth will decrease by 2.25

percentage points.

An interesting result from the previous findings is that, meanwhile the openness

variable in the traditional economic theories affirms that when a country is more open to

foreign competition and commerce it will create a chain of specialization, better use of the

capital and access to better technologies for production will end up increasing the output of a

country. In the main results of the model, shows that when a country is more open to

international commerce, the output actually decreases. This could be a consequence of the

difference between the merchandise exported and imported between countries, meanwhile

Colombia specializes in primary sectors as the production and extraction of agricultural

products as raw materials and not so many in secondary sector as the technical production or

tertiary sectors for the provision of services, other countries with which Colombia trades

(United States, Europe, and many other countries in Latin America) actually specializes in

the secondary and tertiary sectors that has more added value than those of primary sectors .

This, in conclusion, means that Colombia‟s gains from trade are smaller (or even negative)

than its counterparts. Therefore, this result is in line with Rodrik‟s (2000) argument that trade

integration may produce worse results when there is an inconsistency between the integration

and development strategies.

In previous analysis, was found that there is a cointegration relation between variables,

which means that there is a long-term, or equilibrium, relationship between them. In the short

16

In Ismihan (2009), openness variable comes out with positive sign but with insignificant

coefficients.

term, there may be disequilibrium; therefore, an error correction term that will link the short–

run behavior of the variables to its long run values can be introduced.

More formally, the following error correction model is specified:

ΔLn Y = δ0 + δ 1 ΔLn K + δ2 ΔLn H + δ3 ΔOPENK + δ4 ΔMII + δ5 û t-1 + ε t (4.4)

where Δ Ln Y: percentage change of output, Δ Ln K: percentage change of capital

stock; Δ Ln H: percentage change of human capital; Δ OPENK: change in openness; Δ MII:

change in the macroeconomic instability index; û t-1: error correction term (lagged residuals

from the cointegration relations) ; and ε: represents the error term.

A the regression for model (4.4) is performed with Eviews. Ordinary Least Squares

(OLS) regression results are presented below:

ΔLnY=0.0183+1.3318ΔLnK+0.1584ΔLnH-0.0016ΔOPENK-0.1118ΔMII-0.3504û t-1

(-1.3107) (5.0458) (1.001) (-0.6971) (-2.9733) (-3.4139)

[0.1957] [0.0000] [0.3214] [0.4888] [0.0045] [0. 0012]

Adj. R2=0.361721 (4.5)

Note: Inside the parenthesis are the t-values, and inside the brackets are the p-values.

According to the above results, the p values of ΔLn H and ΔOPENK are too high. It

means that they are not statistically significant. Therefore, they can be remove from the

model and run the regression again. These results are shown below.

ΔLnY= -0.0093 + 1.2174ΔLnK - 0.1104 ΔMII -0.3046 û t-1 (4.6)

(-0.8476) (5.0926) (-3.1056) (-3.3494)

[0.4004] [0.0000] [0.0030] [0.0015]

Adj. R2=0.371740

Note: Inside the parenthesis are the t-values, and inside the brackets are the p-values.

The sign of the equilibrium error term is negative, suggesting that Δ Ln Y adjusts to

changes in Ln K and MII in the same time period. As (4.6) shows, short run changes in Ln K

and MII have a positive and negative impact on short-run changes in output respectively. The

interpretation of 1.2174 can be as the short–run elasticity of output with respect to capital

stock; (the long-run elasticity is 0.806). In addition, -0.1104 can be interpreted as the short-

run elasticity of output with respect to MII; (the long-run elasticity is -0.225). Considering the

estimate of the error correction term, in the long term, the output can adapt itself faster

(approximately three years) to the changes in macroeconomic instability and capital stock.

5. CONCLUSIONS AND RECOMMENDATIONS

The most important results of the long-run (cointegration) model can be summarized

as follows: It is shown that if macroeconomic instability index increases by a 0.1 point (via

public deficit, external debt, inflation, change in the exchange rate) then the Colombian

growth decreases by 2.25 percentage points. It is also found that the growth in the output

increases by 0.86 percent if the spending on capital stock increases by a 1 percent, and the

output increases by 0.46 percent if the human capital (a better education and a larger number

of years at school) increases by a 1 percent. However, if the Colombian economy open its

commerce by 1 percentage point this lowers the growth by 1.1 percentage points.

When analyzed the short-term dynamics with the help of an Error Correction Model,

it is also found that macroeconomic instability is detrimental to economic growth. It is also

found that in the long term, the output can adapt itself faster (approximately three years) to the

changes in macroeconomic instability and capital stock.

To sum up, both the descriptive and econometric evidence show that the recurrent

macroeconomic instability seriously affected the growth potential of the Colombian economy

during the 1950-2009 period. Nevertheless, there are also some final remarks that can be

made from the Colombian case. Macroeconomic instability and the recurrent crises have been

expensive for the Colombian Economy and its citizens; that is, Colombia has not reached its

economic potential and its citizens have not enjoyed the economic prosperity because of the

political, social and economic problems and associated instabilities such as the unequal

distribution of wealth, violence and corruption in the economy, especially arising from

government. Moreover, it is evident that the last two administrations (namely Alvaro Uribe‟s

administrations) that ruled the country sacrificed the productive public spending on health,

infrastructure and education which are important for reaching long-term growth and

development, for spending on war and armament (although security is an important factor for

assuring growth in Colombia, it is also important to spend on productive public expenditures).

There are several policy implications from the Colombian experience. First, it is

necessary that the government programs take the macroeconomic stability goal as important

ingredient over the long term. Second, the policy makers should give priorities to some

components of public spending such as education (For example, it is necessary to have more

skilled workers, since the structure of employment in the labor market is changing from

primary sectors to secondary and tertiary sectors). Third, government should also support

capital accumulation since it is one of the important sources of growth.

Acknowledgements

I would like to acknowledge and extend my gratitude to the following persons who

have made the completition of this paper possible: To all my beautiful family who supported

and loved me unconditionally, to my love Can who has always been patient and helpful with

all the writing process, to my thesis supervisor Assoc. Prof. Dr. Mustafa Ismihan, who

encouraged me, supported me with many ideas and made many arrangements to the paper.

Finally I thank to Jehova God for giving me this opportunity and making all my goals

possible

ANNEX

Data Definitions and Sources

Following Ismihan (2009), H, K and MII were calculated as follows:

Human Capital (H). A human capital augmented labor series (Ht) is obtained as

follows, Ht= ht Lt, where ht is the educational attainment per worker or the average per worker

human capital stock. Following recent studies , ht is estimated as: ht = ers, where st is the

average years of schooling of the adult population (aged 15 + over) and r is the rate of return

to schooling. DNP (Departamento Nacional de Planeacion) provides the average years of

schooling from 1954 to 2000 , for the years 1950 to 1953 and 2000 to 2009 the data was

recollected from the Boletines de divulgacion economica that the DNP publish diary and

annually. However, it was not possible to find a single estimate of the rate of return to

schooling in Colombia. Therefore, by following Ismihan and Ozcan (2009) the rate of returnto

schooling (r) was set as 10%.

Capital stock (K) series are not officially available for Colombia. In line with

previous studies we estimated Kt series based on the perpetual inventory method, Kt = (1-d)

Kt-1 + It, where It is gross fixed investment and d is the depreciation rate (0 < d < 1). In

accordance with a number of past studies (e.g. Bosworth and Collins, 2003, and Senhadji,

2000), the depreciation rate was set at 5% (d=0.05). Following Nehru and Dhareshwar (1993)

among others, the initial capital stock (K1959) is calculated as: K1950 = I1951

/ (g+d), where g is

the annual average growth rate over the 1950-2009 period and other variables are as defined

before. (See Ismihan and Ozcan, 2009). For calculate investment was used the total GDP that

was calculated with information (POP and GDP per-capita) from the Penn World Table

(Version 7.0).

Output (Y) was calculated from data (rgdpl * POP), that was taken from Penn World

Table Version 7.0, Center for International Comparisons of Production, Income and Prices at

the University of Pennsylvania

Openness [(Exports + Imports) / output] at constant prices of 2005 (%) the data was

taken from Penn World Table Version 7.0, Center for International Comparisons of

Production, Income and Prices at the University of Pennsylvania

Labor (L) input is measured by employment data. Source: ECONCIFRAS with

information from Departamento Aministrativo Nacional de Estadisticas (DANE) in the

Household Survey, and the Great Integrated Household Survey

The macroeconomic instability index (MII) is used as a proxy for macroeconomic

instability. This index is calculated by using human development index (HDI) methodology

(UNDP ,1992) and it is based on macroeconomic instability indicators, such as inflation rate,

public deficit to GNP ratio, external debt to GNP ratio and change in exchange rate. It is a

simple average of the four sub-indices obtained from these four variables. Note that the four

indicators are not in the same units and more importantly, they have different ranges, i.e. they

have different minimums and maximums. Therefore, it seems not sensible to sum their values

or to take their simple average in order to obtain a composite index. Fortunately, the HDI

methodology circumvents these problems, MII is therefore, constructed in two steps. In the

first step, four sub-indices are constructed based on the general formula: It = (Xt - XMin) /

(XMax – XMin), where It refers to the index value of variable X, i.e. macroeconomic instability

indicator X, in year t, Xt refers to the actual value of indicator X in year t, and XMin (XMax)

refers to the minimum (maximum) value of indicator X over the whole period under

consideration (1950- 2009). Note that in line with their construction, all sub-indices have

common ranges, i.e. they are bounded between 0 and 1. In the second and the final step, MII

is constructed by taking simple average of the four sub-indices obtained as above. Thus, MII

is also bounded between 0 and 1. (See Ismihan, 2003)

Sources: (1)Exchange rate (US$ rate) data for 1949 was found at Banco de la

Republica in an inform about the Currie Mission for 1950 to 2009 the data was taken from

Penn World Table Version 7.0, Center for International Comparisons of Production, Income

and Prices at the University of Pennsylvania (2) Consolidated budget deficit to GDP was

taken from DNP (Departamento Nacional de Planeacion) 1950-1964, Banco de la República

1962-1980 (Series estadisticas), DNP - UIP y Confis 1981-1999 , from 2000 to 2010 the data

was taken from the national accounts that presents the Banco de la Republica (3) The

external public debt data was taken from Banco de la Republica and its economic papers (4)

inflation rate calculated as a percentage change in GDP deflator (1995=100) data was taken

from Banco de la Republica.

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Banco de la Republica.

_______, “Series Estadísticas.” http://www.banrep.gov.co, Date of entry: 03.07.2011.

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